Real Estate Insight - July 2019
We are pleased to share a detailed and insightful analysis of the prospects for the regional real estate market in South East Europe, provided by expert guest contributors, David Allen and Tim Norman of Chayton Capital and Anjelika Klamp of CITE Investments, who argue that the region has outgrown legacy perceptions and is on the threshold of a significant increase in investment from international institutions.
About the Authors
David Allen and Tim Norman are Managing Partners at Chayton Capital. Chayton Capital is an alternative investment manager operating in the real estate and renewables sectors, focused on Central and South Eastern Europe. Anjelika Klamp is Managing Director at CITE Investments. CITE Investments provides consulting services to the alternative investment industry, offering a range of services to managers and investors.
South East European Real Estate: When the Institutions Arrive
For a long time now, South East European real estate has been battling to assert its status as a fully-fledged investment segment, on par with real estate in Central Europe, which has in the last few years benefited from significant investment flows. Despite strong GDP growth in South East Europe (SEE), now sustained for a number of years, and a growing presence of multinational companies feeding it, real estate in the region has continued to be perceived as a niche only suitable for specialist managers, mavericks of sorts.
Some of the common objections to including the SEE region in an institutional real estate portfolio have been that the SEE markets lack transparency, and that local economies lack internal drivers of growth, making them highly sensitive to the global economic cycle and money flows. Another objection has been that the investment opportunities that investors typically pursue elsewhere, such as the Private Rented Sector (PRS), are virtually non-existent in the region due to structural differences. For example, it has been argued that the predominance of the owner-occupier model across legacy residential stock dating back to the communist era renders the residential segment in the region uninvestable.
Such objections were certainly pertinent a decade ago, and the liquidity fallout following the 2008 global financial crisis illustrated how things can go wrong in an immature real estate market. However, the extreme market swings of the crisis separated the “hot money” of the late 2000s from investors with a long-term view and true commitment to the region.
The post-crisis rebound in real GDP growth in the CEE and the SEE regions has been strong, and in some cases, growth has maintained a consistent momentum over several years. Indeed, real GDP growth in Romania, Slovakia, Poland and Hungary has averaged 3.8%, 2.9%, 2.9% and 2.6% respectively since the end of 2010. In the case of Romania, this has compounded to a cumulative 35.2% real economic expansion over the period, making it among the fastest growing economies within Europe.
The EBRD forecasts of real growth continue to be strong for the SEE region, with Romania, Bulgaria and Serbia expected to grow at 3.6%, 3.5% and 3.4% respectively in 2019, compared to the Eurozone forecast of 1.3%.
Yet, real estate investors have been shy to return to a market that many still consider immature and opaque. Perceptions are always slow to shift, but there are signs that this is now changing. We saw a significant pick-up in activity in the SEE property market in 2017, with a number of publicly listed South African PE firms investing over €1bn in shopping centres in Sofia alone, and several hundred million euros in class A offices in Romania. Global direct investors (such as GLL, Morgan Stanley and Cerberus) have been showing interest in the region too, with large transactions of prime assets, alongside some regional PE firms such as PPF Group.
It is hardly surprising that sophisticated investors such as Morgan Stanley and Cerberus are keen to participate in the regional real estate markets. After all, for a number of years now, the combination of regional economic indicators has been favourable, with inflation stable, unemployment low, and public debt levels significantly lower relative to an EU average of over 90%. Equally, local currencies have exhibited low volatility against the Euro over recent years, NPL ratios in the banking sector have been low, Romania’s hard currency debt exposure has been below EBRD averages and local currency base rates have also been stable.
More generally, since the late 1990s SEE has enjoyed a significant increase in prosperity as measured by PPP-adjusted GDP per capita. The 2018 edition of the Legatum report shows that the Romanian capital Bucharest has emerged as a prosperous hub, with its prosperity index significantly above the EU-28 average and in the same range as parts of northern Italy, Austria and Norway, and ahead of many parts of southern Spain and rural France.
What is more meaningful, however, is that 2018 saw the first significantly sized transaction by a domestic investor, with Dedeman purchasing an office building in central Bucharest. Furthermore, the overall share of domestic investment in the regional real estate market stood at around 18% in 2017, while its monetary value is double what it was back in 2011.
Countries in SEE have also made great strides in pushing through reform programmes to improve their governance and business environment. Romania, in particular, has been recognized by the World Bank Group as having “made more progress than any other EU member state except Poland in closing the gap with global best practices in business regulation”.
Entrepreneurship in the region has responded positively to the reforms, with Eurostat showing that enterprise creation rates in Slovenia, Romania, Bulgaria and Croatia are well above the EU average, and that Bulgaria has become a regional hub of “high-growth enterprises”, with formation rates similar to those in Germany and the Netherlands.
Moving Up The Value Chain
The drive to strengthen institutions and its knock-on effect on the business environment have acted as a pull factor for the global business community. Romania and Bulgaria have been at the top of the global rankings for the highest complexity Business Process Outsourcing in the last few years, and have attracted the likes of Amazon, Oracle, Siemens, Bosch, HP and Huawei.
In fact, over the last few years, Romania has undergone a dramatic shift away from low skilled primary sector jobs to highly skilled service jobs, with strong growth in the IT sector, which is expected to almost double its revenue by 2021. It is not surprising that high-tech and IT companies are attracted to the SEE region, as Romania and Bulgaria boast broadband speeds among the fastest in the world, a highly educated young workforce and wage levels still below EU averages.
The automotive sector has also benefitted from the region’s improved business environment, with Romania’s automotive production ranked the 8th largest in the EU in 2018, up by 29.7% from its 2017 levels.
Real estate industry sources also confirm an observable improvement in the transparency of the real estate market in the region. JLL LaSalle’s Global Real Estate Transparency Index rankings place Romania 29th out of the 100 countries reviewed in 2018, i.e. in the “Transparent” category alongside Spain, Norway, Austria and Japan.
However, while some larger more sophisticated investors have been quick to seize the investment opportunities in SEE, many institutional investors are still considering whether they should dip their toes in the water. Many feel that once the “trophy” assets have been purchased by the large players, the markets do not offer sufficient depth and breadth for further investors to come in. This could not be further from reality, however.
Recent market developments, in the PRS space for example, suggest that other opportunities are available for those investors with a medium to long-term view. And with yields outside the prime office segment having still shown no sign of compression, these opportunities could potentially be rewarding.
Residential is indeed one investment segment that has emerged in SEE in recent years, and is expected to evolve along a path similar to the one it took in Poland a few years ago.
The bulk of the housing stock in SEE dates back to before 1980 and is in varying states of obsolescence. Overcrowding is also a huge issue in both Romania and Bulgaria, with the millennial generation particularly affected. Over 60% of 15 to 29-year-olds lived in overcrowded conditions in Romania and Bulgaria as at 2017, a level well over double the EU-wide average of 27%. This, coupled with the average size of a Romanian dwelling at only 43.9m2, well below the European Union average of 96m2, suggests that overcrowding is particularly acute in Romania, and the need for accommodation, whether to buy or to rent, is particularly obvious in this market.
Of course, an important determinant in whether demand for new accommodation exists in practice, is affordability and availability of financing for those who wish to purchase. The latter has been addressed in Romania since 2009 by several iterations of the Prima Casa initiative, a mortgage guarantee programme by the government. This has helped boost lending, such that after years of credit contraction, domestic banks have restarted to increase their lending to households. With both domestic and EUR interest rates near their historical lows, a lower rate of VAT on affordable new apartments and with required deposits under the Prima Casa of only 5% of the property value, mortgage affordability has been favourable.
On the other side of the residential coin, the PRS sector, which has historically represented a very low proportion of the residential market in CEE and SEE, is also beginning to catch on under the form of “communal living”. Indeed, the traditional version of PRS, dominant in Western Europe, has been adapted to fit local requirements, with accepted market norm favouring smaller units (studios and one-bedroom flats not larger than 40m2).
The “communal living” PRS model as it is used in the region involves fully-furnished units with facilities such as a gym, a laundry room, security and parking, as well as provision of utilities and communication services. It is common to use 12-month rental contracts, with option to revise rent at each expiry. Such accommodation tends to be popular with the millennials, students and young professionals, keen to move away from their families.
For years the PRS model existed on the margins in CEE and SEE. The segment was mostly dominated by private landlords, who, in some cities in Poland for example, used to account for up to 40% of all residential transactions. The market remained inaccessible to institutions because of fragmented asset ownership, a legacy of the communist era.
However, since 2014 the PRS segment in Poland has seen the start of its institutionalization process, with a number of investors, such as Catella Real Estate and Bouwfonds Investment Management, entering the market. These have collaborated with local developers on new residential projects, with a total investment volume in excess of €1 billion.
The Romanian PRS market is likely to follow a similar trajectory, as demand for co-living style accommodation is strong, and there are already a number of large-scale PRS projects funded by developers themselves and functioning successfully.
With the lack of modern housing in the SEE clear, the process of institutionalization of the PRS segment in countries such as Romania and Bulgaria will go hand-in-hand with a wave of new residential construction, as institutional investors recognize the full investment potential of the residential segment in the region.
 Eurostat Real GDP growth data; annualized and compounded by CITE Investments
 World Bank Group, “Doing Business in the European Union 2017: Bulgaria, Hungary and Romania”, 2017
 Employers’ Association of the Software and Services Industry, in SEE News, “Romanian software, IT sector revenue to reach 4.5bn euro in 2018“, September 2018
 European Automotive Manufacturers’ Association, “Economic and Market Report – EU Automotive Industry Full Year 2018“, February 2019
 Colliers, The CEE Investment scene – H1 2018 CEE flows and drivers
 CITE Investments in the Financial Investigator magazine: “Investment for Sustainable Real Estate in South Eastern Europe”, October 2018 (pp. 76 – 77)
 European Commission/European Construction Sector Observatory, Policy measure fact sheet – Romania First Home Programme, June 2018
 EBRD, CESEE region sees steady progress in bank lending, improving access to finance and NPL resolution, new Vienna Initiative publications show, November 2017
 TPA/REAS “Institutional investments in the Polish private rented sector”, 2017