Compelling fundamentals may present excellent opportunities for investors prepared to venture into Turkey's opaque real estate market, although political tensions never seem far away. Paul Benjamin reports

Istanbul is the megacity with a unique proposition for investors in these uncertain times: the chance to make a single play that covers two continents, both Europe and Asia.

Straddling the Bosphorus at the meeting point of east and west, this metropolis of 12m is the business and cultural centre of Turkey, the world's 12th largest economy.

Mercifully, Turkish banks have stayed out of the sub-prime disaster. The financial sector was heavily restructured after the country's own financial crisis in 2001, and many feel that the sharp slowdown the country is experiencing will be short-lived. The Economist Intelligence Unit puts GDP decline at -4.5% this year, improving to 1.2% growth in 2010.

Kerim Cin, managing partner, Colliers International Turkey, says: "Interest from foreign investors is high in principle as fundamentals such as population growth, demographics, and production capacity are still strong. However difficulties with financing development and the lack of quality income producing assets are slowing down FDI realisation."

Certainly the monetary climate is less appealing than in many western countries - interest rates are at a relatively high level, cut by over 8% in the last ten months to stand at 7.75% in August. CPI inflation is running at 5.39% and unemployment at an unhealthy 13.6%. Access to finance remains tricky.

Although a secular democracy, Turkey is troubled by political tensions that include corruption disputes, the Kurdish issue, and further pressures on the international stage with the EU, US and Iraq. EU accession, troubled by disagreements over Cyprus, remains a distant prospect and, even if everything goes perfectly, is impossible before 2015.

Yet the underlying strengths of Turkey are clear - a significant geographical, logistical and political crossroads between Europe and the Middle East. Half of Turkey's population of 70m are under 30 and getting wealthier, creating potential demand for retail and housing. The country has a strong manufacturing export base, particularly in metals, textiles and vehicles. Within Turkey, Istanbul's edge over other big cities like Antalya, the capital Ankara and the manufacturing centre of Izmir are its location, diversity and size - accounting for around a third of the national economy.

Indeed, PwC's 2009 survey, Emerging Trends in Real Estate Europe, is particularly enthusiastic about Istanbul, ranking it third out of 27 European cities for investment market prospects and awarding it top place for development prospects.

Alan Robertson, managing director, Jones Lang LaSalle Turkey, says: "There's a growing regional role for Istanbul. It is in a good time zone and its a natural choice for multinationals building a hub for Eastern Europe, the Middle East and Africa. Microsoft services around 80 countries from here."

Burhannetin Yurtseven, Istanbul General Manager of Pramerica Real Estate Investors, notes: "Istanbul is important for international companies, especially for Arab investors who want to secure their assets in a safe (but Islamic) country since Dubai got affected by the financial crunch and Beirut lost its position as a major finance location."

Istanbul's different classes of real estate show some stark contrasts. Analysts say the office sector is the most attractive option, as undersupply and a shortage of land are propping up demand.

JLL's Robertson says: "Office could come out of recession quite quickly. There was strong demand over the past few years but little construction, and that could prove to be a blessing in disguise. Demand has slowed down but because there's no oversupply the impact hasn't been as dramatic.

"We're seeing a good level of enquiries about office. Around 90% of offices in Istanbul are poor quality and multinationals who are used to grade A are underpinning demand. Many corporations are deferring relocation plans and are asking for extensions of one year."

One feature of office leasing in Turkey is that the property comes as a shell and it is left to the tenant to fit the space out with partitions, a raised floor, air con etc, which adds significantly to the overall cost.

The Istanbul CBD runs along a strip on the European side, including the areas of Levent, Esentepe, Maslak and Zincirlikuyu, while lower grade office space exists on the Asian side. There is a clear rent differential between them and an economic recovery and rising rents could see many tenants flee to the cheaper option. Also, the lack of CBD land will eventually force refurbishments and new developments onto the Asian side, or more peripheral areas of the city.

The retail picture is very different. The retail sector has been the main driver of real estate development in Istanbul and, in the space of a few years, chains of regional brands have sprung up alongside mall developments and high-end luxury outlets on both sides of the city. Istanbul saw a big number of projects come online in 2007 and 2008 and, with retail spend per m2 still relatively low, question marks remain over the viability of the new supply set to come on in 2009 and 2010, though some has been postponed.

Cin says that rents in have "already dropped dramatically, so will stabilise" and he foresees little commitment to new supply in the near future. Occupancy rates are down in 2009 and continue to fall. Colliers does not see this reversing until late 2010, though in the longer run the sector is still relatively untapped compared to other major regional cities.

Istanbul's logistics market is comparatively undeveloped and holds significant potential thanks to its location and growing retail market. While infrastructure can be quite poor and nationally there is a heavy reliance on roads, Istanbul has three ports and its international airport took half of Turkey's air freight in 2007. Much of the new warehouse development has taken place on the Asian side, which is emerging as a prime logistics site.

Another trend is logistic village projects, and the Havsa International Logistic Village due to be completed in 2011 will be the largest in Turkey. However, existing industrial stock is often of poor quality and interest from international firms is being met by property that is built to meet their needs, rather than speculative builds.

Residential prices have suffered since the global slowdown began, and are still falling, with some analysts predicting a further 15% drop. Big suburban developments which have sprung up in recent years have been worst hit, but Pramerica's Burhannetin Yurtseven says city centre and luxury are faring better. "Despite the downturn there is still demand for prime residential, especially penthouse flats in high rise buildings."

Again, the fundamentals look good, the city's population is rising and large households are fragmenting as lifestyles change. A larger middle class is emerging, as is a mortgage market, and there is pressure to replace stock that is less resistant to earthquakes. The hotel sector is also attractive, as tourist numbers have tripled to over 6m between 2000 and 2007, and existing stock lacks depth within the midrange.

The biggest challenge for investors is risk and market transparency. The PWC survey ranks Turkey as the 8th riskiest place to invest, with Moscow the riskiest and Munich the safest. JLL's global transparency index ranks it 67th, putting it in a woeful class of "low transparency" with roommates such as Vietnam, Venezula and Egypt. This is an area the country needs to improve if it is to lure more investors in. Otherwise more may agree with an investor answering PWC's survey who put it: "Istanbul is still good, but too exotic for us."