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by Ákos Budai | Interview

The first half of 2017 saw the Czech Republic overtake Poland as the most popular investment destination within CEE. Based on the current pipeline of deals Poland might retake its position rather soon, nevertheless, the combination of growth, yields and stability make Czech Republic and other countries in the CEE region highly attractive to international and domestic investors. Luke Dawson, Managing Director & Head of Capital Markets CEE at Colliers International shared his expectations with Property Forum.

Luke Dawson will join the senior CEE investor, developer and banker roundtable at CEE Property Forum 2017 in Vienna on 19 September.
CEE investment markets have posted strong results in the first half of the year. How long do you think the current growth momentum will last?
Well into 2018. We believe that the current "sweet spot" in the real estate and economic cycle in the CEE investment markets (defined throughout as Poland, Hungary, Czech Rep. Slovakia, Romania and Bulgaria) is likely to sustain for the rest of 2017 and well into 2018. At present, economic growth indicators are very healthy. GDP grew in Q2 2017 in a range of 3.2% y-o-y (Hungary) up to 5.7% y-o-y (Romania) in the region, in some cases expanding at the fastest rates seen in this cycle. Leading indicators that we follow suggest that the robust rate of economic growth should sustain into next year. We see the "sweet spot" because these tenant demand-stimulating growth rates are not yet accompanied by general inflation in the economies. Whilst we expect inflation rates and therefore interest rates to rise over the coming quarters, they will be doing so from very low levels. Higher interest rates will thus act via higher funding rates to moderate the real estate investment cycle but not to any great extent until 2018. Real estate development supply should increase in response to the strong economic story but is again likely more of a 2018 than a 2017 phenomenon.

The Czech Republic has overtaken Poland's position as the most popular investment destination within CEE. What makes the Czech market so attractive to investors?
The combination of growth, yields and stability. At present, the Czech Republic offers the commercial real estate investor opportunities to be exposed to rental growth across the sector spectrum. In industrial, both the country's location as a major manufacturing export supplier to Europe and more recently as a logistics hub serving Europe has boosted the demand for relatively scarce assets. Czech GDP growth registered 4.5% y-o-y in Q2 2017. Vibrant domestic demand and wage growth also underpins the demand for logistics and warehousing assets as well as all assets across the retail sector. The strong export and domestic demand story is boosting employment growth (the country has the lowest unemployment rate in the EU) thus underpinning interest in and demand for office sector assets. In hotels, Prague remains one of the most popular city tourist destinations on the continent and occupancy levels are very high. The prevailing Prague prime office sector yield of 4.85% and TSC retail yield of 5.0% are similar to those figures in Poland but the domestic financing costs are much lower, with the 10Y bond yield standing at just 0.9% and policy interest rates still at a paltry 0.25%.  The establishment of a stable domestic investor base, with for example 34% of deal volume in H1 2017 coming from local sources, makes the market more liquid and perhaps less volatile than its peers in the region.
Do you expect Poland to reclaim the throne in the near future?
Yes, but it will be tight. Poland had a weak Q1 2017, with only €450 million of volume, versus €1.57 billion in the Czech Republic. Poland's volume in Q2 2017 rebounded to €1.07 billion, with the Czech market seeing €585 million of deals. Known region-wide portfolio deals in Q3 2017 (CIC's purchase of the Logicor assets and the NEPI/Rockcastle transaction) will boost Poland's numbers more than the Czech numbers. On Q2's evidence, Poland may thus just overhaul the Czech market in 2017 but it will be close. A differentiator in some investors' minds has been the degree of political risk, with the Czech Republic seemingly moving towards a market-friendly ANO Party-led government after this October's parliamentary elections whereas Poland's PiS government appears less market-friendly in character. Regardless of the final tally, we believe both countries will have strong years with very positive momentum heading into 2018.
Romania and Bulgaria experienced the strongest year-on-year growth in H1 2017. Are international investors warming up towards these previously overlooked markets?
Yes. The volumes, origin of investors and downward yield movements do suggest increased interest in the opportunities in Romania and Bulgaria from international investors. Just 0.8% of the investment volume of €399 million into Romania in H1 was from domestic sources. And just 12% of the impressive €389 million into Bulgaria in H1 came from local sources, a much lower proportion than seen recently. International investors, including from South Africa, the Czech Republic, Greece and Germany, thus made up much of the strong y-o-y investment momentum in these markets. Yields compressed in Sofia in all three of the major investment sectors, office, industrial and retail. We expect further compression in Sofia's TSC retail yields over the next 12 months, as well as in Bucharest's office and industrial sectors.
Looking ahead at 2018, which CEE countries have the strongest growth potential?
Most countries. Looking across the key sectors, we expect rents to be generally robust in the next 12 months across the region but most likely to be firming in prime Budapest and prime Prague. Office vacancy rates are approaching cyclical lows in these cities whilst strong economic growth is inspiring tenant demand for logistics and retail assets both in the capital cities and in provincial centres. Industrial prime capital city yields are under downward pressure across the CEE-6 region, indicating potential for capital growth. The same likely yield compression and capital growth potential applies to Budapest office and retail, Bucharest office and Sofia retail.
Do you expect new investors to enter the region within the next 12 months? Where will new capital be coming from?
Asia, CEE and new investors from old sources. We believe that capital will arrive in the CEE region from Asia, as participants from various Asian countries start to diversify their Western European holdings through fresh investments. In addition, money from within the wider CEE region (from the core CEE-6 and Russia/CIS countries and Turkey) is becoming more active on a cross-border basis. We would also expect more activity from new investors from traditional markets such as the UK as the CEE investment story (high economic growth, firm rents, higher yields) becomes more understood and as the recent higher CEE volumes themselves trigger liquidity thresholds for these latter investors.
Real estate investment trusts, which have been present in certain countries of the region for some time, are now being introduced in Hungary and soon in Poland.  What kind of effect can the growing popularity of REITs have on the CEE investment market?
Fresh capital and positive perception. The formation of new REITs with fresh capital targeting fresh assets will increase the demand for existing real estate, acting to push up prices. Every time a REIT increases its capital base also creates "captive capital" needing to be deployed into the region. In terms of perception, REITs provide a retail investor with a liquid vehicle to access the relatively illiquid real estate investment market asset class and one that can be sized according to their demand. Thus, the whole spectrum of retail investors from regular savers committing €100 a month to a brokerage account to high net worth individuals accessing via wealth management platforms gain access to investing in commercial real estate and become aware of it. In addition, institutional mutual funds and pension funds will also allocate portions of their portfolios as and when they judge it opportune. Some liquidity issues might arise if a REIT distributes all of its income, perhaps at times higher than its cash flow, thus being required to sell assets. However, this risk should be overshadowed by the added liquidity regional REITs provide, particularly during any future downturn when foreign capital tends to more cautious.