The addition of eight Central European countries to the EU in May 2004 added relatively little to the Union’s aggregate GDP. The countries, with the exception of Poland, all have relatively small populations and small economies. Yet their inclusion in the EU has had a major impact on the prevailing investment psychology of those interested in or active on the continent.
Specifically, the addition of the new members indicated an eastward expansion of the Western sphere of influence and provided evidence that the capitalist model is succeeding and spreading. As a result, Central Europe today is an attractive sub-market within the larger EU, offering real estate investors willing to explore opportunities beyond the continent’s more mature free-market economies a compelling proposition.
The Central European market consists of Poland, Czech Republic, Hungary, Slovakia, Slovenia, Estonia, Latvia and Lithuania, all countries formerly closely aligned with the Soviet Union.
Creating a closer, long-lasting relationship with the EU has already resulted in economic benefits for Central Europe, with businesses and investors correctly anticipating fast growth, as the former command economies transform themselves. The favourable conditions are expected to continue for many years, as the poorer Central European countries use their lower cost structures to attract businesses and create jobs in the manufacturing, back-office support, and retail sectors.
The income gap between Central Europe and Western Europe is likely to narrow but remain in place for at least 20 years, based on projecting recent growth rates into the future. The differential is therefore likely to be a source of comparative advantage for Central Europe for decades.
Growth in all of the Central European countries in the past five years has been strong. Each of the eight countries grew at a faster rate than the EU as a whole during the 1999-2003 period. Latvia, Lithuania and Estonia – the Baltic countries – each generated growth at a compound annual rate greater than 4.8% during the same period. Growth in Poland and Czech Republic was slower, at 2.9% and 2.4%, respectively, reflecting the countries’ closer ties with the rest of the EU, which grew at a 2% rate.
Projected growth rates suggest the strength of the Baltic states will continue. Estonia, Latvia and Lithuania are expected to generate economic growth of 5.5% or greater on a compound annual basis over the next two years, approximately three times faster than the EU as a whole. After slowdowns in the early 2000s, Poland and Czech Republic are expected to generate growth in excess of 4%, returning to levels last seen in the mid-1990s.
The surging economies of Central Europe are fueling demand for real estate from a variety of space users, with interest both from international corporations eager to pursue business opportunities in the formerly closed markets and from local businesses eager to serve newly affluent populations. Increasingly, investors are taking note. It is no longer unusual to see real estate acquisition and development deals valued in the hundreds of millions. As activity has increased, the prospects for different property types have shifted.
Office: The real estate markets in Central Europe have made significant progress since the mid-1990s, when international firms that wanted to do business locally rented residential units in the city centre and retrofitted them to become quirky, inefficient office space for employees. Early-generation office space lacked modern amenities such as air conditioning and wiring for modern telecommunication systems. Today, successful office developments in Central Europe have characteristics similar to those in Europe or North America and feature experienced international developers, international architects, high-quality construction, and professional property management.
Retail: Retail space has evolved rapidly, with international retailers such as Mango, Max Mara, and Zara establishing operations in Central Europe. Retail development has taken longer to emerge than office, as store operators overcame the challenge of stocking stores or groups of stores in countries with immature distribution systems. The pattern has been to open a flagship on the high street or in the best downtown mall and then open smaller satellite locations in other malls around town. Hypermarket-anchored shopping centres emerged at first, with fashion and entertainment-oriented centres coming more recently as personal incomes have increased. Overall, retail conditions are favourable in Central Europe, but, for continued growth and success, certain issues need to be addressed. In the largest markets, the concern is borderline oversupply, as space per capita levels approach those in Western Europe. Developers continue to see favourable economic and retail sales forecasts and continue to deliver new product. The best defence for retail owners is probably to own dominant assets in strong locations and with the best retailers.
Industrial: Modern industrial property in Central Europe has been slower to emerge than the other property types, as initial users took communist-era warehouse space as a stopgap measure. Modern distribution facilities have been developed as demand has materialized. Third-party logistics providers have been a significant source of demand for space, as have value-added assemblers. Industrial property’s importance is expected to increase. Membership of the EU and the adoption of the euro as the common currency are expected to drive increased international trade. The former Soviet-dominated countries offer cheap, educated labour forces for manufacturing companies, creating a need for distribution schemes near manufacturing facilities. Growing consumer incomes are leading to greater demand for retail goods and retail-related distribution capacity.
Notably for investors, there is and has been a significant spread in yields between Central Europe and the rest of the EU. This spread reflects the gap between investors’ presumptions about risk and the actual risks confronting real estate investors in Central European countries. Initially, investment efforts in Central Europe centred on Poland, Czech Republic and Hungary, the largest of the countries. Since then, yields have compressed towards levels available in Scandinavia, Germany and other parts of Western Europe. As a result, attention has increased in what could be termed second tier countries – Slovakia, Slovenia, Estonia, Latvia and Lithuania, which together now form an important, high-potential, secondary opportunity in Central Europe.
These markets, located farther east and perceived to have stronger links with Russia and the former Soviet Union, are less familiar. As a result, they are widely believed to be riskier than Poland, Czech Republic and Hungary. Risks in the markets are less related to their history and location than to more fundamental factors, such as the small size of the markets. As a result, the primary source of the return premium is the misperception many investors hold regarding the countries and the opportunities they offer.
These second tier countries today offer the greatest opportunity within Central Europe to participate in restructuring and rapid growth. Current research indicates that compared with other areas of Europe, Central European real estate continues to offer superior expected yields, more than compensating potential investors for bearing any incremental risks that may lurk in these developing markets.
A look at typical yields from European office properties illustrates the current situation. While cap rates in Central Europe generally have been compressing, yields from markets like Budapest, Prague and Warsaw still run as high as 375 basis points above major markets in Germany and 200 basis points higher then Scandinavia. In the Tier Two re-emerging countries, such as Slovakia and Estonia, yields in the 9.75-10.5 % range compare even more favorably with 5.25-5.63 % in Germany and the 6-6.75 % range in Scandinavia. While these tier two countries have smaller office markets, making the exit less certain, the spreads represent a favorable opportunity for investors willing to bear the risk of investing in markets that are less developed and less familiar. As a result, it is not surprising that major institutional players have placed significant resources on the ground in these markets and that major investment funds have been established and fully committed to take advantage of the Central European opportunity.
The awakening of Central Europe’s real estate markets began in the mid-1990s. Since then, particularly over the last five years, investors in the region have improved their understanding and appreciation for these “re-emerging markets,” even as they have developed strategies to produce continued above-average returns from their activity there. Eventually, the spread related to inaccurate perceptions of risk will close, leaving a yield spread that relates to the actual risks of investing in Central Europe. Until then, however, the gap between perception and reality will continue to play into the hands of smart investors who carefully research these markets and pursue a disciplined approach within them.
Christopher Merrill is the managing director of international private equity at Heitman LLC