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Investment Analysis

Eastern Europe risks and rewards

by MATTHEW MONTAGU-POLLOCK

Jan 06, 2008


It's been another year of house price rises in Europe. Never before have house prices across Europe risen in such a unified, coherent pattern.

Price Rises 2005:

  • Estonia: 56.7%
  • Latvia: 27%
  • Turkey: 20%
  • Russia: 18.5%
  • Denmark: 18.4%
  • Romania: 15%
  • France: 14.7%

There are of course still enormous differences between housing markets. Most important there are big differences in earnings, and in economic growth rates.

The importance of GDP growth

It is no coincidence that it is the high-growth economies of Ireland, Estonia and Latvia which have seen Europe's highest house price rises during the past decade. Academic research has firmly established that increases in the long-term value of property are strongly correlated with high GDP growth rates.

Annual GDP/CAP Growth Over 5 Years

HIGH GROWTH GDP GROWTH (AV) PRICE RISES 1 YR PRICE RISES 5 YRS
Ukraine 9.26% N.A. N.A.
Estonia 8.61% 56.7% 314%
Latvia 8.23% 27.03% N.A.
Lithuania 7.72% 6.62% 18.8%
Belarus 7.49% N.A. N.A.
Moldova 6.98% N.A. N.A.
Russia 6.65% 8.5% 115.7%
Romania 6.14% 15.0% N.A.
Bulgaria 5.97% N.A. N.A.
Slovak Rep 4.60% 6.3% 27.05%
LOW GROWTH GDP GROWTH (AV) PRICE RISES 1 YR PRICE RISES 5 YRS
France 0.98% 14.8% 78%
Macedonia 0.92% N.A. N.A.
Italy 0.56% 7.1% 56.9%
Germany 0.53% 0.7% 52.9%
Switzerland 0.45% 3.5% 1.1%
Netherlands 0.27% 5.3% 17.05%
Malta -0.41% 10.4% 61.8%
Portugal -0.08% 2.3% 16.3%

These are very significant differences in GDP growth rates. Estonia's growth rate means a doubling of per capita GDP every eight years. This kind of dramatic growth is very likely to translate into rapid house price growth, because land is a limited resource, and labour costs (which are important in house construction) increase with economic growth. House prices in Kiev, the capital of Ukraine (for instance) rose by around 65% during 2005 (Ukraine has no official house price statistics).

Eastern Europe's house price surge

Estonia and Latvia, Europe's GDP growth stars, have seen Europe's highest residential price rises over the past five years, the result of previous episodes of high GDP growth But that begs the question have prices in these countries risen too far? Are these countries still attractive investment destinations, even after the recent price rises?

Vital Statisics: The Baltics States

COUNTRY LATVIA ESTONIA LITHUANIA
Rental Yield 8.17% 7.74% 6.60%
SQ.M. Price City Centre 1,083 1,467 1,667
Round-trip Cost 6.25% 4.15% 4.00%
Landlord & Tenant Law Pro-Landlord Pro-Tenant Pro-Tenant
Income Tax on
1,500/mo.
nil nil 3.54%
Capital Gains Tax nil 22.05% nil
Annual GDP/cap Growth
Over 5 yrs
8.23% 8.61% 7.72%
Economic Freedom
5-yr Change
0.57 1.38 3.85
Property Rights Index (1-5)
Price Change 1 yr 27.03% 56.69% 6.62%

In our view, yes. Rental yields in Estonia and Latvia are strong at 7% to 8%. These high yields are combined with very low round-trip buying guide and selling costs. In our view the three Baltic countries definitely remain attractive (although their yields are lower now than previously).

These countries have low taxation regimes. Their transaction costs are low. They benefit from hi-tech partnerships with the Scandinavian countries, to whom they provide low-cost hi-tech outsourcing solutions. The amount of inbound investment, especially from Scandinavia, has been substantial.

However gross rental yields in these Baltic countries are falling as house prices rise. So it would be wise not to ignore other possibilities. While a track record of GDP growth is important, yields are also a very important consideration.

The importance of yields

Countries with high yielding housing markets are attractive as investment destinations, not only because high income can be earned, but also because high yields make capital appreciation more likely.

Property in the heart of Eastern Europe produces very attractive rental incomes (rental yields). Most developed European countries have rental yields of around 5%, meaning that an investment of $100,000 would earn $5,000 per year in rent. But in Eastern Europe, the returns are much higher.

Rental Yields in Europe

COUNTRY RENTAL YIELD SQ.M. PRICE CITY CENTRE
Poland 13.28% 1,175
Romania 12.86% 1,167
Slovak Rep 12.48% 1.042
Moldova 11.12% 567
Bulgaria 10.00% 1.000
Croatia 9.33% 1,500
France 8.25% 6,667
Netherlands 8.25% 6,667
Latvia 8.17% 1,083
Belgium 7.74% 1,984
Estonia 7.74% 1,467
Turkey 7.54% 2,467
Macedonia 7.06% 1,177
Malta 6.94% 1,967
Czech Rep 6.93% 2,367
Slovenia 6.81% 2,467
Lithuania 6.60% 1,667
Andorra 6.19% 2,583
Sweden 6.00% 3,167
Switzerland 5.87% 5,934
Portugal 5.72% 2,517
Russia 5.48% 10,000
Greece 5.45% 1,833
Hungary 5.34% 1,733
Finland 5.00% 3,333
UK 4.90% 27,400
Luxembourg 4.88% 3,934
Denmark 4.88% 3,784
Germany 4.42% 3,167
Austria 4.40% 3,000
Italy 4.27% 6,083
Norway 4.22% 5,117
Ireland 4.00% 5,000
Cyprus 3.96% 2,084
Liechtenstein 3.29% 6,333
Spain 3.15% 4,000
Monaco 2.43% 24,900

The range of rental yields in the six countries at the head of the table is between 9.3% to 13.3%. These 'high-yielding Eastern six' (Poland, Romania, Slovakia, Moldova, Bulgaria, and Croatia) produce residential property rental incomes considerably higher than those available in the best paying countries of Western Europe. The highest rental yields are to be found in precisely those countries which have the lowest per sq. m. buying costs, which isn't really so surprising.

The disadvantages of Western Europe

Some West European countries also produce good rental incomes on property (though at best they yield 2% - 4% less than Eastern Europe's High Yielding Six). But they also have quite substantial disadvantages as investment destinations:

  1. Property is expensive, in sq. m. terms.
  2. Buying property is much more expensive in terms of legal fees and realtor fees (link to Western Europe Transaction Costs).
  3. Western European landlord and tenant laws are 'pro-tenant' or 'strongly pro-tenant', according to Global Property Guide classifications. Investing in a 'strongly pro-tenant' country is something you do not even want to contemplate (see Swedish Landlord & Tenant Law).
  4. The high yielding Western European countries have significantly lower real GDP growth (see GDP/cap Growth 5 Years) than their Eastern counterparts. Not just lower growth dramatically lower growth.

The High Yielding Eastern Six

The Eastern European 'high-yielding six' tend to have had large increases in economic freedom a good predictor of high future growth rates. Little wonder that they are the darlings of investors. Their GDP growth is very high. And they tend to have legal systems which are pro-landlord.

But they are going through very dramatic social transformations. These transformations sometimes cause explosive social strains, adding to risk.

The troubling transition from Communism

The typical sequence in Eastern Europe appears to be:

  1. Communism
  2. Radical economic reform, the result of impatience with previous conditions. This is normally followed by dramatically increased economic growth
  3. Electoral reaction by 'victims' of such growth. Return to some form of socialism or nationalism. Increased xenophobia. The return of corruption.
  4. A period of oscillation, and the birth of normal class-based politics.

Transitions in the High Growth Six:

TRANSITION STAGE

Poland - 13% yields, but risky politics return to nationalism
Romania - 12.7% yields, strengthening economy radical reform
Slovakia - most attractive, but unfortunate election result return to nationalism
Moldova - ruled by a Communist Party which delivers growth! radical reform
Bulgaria - 10% yields, reform on track radical reform
Croatia - 9% yields, but security of ownership worries muted reform

Which is it going to be chaotic but dynamic Poland, dominated by the eccentric Kaczynski twins? Sombre Romania, poor and socialist, but changing fast? Croatia and Bulgaria, with their tourist hoardes? Peaceful Slovakia, with a less-than ideal government but stability and proximity to Austria?

The buyer will have to take his pick. Buying a property for profit is not an entirely rational process, but involves a capacity to 'smell' growth and prosperity as it comes to a country.

Faites vos jeux, messieurs!

Eastern Europe's Six High-Fliers:

In Poland the risks have increased since the election of Lech Kaczynski as President in October 2005 and of his brother Jaroslaw Kaczynski as Prime Minister in July 2006.

The new government has deliberately lobbed insults at Germany, its main donor. The Kaczynski brothers, identical twins, pledge to defend traditionalist Catholic values and to fight corruption, but the new Polish government seems populist, ignorant, and abrasive. The Kaczynski twins have fired the reformist central bank governor Leszek Balcerowicz.

The situation is doubly worrying because populist pressures could easily re-instate a recent very pro-tenant the law, only narrowly ruled unconstitutional. This could dramatically reduce the value of your investment.
All the facts you need to buy property in Poland.

In Romania the November/ December 2004 elections were won by an alliance of liberals and democrats headed by president Traian Basescu and prime minister Calin Tariceanu, in a reaction against the previous stagnation.

Tariceanu's government has won praise from EU officials for its efforts to tackle corruption, and has launched numerous criminal investigations into the activities of senior officials and members of the judiciary. Tariceanu had a successful business career before entering politics. The reform momentum is being supported by the EU's decision to offer Romania EU membership under strict conditions in January 2007.

Yet Romania has a long way to go. The early 1990s saw almost total stagnation under ex-communist Ion Iliescu and the National Salvation Front. Romania also has weak property rights.
All the facts you need to buy property in Romania

Slovakia was until recently Eastern Europe's most attractive investment destination. It benefited from eight years reform under the centre-right coalition led by Mikulas Dzurinda (1998-2004) whose reform package won praise from international organizations, and oversaw EU and Nato entry. Bratislava, Slovakia's charming capital, become a favourite destination for foreign investors.

However in June 2006 a new coalition government was elected, reflecting a 'protest' vote by those left out of Slovakia's economic growth. It includes a disreputable collections of crooks and xenophobesheaded by the left-wing smer party led by prime minister Robert Fico, the centre-left Movement for a Democratic Slovakia led by Vladimir Meciar, and the right-wing Slovak National Party.

The government's gut instincts, though it makes free market noises, are to undo the reformist good work of the past eight years.
All the facts you need to buy property in Slovakia

In Moldova the Communist Party was re-elected in March 2005 under President Vladmir Voronin. Despite its name, it has been effective, with 2001-05 average growth 6.8% per annum. The government also seems to be near settling the Transnistrian separatist issue.
All the facts you need to buy property in Moldova

In Bulgaria (average yield 10%) the outlook is promising. Bulgaria's transition from communism only began in earnest in 2001-2005 when former King Simeon II became prime minister.

King Simeon pushed market reforms. The economy grew remarkably, with unemployment falling to just 14.3% in 2003 from a high of 20% - a big change from the previous stagnation. Inflation was reduced to 2.3% in 2003, down from 10.4% in 2000.

The 2005 election led to a coalition government with the majority Socialist Party providing the prime minister (Sergei Stanishev) in alliance with the liberal Movement for Simeon 11 (NMS) and the ethnic Turkish Movement for Rights and Freedoms (MRF). The EU's tough list of requirements for accession in January 2007 is likely to keep reform on track.
All the facts you need to buy property in Bulgaria

Croatia has made good progress. In reaction to the corruption of Franjo Tudjman whose Croatian Democratic Union (HDZ) led Croatia through the war (and which was wholly unwilling to accept EU demands for the surrender of war criminals), the social democrats and social liberals won control of parliament in 2000, appointing Ivica Racan as prime minister. Pro-European candidate Stjepan Mesic, of the Croatian People's Party, won the presidency in February 2000.

In 2003 the HDZ's Ivo Sanader became prime minister, but he emphasizes that the country has moved forward since the Tudjman years.
All the facts you need to buy property in Croatia

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