Central and eastern property markets are back on the map for institutional investors. Kostis Papadopoulos reviews the case for Poland, Czech Republic and Hungary
Over recent years there has been a surge of interest shown by investors in several Central and Eastern European (CEE) economies, particularly Poland, the Czech Republic and to a lesser extend Hungary. With core European countries suffering from anaemic growth and Southern Europe remaining over-fuelled with government, household and corporate debt, the CEE seems to be offering some leeway, albeit from selective countries.
Poland is by far the largest of the three examined, both in population and GDP levels, followed by the Czech Republic and Hungary. But, according to UN data, Poland and Hungary are shrinking at a higher rate than Europe, although still slower than Germany. The Czech Republic expects population growth primarily through high net-migration rates.
Economic growth in most CEE markets came after the fall of Communism in the Soviet Union’s in 1989 and, following significant reforms, transition to a market economy. Po-land, the Czech Republic and Hungary became full EU members in 2004, leading to acceleration of GDP growth, lower unemployment and easing of inflation, a major issue at the time. Further, there was a sharp reduction in borrowing costs, an increase in domestic demand and an influx of foreign direct investments.
However, as we approached 2009 and the credit crunch crisis was already underway, the Czech Republic and Hungary proved not to be immune and faced severe downturns. Poland on the other hand, was the only country in Europe that didn’t face a recession during that year.
All three markets have now been positioned to join the eurozone, which means they will have to satisfy strict Maastricht criteria. Currently, government debt levels as a percentage of GDP are relatively sustainable with only Hungary close to the already high 83% EU average. Budget deficits in all markets are exceeding the European threshold with Hungary facing pressure to come below the targeted 3% of GDP.
Several existing member countries are also in breach of both the government debt and budget deficit limits that euro-zone membership requires. Nonetheless, fiscal tightening measures will have to be taken before the three CEE countries are accepted in the euro-zone and that could hamper growth in the short term.
What increases their vulnerability is their dependence on public sector office employment, which is usually hurt most in fiscal contraction periods. Additionally, Poland and the Czech Republic have very close economic links with Germany, which could be an advantage when Germany is booming, but also poses risks when there is such high dependence on one country. Politically, Poland and the Czech Republic are considered stable with Hungary facing political tension after the election of a controversial prime minister.
CEE is a relatively small part of Europe in terms of real estate invested stock, which can be used as a proxy for market size. According to DTZ’s Money into Property, Poland, the Czech Republic and Hungary accounted for just 3% of the European invested stock at the end of 2010. Although the share is small, we have to consider the low value those markets started at following the collapse of Communism and the rate of the historical and likely future growth.
Over the past decade, Poland’s and the Czech Republic’s invested stock has grown remarkably. Hungary, where capital values were hit most during the financial crisis, has grown to a lesser extent. In terms of potential future growth, only 26% of the investable stock has been invested in Poland, 41% in the Czech Republic and 45% in Hungary, which presents development and sale and leaseback opportunities for the future.
Following the economic reforms of the 1990s, prime office rents in Warsaw, Prague and Budapest were at high levels as supply, affected by the political instability, could not catch up with demand. However, during the late 1990s and early 2000s, new development grew rapidly, especially in Warsaw, resulting in oversupply and a continuous drop in rents until 2005. Since then, rents in Warsaw grew aggressively and then corrected following the credit crunch. They are currently in a process of steady recovery. Vacancy rate is low but there is a significant amount of new supply coming into the market in the next few years. The Czech Republic and Budapest witnessed a drop in office rents during the credit crunch but have been stable since.
Retail in Poland has been completely reformed since the early 1990s from a limited number of state-owned enterprises to an emerging key destination of international brands. Prime unit shop rents have increased since 2004; there was a slight disruption in 2009 but rents returned to growth the following year. In Prague, prime rents have grown aggressively in the past decade, while Hungary has been more cyclical with rents rising strongly until 2007 and then plummeting to stabilise in 2010.
The industrial sector in Warsaw and Prague is in a recovery process following the financial crisis, with vacancy rates remaining elevated. Rents in Hungary had been declining from 2004 to 2010 but have remained flat since.
Prime yields have witnessed significant compression since the early 2000s when they were at 10+% levels in all markets and sectors, the only exceptions being Prague and Budapest offices at 9.25% and 9%, respectively, in 2000. The economies have become stronger, property has attracted significant foreign capital and there have been improvements in transparency.
For these reasons, fuelled by the global economic boom in the mid-2000s, yields compressed to exceptionally low levels for these markets and came to correct aggressively during the credit crunch. With the recovery underway, yields in Warsaw and Prague offer premiums of 25-250bps, and in Budapest a further 100bps relative to core Europe.
With the debt taps closed for anything not considered core, yields are not expected to move further in the short term. As the markets mature and economic conditions improve, we could see some further yield hardening, although a lot of the structural compression has probably already happened.
Poland and the Czech Republic have been through various, painful reforms resulting in a long-term strengthening both economically and from a property perspective. Additionally, they offer low total return correlations with the rest of Europe that can enhance diversification benefits. As a result, they can be included in the investable universe of a core European investor. Hungary, on the other hand, still has some way to go towards economic and political stability and would not be recommended at this time.
However, this does not necessarily mean now is the time to enter these markets. There are short-term risks of potential fiscal contractions to meet the criteria to adopt the euro. Furthermore, there are significant levels of new supply coming into Warsaw that could limit rental growth. in the long term, risks would primarily lie on the demographic side where a slight population contraction is expected in Poland. Furthermore, if the euro-zone crisis is prolonged, investors might require higher risk premiums, which could lead to a further polarisation of Europe and an outward movement in yields.
Kostis Papadopoulos is a property research analyst at PRUPIM