Safe as houses?
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Emerging Markets

Safe as houses?

As incomes in the new EU members catch up with those of western Europe, credit for property investment has grown rapidly, prompting overheating fears. But not all markets are equally vulnerable

By Philip Alexander


As incomes in the new EU members catch up with those of western Europe, credit for property investment has grown rapidly, prompting overheating fears. But not all markets are equally vulnerable


Consumer lending was up 30% year-on-year in Latvia in March 2007, with a similar rate in Bulgaria for 2006 as a whole. Cheap credit further encourages mortgage borrowing by residents whose confidence has already been lifted by falling unemployment and rising standards of living.


As a result, the international house price index compiled by property consultants Knight Frank shows Latvia recording a staggering 67% year-on-year growth in the fourth quarter of 2006, with Poland on 33% and the other Baltic states plus Bulgaria all in double digits (the index does not include Romania).


“In the Baltic states, we have almost a classical real estate bubble,” says Zsolt Papp, head of EMEA economics at ABN Amro.


The banks themselves are already taking evasive action, especially Hansabank, the largest retail lender in the Baltic region. “We have become more conservative towards financing early real estate development and generally are looking at lower leverage of real estate related projects we are financing,” Andres Trink, the group’s head of risk management, tells Emerging Markets.


The banking sector as a whole is protected by high levels of foreign (especially Scandinavian) ownership – Hansa is a subsidiary of Swedbank. The tightened credit conditions, however, can still hurt overexposed borrowers, and the banks will be steering a difficult course between bringing the market back to sustainable conditions, and causing a sharp contraction that is in nobody’s interests.


Kristjan Kivipalu, who manages the Explorer Property Fund, a joint venture in the Baltic states between Estonia’s Arco Real Estate and the Sweden-based investment firm East Capital, believes developers in Latvia especially could be in for a shock.


“These guys are still looking very much from an emotional point of view, not at the mathematics of the yields. For “A” and “B” class offices, they are asking prices almost in line with London,” he says.


Although a slowdown in residential property would not immediately feed through to the commercial sector in which his own fund specializes, Kivipalu believes it could eventually hinder the development of new businesses to serve the fast-growing suburbs of Riga, which would affect demand for new office and retail space.


In Estonia and Lithuania, the property market is less extreme, but Kivipalu notes that the limited supply of top-quality office space in Tallinn is driving up prices there also. Expansion there is constrained by the lack of available land for development, so the costs of investment are too high for his taste.


By contrast, he thinks there are good prospects in Lithuania, where the population of 3.6 million is about 50% greater than that of Latvia, and valuations in Vilnius remain attractive. “It is still a sleepy city if you like; the effects of higher per capita incomes have not been seen yet in the property markets,” he concludes.


The pent-up demand generated by higher incomes is also a focus for Dennis Selinas, who co-manages Charlemagne Capital’s European Convergence Property Fund, which has investments in Romania and Bulgaria. “There are 570,000 apartments in Bucharest, and it is estimated that 500,000 of those are substandard,” he tells Emerging Markets. “Post-communism, these apartments were privatized by selling to their tenants, which gives them more than sufficient equity to buy a new and better property.”


Of course, a more consolidated and liquid banking sector, with access to capital from foreign parents, is also playing a part. “Mortgages are more affordable, and there is more funding available for development projects. Lending spreads in Romania especially are lowering towards western European levels of around 150 basis points over Libor, and debt and equity funding methods are rising, causing demand to far outstrip supply,” he says.


However, Selinas stops short of anticipating a credit-driven bubble that is followed by a serious reversal, comparing the situation in Romania favourably with events in Poland a few years ago. Then, developers built around 600,000 to two million new commercial units, causing a glut in the market and a period of consolidation.

“The work in Romania is less speculative; there has been more use of pre-leasing, so developers know they are meeting genuine demand,” he says.


By contrast, he is more cautious on whether the fundamentals in Bulgaria support the pace of development, noting for example the much lower footfall in Sofia retail space than in Bucharest.


Ultimately, his base-case scenario is for the property market to stabilize, with rents easing as choice improves for tenants. “At the moment, developers in Romania and Bulgaria can make 40% profit margins, compared with 10% in western Europe. That will ease to maybe 20-25%, and investors will have to become more sophisticated, looking at stronger branding, and features that can increase the value per square foot without pushing up their development costs,” Selinas concludes.

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