Pertti Rahnel of Hansa Investment Funds -
The real estate sector has had it rough recently. Take the US for example - for the first time in the post-Second World War history, prices of residential properties are dropping with dire consequences for the banks and property owners. There are worries about real estate price sustainability elsewhere in the world, not least in Western Europe in places like Spain and the UK. Unsurprisingly, Central and Eastern Europe has not escaped entirely unscathed. Will we see a long and painful adjustment in the CEE real estate business or are there still attractive investment opportunities available for long-term investors?
Answering this question requires taking a look at the underlying forces of supply and demand that are prevalent in the regional residential, retail and office property markets. A brief look at history also helps. Under the planned economic system, there was chronic under-investment in real estate as well as capital equipment. The large areas consisting of similar looking grey blocks of flats with walls so thin you could follow the conversations next door really didn't meet people's expectations. Unfortunately, such buildings were all too abundant in the cities across the region.
With the improvement in credit availability due to the development of the banking system, increasing wages and lower interest rates, people are increasingly taking out mortgages and purchasing modern flats and houses. Renovating existing properties and making them more energy efficient is also widespread.
In several CEE countries fast development in mortgage lending has probably run its course by now. The most likely candidates of this are Estonia and Latvia, as they have seen the highest growth in recent years. In Estonia, the level of mortgage loans per capita GDP has already reached the average of the Eurozone. For this reason, it's very hard to see the growth of past years continuing. In the rest of CEE, not to mention the CIS, there is still plenty of room to grow, however.
For an investor, it is very important to follow closely the residential real estate cycles in different regions to get out of the markets before serious oversupply develops. Relying on macro indicators and anecdotal evidence, Hansa Eastern Europe Real Estate Fund team managed to spot the Baltic residential property bubble early, reducing the fund's exposure to local construction companies and developers.
Source: Eurostat, Erste Bank
Lack of quality
The picture regarding office space and shopping centres is quite similar in the region. There is a lack of modern office space in virtually all major cities in the CEE. Again, the shortages are less pronounced in the Baltic capitals as well as in Central Europe, but even there the vacancy rates are low. Growth opportunities in the Balkans, Russia and Ukraine are, however, abundant.
While economists and central bankers around the globe are noting that the global economy is about to slow, CEE has good potential to keep on growing even if the economic activity is sluggish elsewhere. Its trade links to the US are largely non-existent and economies across the region have shown resilience on the backdrop of strong internal demand, growing exports and investment. This gives reason to believe that retail and office segments will keep growing in the years to come, albeit admittedly at a slower pace.
Source: Pramerica Financial
Sold down beyond reason
With investor sentiment towards real estate having soured, regional publicly traded real estate stocks have taken a serious beating. Investors have largely sold without regard to the underlying growth story and company fundamentals. This behaviour is probably best explained by behavioural finance, not traditional textbook theory, as the dissonance between fair value and market price is in some cases substantial indeed. Developers in the Hansa Eastern Europe Real Estate Equity Fund investable universe are often trading at less than 0.5 price/net asset value and sometimes at a discount to the price of the land itself.
While tightening credit conditions and increasing borrowing costs might delay some projects and reduce earnings expectations, equity market currently prices in too much of a bad thing. Once the situation stabilizes in the developed markets, we will see investors once again start paying a premium for growth. As global risk aversion has started to show the first signs of relenting, there is hope the light at the end of tunnel isn't that the one of an oncoming train.
Pertti Rahnel is Strategist at of Hansa Investment Funds
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