Czeching in for European partnership
If one word had to be picked to sum up the present state of the Czech real estate market, a front-runner would be “stable”. More so even than its near neighbours Poland and Hungary, the Czech Republic has succeeded in managing the transition from a planned economy with only the sketchiest of private property rights and financial systems to a transparent, liquid and stable market in which real estate investment can thrive. The path has not always been easy – given the magnitude of the task, it never could be. In the 1990s the Czech Republic regularly suffered from economic imbalances such as payments crises or inflationary scares, leading to periods of stop-start growth as the necessary policy medicine was administered. However, the Republic’s admission to the EU on May 1st served both to highlight, and to further promote, convergence with Western Europe.
The Czech Republic has the highest GDP per capita of any of the larger new accession countries (it is just pipped by tiny Slovenia for the overall prize); but more significantly, it is also closing rapidly on poorer Western members such as Greece and Portugal, at least in purchasing power parity terms. In Prague the figure is already well above the EU average. Unemployment is low by European standards at 7.3%; and in Prague it is just 4%. Interest rates – as recently as 1998 in double digits – are now on a par with the Euro-zone. A substantial current account deficit – of around 7% of GDP – remains, though for several years now it has been consistently matched by stable flows of inward investment capital.
Only the public finances remain a major item of concern – the state deficit was an alarming 12.9% of GDP last year, leading S&P to downgrade the Republic’s credit rating from A+ to A last month. Looking forward, most commentators expect the Czech Republic to see GDP growth close to double that of the Euro-zone – at inflation rates that are low and, crucially, stable.
It is not just the economic and politicalsytem that has achieved such a degree of stability. Commercial real estate markets – following a period of over-renting and over-building in the 1990s – have seen stable rents for several years now, in contrast to the sharp decline in office rents seen in most Western European cities over the same period. This is not to say that office rents will start growing healthily any time soon. Take-up and new supply remain finely balanced, and the development pipeline suggests that this will continue to be the case for the foreseeable future. Nonetheless, with capital values now close to construction costs, the downside risk in the rental market has been more or less excised. In the longer term, we might expect rents to grow at least in line with Czech construction costs – which, given likely cost catch-up between the Czech and EU construction industries, could be at an annual rate of 3-4%.
While rents are stable, yields have been on the move recently. Having stuck at 9% through most of the late 1990s (a figure that is based, however, on very few transactions), prime office yields have declined sharply in recent quarters as investor money has started to arrive in the Prague market en masse. Investment transactions in the first half of 2004 have already matched those for the whole of 2003 – itself a record year. While most agents still quote around 8% (end-Q2) as the prime yield, some recent transactions have pushed well below the 8% watermark and these are likely to set the standard going forward.
In the retail and warehousing sectors too, occupier-market stability has been characteristic of the last few years. Industrial rents have been unchanged since early 2001, while high-street retail rents in Prague have been under some gentle upward pressure as international chains jostle for position in the historic city centre. The capital’s position as a major tourist destination means that high-street spending power can hold its own against many Western cities. At the same time, demand for out-of-town shopping centres remains barely satisfied by new supply.
Warehouse yields, however, remain very attractive (typically in double digits). The Czech Republic’s position at the hub of many of the transport routes between east and west, together with its substantial infrastructure program (something that is less apparent in some of its neighbours), mean that the regions around Prague and Brno could become major logistics nodes in the future. Finally, business and tourist demand has led to a sharp up-tick in recent months in the financial health of the hotel sector. Occupancy is now back above pre 9/11 levels; and unlike in several other Central European cities, supply is only just keeping up with demand.
The pick-up in investment volumes is not, as we have seen, the result of expectations of rental growth. To an extent, it is of course driven by expectations of further yield compression. However, the main driving force is simpler. Over the past few years, the Czech real estate market has achieved a level of transparency, liquidity and sophistication that puts it on a par with many of its Western European peers. Lease structures and property law would be familiar to any operator in Western Europe, and rents are contracted in euros. The agents and asset managers who oil the wheels of real estate investment further west are also present and correct in the Czech Republic; those who wish to make transactions will find an English- and German- speaking infrastructure to help them do so, while those who wish to invest in the country without getting involved in the markets directly will find a growing number of specialist Central European funds willing to invest for them. Restrictions on foreign ownership can be easily circumvented via share deals. Given the weight of money targeted at real estate in Europe, it was inevitable that some would find its way to the Czech Republic once the required degree of market sophistication and familiarity was achieved. Barring extraordinary further pricing shifts, this pressure will continue for several years to come.
This is not to say that there are no complications or risks involved in Czech real estate investment. Taxation and accountancy standards remain complex and, in some cases, untested. Uncertainties remain over certain locations; for example, it is clear that the historic centre of Prague cannot support the demand for modern office space but it is less clear which districts will attract clustering of high-paying tenants. Some currency risk remains, since rents are submitted in local currency equivalents and market (as opposed to contract) rents are likely to be linked to local economic conditions. And the investment market – while growing rapidly – remains small enough to cause some short-term liquidity concerns. But these uncertainties play a larger role in the Czech Republic’s Central and Eastern European neighbours – and even, in some cases, locations further west. Compared to, for example, a 6% prime office yield in Rome, Prague still looks rather cheap.
Nick Tyrrell is head of research and strategy for JP Morgan Fleming Real Estate Europe