Keen pricing in the west and debt crises in the south helped propel investor capital towards Poland and Czech Republic. But are investors willing to explore the CEE regions further? Shayla Walmsley reports

As economic woes drag southern Europe to a financial cliff edge, the northern countries are pulling towards a recovery, creating a division within Europe which, some argue, threatens the entire union. This divergence is now becoming particularly apparent in the property markets.

Real estate investors have identified Central and Eastern Europe (CEE) as an alternative to Western Europe where: the forecast is for low growth; inflation threatens; peripheral economies are in crisis; and there is a rising currency risk. CBRE data to the end of September shows that UK investors, for example, increased their activity in the region by 80% compared with last year. But the real big spenders are Austrian - taking over from German - pension fund and insurance investors.

It helps that, as a regional real estate market, CEE has much going for it. Günter Artner, co-head of CEE equity research at Erste Bank, points out that GDP is a percentage point higher in CEE than in mature Europe and regional growth forecasts for 2012 in CEE is higher than for Europe, despite uncertainty because of dependence on exports. "The rating agencies are lagging behind - the market is already pricing in risk," he says.

In any case, few investors are looking at the region as a whole; they are looking only at parts of it, namely Poland and the Czech Republic. "Poland will be a good story internationally for the next three or four years," says Joe Valente, managing director at JPMorgan Asset Management. "There's no debt problem in Poland."

Debt might not be a problem, but pricing could be, in the medium term. Current concerns over aggressive pricing are probably slightly premature. CBRE CEE capital markets director Paddy O'Gorman, for one, believes that Polish pricing is currently at about the right level. But Valente points out that it is being driven by foreign capital, which has pushed yields down from 7% to 5%, rather than domestic or regional demand.

"If it becomes uncertain, capital might not be particularly sticky for Poland and there's no domestic market when yields are at 5%," Valente says. "I'd be more comfortable with a variety of investors in the market, and different price levels. But I think existing trends will continue in both [Poland and the Czech Republic]."

According to Charles Taylor, managing director of Cushman & Wakefield Budapest, recent post-crisis deal prices have been confined to best-of-class assets with significant investor differentiation according to income profile, location and building specification. As a result, while best-in-class Warsaw offices are transacting at close to 6%, other office assets in the capital are closer to 7%. What is noticeable, Taylor says, is a less marked differentiation in yields between the two major CEE markets and Western markets - but that is to be expected as investors increasingly see Warsaw as a core market.

There will still be takers even with meagre yields, in any case. Artner points to super-cautious Austrian institutions that still prefer to invest in residential even when yields are at their lowest. Returns are "of tertiary importance" to investors, he says. "What are important are inflation-protected returns that are relatively stable with a reasonable yield."

On the edge of the periphery
As in Western Europe in recent years, investor appetite in CEE markets has been restricted to prime assets in capital cities and, at a push, second cities. The problem is that in the Czech Republic and other CEE markets, there are a limited number of them. Poland is the exception: shopping centres have been developing outside Warsaw since 1998 with the expansion of retail. Clothes retailer H&M - the bellwether, it seems, of likely take-off - has a presence in all of them.

Otherwise, says Atrium CEO Rachel Lavine, pricing is "completely different" in large and small cities. "In secondary cities growth is negative," she says. "People are moving to the big cities."

Atrium's predicament is this: even if Hungary is showing signs of stabilisation and there is money to be made in Bulgarian developments, it needs credible credit ratings to justify the investment. So rather than focusing on development, Atrium is focusing on existing assets; and rather than looking for opportunistic investments, it is looking at prime.

"We buy in these markets and we see what's happening. When a prime asset is for sale, you see 10 bidders," she says. "When a secondary asset is for sale, bidders are hard to find," she says. "Our strategy for investing in this region is not opportunistic at all. I can't see there being any prime distressed assets."

Lavine's aversion to secondary is not universally shared. Dita Kubankova, a regional spokeswoman for DTZ, says that despite marginal yield compression on prime assets, the differential between prime and secondary products remains. As a result, DTZ is seeing increased demand from value-add investors looking for potential upside.

Increased demand for secondary assets, if such there is, could address a strong feature of peripheral CEE markets such as Bulgaria and Romania - that vacancy rates remain high, despite a meagre pipeline in some areas. "Increased demand could lower the vacancy rate pretty quickly," Artner said in a recent presentation.

Competition for assets in the Czech Republic and Poland has increased not only pricing but also the appeal of some of their neighbours, at least for somewhat bolder and yield-sensitive investors.

Certainly, some investors see potential traction, if not in secondary assets or secondary cities, in smaller or slightly riskier markets. Investors interviewed for IP Real Estate almost all said they knew of one or two of their counterparts and competitors looking at Hungary, Romania, Slovakia, or Latvia. Europa Capital, in August, took a chance on the Bulgarian market with the acquisition of the shopping centre in Sofia.

Yet if Slovakia is a borderline case (see Bratislava: like Prague but smaller), the rest of the region is lagging far behind. Furthermore, Hungary and Bulgaria are small markets with population issues. Size-wise, Romania is in a better position. Its outstanding supply issues, according to Holger Schmidtmayr, board member of Austrian property investor S-Immo, are being resolved as new tenants come in and developers' inability to secure financing for Bucharest shopping centres soaks up oversupply.

"Romania raises concerns for investors - but what doesn't?" he says. "The financial crisis helped in the sense that no one was able to get financing for a Bucharest shopping centre, which lowered the risk of oversupply." The company's Bucharest shopping centre development project is currently on hold.

Market-level shifts and their fixes are pretty much speculative when the reality is that few banks are willing to fund development in any case, hence the incomplete shopping centres dotting the Romanian landscape. "In 2008 a lot of tenants signed contracts [but] never entered the building. You have to be compensated for development risk," says Lavine.

"It's not that we're not developing, but developments make up a low percentage compared with income-producing assets. We'll invest 10-15% in development but not more than that." Even in the Czech Republic, Czech National Bank data shows an increase in credit risk of 13% for some developers and 9% for other industry operators.

It is a different picture for those developments that were actually built. Lavine says she is seeing investors slowly returning to the Romanian office market, but not in significant numbers. "Investors will slowly move towards Bulgaria and Romania because they offer a positive yield compared with Western Europe," she says.

In any case, for Schmidtmayr, as for other regional investors, there are risks and there are risks. Even if Romania is beginning to look attractive again, Kiev has "nothing institution-worthy" and Slovenia has high prices but the small market and is "too expensive for our taste".

Given investors' reluctance to venture far beyond the Czech Republic and Poland, it seems almost inappropriate to bring up Russia. Even so, this is where much of the money is going, according to the most recent CBRE data, although it is unlikely to be pension fund capital.

Data published to the end of September indicates that investors had ploughed €8bn into the Czech Republic, Poland and Russia - double the figure for the same period last year.

"There are investors active in Russia because of the high risk and high return. In Moscow, we faced a situation in 2009 where we were giving a 40% discount to most of our tenants," says Lavine. "It's a big market and a powerful market but - how do I say this gently? - a less than transparent market. In Poland we never traded at a 15% yield, but we never had to give a 40% discount either."

In any case, as Taylor points out, even for those seeking higher returns and beginning to accept country risk, the focus remains resolutely on best-of-class, low-risk assets - even within non-core, higher-risk markets.