People in the Know: Breathtaking Prospects

Other countries, including Russia, follow a different pattern forcing Western investors to revise their traditional approach. Cory Hrncirik, head of Central & Eastern European Research at CB Richard Ellis, has agreed to share his views on the prospects of the commercial property market’s development in the C&EE countries.

-What are the main tendencies that shape and will shape the development of commercial property markets in the transition economies this year, and in 2006?

This year, the supply of new properties has exceeded the figures of 2004. Vacancy rates in Warsaw, Budapest, Prague, and all other major cities, Moscow excluded, were quite high. But the number of deals grew in 2005, that is why the vacancy rate in Warsaw dropped below 10% while only two years ago it stood at 15%. Office vacancy rates in Budapest and Prague fell to 12%. On the whole, the supply is high in those countries: the property market has seen a certain rash of activity.

-What is the situation like in Russia?

Moscow is the largest market in the region. My Moscow colleagues report that in the first 9 months of this year the take-up reached 700,000sqm and expect it to hit 900,000sqm by the end of the year. Those are breathtaking prospects! In Warsaw or in Prague, for example, the total office supply does not exceed 1.5 million square meters, while in Moscow, the stock of office space alone is being put at 1 million square meters, but there are other property sectors, too.

-Is it fair to say that capitals draw off a considerable share of investments from provincial towns?

Of course, many developers are much more attracted to capital cities. I would like to note that investment markets in Central Europe are more developed than in Eastern European countries.

In terms of investment, Poland is the most developed market. In that country the level of investment in the projects based in the capital is comparable to the level of investment in regional projects. However, on the whole, such a situation is uncommon for C&EE. For example, Budapest or Prague account for about 80% of all [real estate] investments.

But investors arriving in capital cities and realizing that the supply is scarce begin to look around, examining new fields and then move to the regions, at first to the large cities and then to more remote localities.

The tendency is such that initially investments are made in retail. That is how it happened in Poland, the Czech Republic, Hungary and later on in Slovakia. Retail property investors find their targets all across the country, whereas investors involved in office real estate focus chiefly on capital cities. Such a stance is quite reasonable as most C&EE countries are quite small.

Poland’s population stands at 49 million, Hungary and the Czech Republic have approximately 10 million inhabitants each, and Slovakia 5 million. Their capitals, therefore, prove to be the most important business venues. And of course, in the future Russia will become one of the largest markets in that region.

-The Dutch researchers suggest that as Europe is aging, in 20 years or so office demand in European countries will drop off considerably. What is your take on that?

This is, indeed, an important issue that has to be taken into consideration everywhere across the globe, and not only in Europe. In the countries of C&EE though, even though the population is aging the share of workers involved in the services sector is growing. As a result, the demand for office properties rises as well.

Traditionally, the C&EE countries housed large production facilities. Regional markets also have large potential for office development. For example, major international firms in Poland rent offices outside Warsaw, in large cities such as Katowice, Krakow and Poznan.

There is a similar situation in the Czech Republic where office development is on the rise in Brno, the second largest city. When they arrive in provincial towns investors create new jobs.

-What prospects do you see for Turkey where the population is growing? Some analysts even expect Istanbul to assume the role of a new European business capital in the future…

Turkey is a sort of challenge for Europe. It will undoubtedly vie with the C&EE states in terms of salaries, prices, and a variety of other factors. But, judging by the numerous reports in business media, Europe is clearly at odds over whether to admit Turkey to the EU.

At the same time, Turkey is an enormous part of the Central European market which is of great interest to Poland, the Czech Republic and Russia. Turkey has stable economic ties with several European nations and I think that the country is likely to become a home for offices of a whole series of service companies expanding eastwards. They may include business support centers, call-centers and other services firms.

Meanwhile, it is much more convenient to operate them in Europe, in the Czech Republic, for example, and not in traditional countries such as India. The main reason is the lack of cultural differences and language barriers.

Many people in Poland, Russia and Hungary can speak one of the working languages, English or German, while in Turkey this is not the case. That is why so far it makes no sense to move further eastwards to markets that differ from those in Europe. But in the long-term, Turkey’s time will also come. This, however, will not happen for several more years.

-What do you think of the problem of overinvestment on the commercial property market? It is said that Warsaw has too many hotels now, while Moscow, on the contrary, suffers an acute shortage of them. What other examples could you cite?

Warsaw definitely has too many hotels and the stock of apartments [for lease] is also very high there. Returns in that sector are low. In Hungary and the Czech Republic the opposite is true. The average hotel occupancy rate in Prague and Budapest, and in Moscow, too, is 80%, which is very high, unprecedented for most Western European countries where average occupancy rates stand at 60-70%. In defense of Moscow, I would note that many new hotels such as Swisshotel, Ritz Carlton, Four Seasons, and others, have been built there in recent years. Things are looking up.

-Are there countries in Central and Eastern Europe where the stock of office space exceeds demand?

I think that for the time being the demand for office space remains high in all those countries. A couple of years ago some speculated that office supply was too high in Budapest and Warsaw. Last year, the sector saw a large increase in new properties. This is the result of general economic growth – 4-5% annually. The office vacancy rate in Warsaw amounted to 10% and was approximately the same in Budapest. But cities such as Sofia or Bratislava are feeling the shortage of office space. As Western investors are moving eastwards the demand for offices grows and the scarcity of supply is growing increasingly acute.

-What is the situation like with retail properties in the C&EE countries?

Retail is quite another matter. Warsaw, Budapest, Prague, Bratislava, and even certain provincial towns, are showing signs of a glut. Some shopping centers are now being closed for reconstruction, in some cases even for a radical revision of concept. Nevertheless, the growth continues. In Poland, for example, we can clearly see the diversification of the retail sector, from shopping centers to warehouse stores and factory outlets.

-What are they?

Those are warehouse stores, upmarket discounters, so to say. They offer goods of the leading international brands, such as Levis, for example, at lower prices, supplied directly from manufacturers at the end of season. Austria was the first country to launch that format. Now there is hope that other C&EE countries will adopt it.

-Which of the Western European and U.S. realities of the commercial property market have already taken root in C&EE?

Most importantly, I think, is that the building standards have been improving fast. Some five or ten years ago you could still see buildings here raised in accordance with some quite dubious standards, semi-standards, so to speak; these days the situation has changed radically.

Modern commercial properties in Warsaw and Prague are not in the least inferior to those in London and other large cities in terms of quality of construction. Major international developers dominate the local markets. Russia, so far, is an exception.

-Why? Could it be that the reason lies in poor bank guarantees, underdevelopment of the Russian banking system?

I am not well posted on all the details concerning legislation. I can only say that investors are extremely interested in the Russian market. In our company offices in Prague and Budapest we often meet clients who show a keen interest in Russia. I think there are several reasons for insufficient activity by foreign investors in Russia and weak bank guarantees is only one of those.

There are also such things as the lack of transparency, fear of red tape obstacles, etc. But the situation is improving and I think, in about two or three years radical changes will take place and investment will grow. Already last year we saw an increase in investment from Great Britain and the United States.

-Which of the commercial property sectors do you find more promising in terms of investment? Several years ago the office sector was showing the highest returns, then came the time of retail properties; perhaps today warehouse development is showing the best results, and then the time will come for hotels…

That is true. Our company has noted that on less active markets such as Moscow, Sofia, Bucharest and even Bratislava the office sector accounts for a considerable share of real estate investment, while cities such as Prague, Warsaw and Budapest have enough office space already.

That forces investors to switch to projects in other sectors, retail for example, especially shopping centers. Remarkably, over the first six months of this year the level of retail property investment in C&EE reached that of office investment. It is an uncommon situation in Europe.

In Western Europe investment in retail real estate usually stands at 25% of the total commercial property investment. The share of office development stands at about 50%, while other sectors account for the remaining 25%.

Industrial real estate is the next logical step for investors. That market is underestimated, failing to attract sufficient investment. Advanced markets – I mean Poland, the Czech Republic and Hungary – have already seen a few deals in that sector, but even those still do not have enough opportunities for the normal development of the industrial property sector.

The share of industrial property investment is incommensurably small. Over the period from early 1998 to mid-2005 the total investment in commercial real estate in the C&EE states reached 10.5 billion euros, with office and retail development accounting for the lion’s share of it. Industrial property investments, on the other hand, stood at only 300 million euros.

-Why is that? Is it because redeveloping former production facilities into modern warehouses is so difficult and time-consuming?

That is an interesting question. Redevelopment has always been seen as a riskier venture than development proper. Significant funds need to be poured into development of the area, environmental measures. As a rule, major development firms rebuild former industrial properties as state-of-the-art warehouse facilities, enormous boxes. Anchor tenancies in such properties are held primarily by large logistics company and retail operators.

But investor interest in industrial facilities is growing gradually. Another reason why investment is still scarce lies in the strategies pursued by investment funds which make up a considerable share of the investors. Each fund follows its own rules outlining which sector they can or cannot put money into.

Conservative funds put up money solely in office properties. Other funds do not rule out retail and other commercial property sectors, but traditionally most investment funds opt for office properties. But, I think, that will soon change.

Returns on industrial property investments are higher than returns on office or retail. For example, the rate of return on office investment on major Central European markets now stands at 5-7%, retail stands at 7.5%, the industrial property sector at 8.5-9%. As returns on office and retail investment drop, the industrial property sector will gradually become increasingly appealing to investors.

-Wouldn’t it be better then to invest in the development of multifunctional properties featuring office and retail properties, and, perhaps, a hotel?

On the whole, such projects are successful. Developers believe they bring good returns on investment. Besides, investing in a multifunctional project is a good way to diversify the investment risks. In Prague, for example, Merrill Lynch recently purchased Gold Millennium Plaza, a multifunctional complex comprising offices, a small shopping arcade and a Marriott hotel.

-Some say that Russia suffers from a lack of long-term funding. Banks rarely finance commercial property deals, while private investors cannot afford to enter the market. What can be done to create favorable conditions for the development of the property market in Russia?

The conditions have already been created. Russia is literally a gold mine for investors. Many companies arriving in Russia are confused by the wide range of opportunities. Russia’s potential is high enough to become a center of global investment activity. In the long-term Moscow has every chance of becoming a major center of international business development.

-Which of the largest property projects in the countries of C&EE and in Moscow are worth mentioning?

Moscow has a large number of grandiose projects that are likely to win international acclaim. Those are Naberezhnaya Tower and the Moscow-City business center, the development of which will substantially increase Moscow’s stock of modern office space.

In Prague, it is, first and foremost, The Park in the south of the city, a large office property highly popular with international companies such as DHL, IBM and others. One of the most striking projects in Warsaw is the Metropolitan office center (34,000sqm) designed by Norman Foster, the winner of a number of prestigious prizes, including the MIPIM-2003 best office award. Among the multifunctional projects I would note Zloty Tarasy (225,500sqm) in central Warsaw, interesting for its grand concept and successful combination of multiple use properties.

As the head of Central & Eastern European Research at CB Richard Ellis, Cory Hrncirik is responsible for coordinating research in Austria, Bulgaria, the Czech Republic, Hungary, Poland, Romania and Russia. He joined the Prague office of CB Richard Ellis in April 2002.

In Russia, CB Richard Ellis works in association with Noble Gibbons. Noble Gibbons was established in 1994. The company offers a wide range of services on the commercial property market, including property and asset management, strategic consulting and valuation. CB Richard Ellis Group, Inc., a FORTUNE 1000 Company headquartered in Los Angeles, California, is the world's largest commercial real estate services firm. It has over 300 offices across the globe.