Foreign Investment

Eastern Europe Looks West

The Czech Republic, Hungary, and Poland Welcome U.S.-Style Development.

In less than 10 years, the Czech Republic, Hungary, and Poland have made an enthusiastic leap from Soviet-style socialism to Western-style capitalism. Multinational corporations are moving in, the tourism and hospitality industries are booming, and residents have more money in their pockets—and a big appetite for goods and services that they missed under 45 years of communism. The nations also are poised for membership in the European Union in the next five to 10 years.

Today, these markets seem ripe for commercial real estate. "I really think that they’re Westernizing and privatizing and moving into the free enterprise system far faster than other portions of the Soviet bloc," says Norman D. Flynn, CRE, CRB, president of Norman D. Flynn Associates, Inc., in Madison, Wisconsin, and chairman of the board and president of the Eastern European Real Property Foundation (EERPF). "If you have any international appetite at all, those are three countries that I think—because of the stability of the marketplace and the nature of the free-enterprise system there—would allow greater ease of access and a higher probability of success than...in markets as you go further east."

But investors and developers face an added challenge in these countries: Most factors affecting real estate practice were developed just in the last decade and still are changing—the economy, the political system, the laws, and the real estate business itself.

Wojiech Kic, CCIM, CPM, vice president of Clark, McDowell, & Kic in Houston, discovered this as he traveled through Poland four years ago to lecture on marketing, sales, finance, and business start-ups. "Since real estate hadn’t been an industry," Kic says, "Poles at that time didn’t have the vocabulary to describe what we do. I told them that I was a property manager, but they didn’t know what I did. Was I a developer?"

But Eastern European countries are becoming more real estate savvy, Kic says, as European and U.S. real estate groups travel there to teach the basics, as well as the finer points, of real estate practice.

Todd Clarke, CCIM, an investment broker at Grubb & Ellis in Albuquerque, New Mexico, and the Commercial Investment Real Estate Institute’s ambassador to Eastern Europe, believes that housing is a key. "Once you have a stabilized base and some kind of demographic profile, then retailers understand who lives in the area, what they’re looking for, what they make."

The Players
The Czech Republic, Hungary, and Poland present opportunities spanning the real estate spectrum—from retail to hospitality to office. All three countries have been affected to some extent by Russia’s economic woes, but they continue to offer investment options.

The Czech Republic. The Czech Republic elected a new government in June, but the country still faces an economic slowdown. After growth of more than 4 percent in 1995 and 1996, the country’s gross domestic product was only 1.8 percent in 1997, although it was expected to rise to more than 3 percent this year. Unemployment was expected to rise to about 7 percent, the lowest for Eastern Europe.

While most of the country’s development has been in Prague, says Carlo Gradl, a partner at Apollo Real Estate Consultants, a Swiss/German company in Prague, activity has picked up in the last year in other large cities such as Brno, Plzen, and Ostrava. Along with shopping center development, some big multinational companies that have been operating their Czech businesses from Prague are opening branches in these cities, he says.

Demand for office space in Prague is brisk, with an increased tendency toward preleasing, according to the international real estate firm Jones Lang Wootton’s report European Property Investment, which notes that in March, 35 percent of space due to be completed in 1998 already was preleased. Prime central business district (CBD) rents range from $2.30 per square foot (psf) to $3.25 psf per month; suburban locations can vary from $1.10 psf to $1.85 psf.

Prague’s CBD is attracting international retailers, but the city’s first large Western-style shopping mall opened only at the end of 1997. However, more than 25 projects are planned for the Prague area, with particular interest by multiplex movie theater developers, the report says.

Tourism also has affected development, large and small. "One of the things that’s impressed me so much is the retention of the Old World feel in the downtown areas," says J. Daryl Lippincott, CRE, an independent Phoenix real estate counselor and a director of EERPF. "Budapest and Prague are good examples; they’re just a delight." Lippincott points out that restaurants and cafes are springing up to accommodate strolling tourists, and many owners of hotels built during the Soviet regime are refurbishing them to more luxurious Western standards.

One market segment that has not increased significantly in the Czech Republic is the industrial sector. Lack of funding appears to be the main problem, as well as inefficient or poor-quality existing structures. However, reports the Ernst & Young Real Estate Group in London, smaller sites in good locations can be attractive to developers who can build more efficient, modern facilities.

Hungary. Hungary also has a new ruling party, elected in May. The country’s retail market in particular is flourishing, with two large shopping centers in the Budapest area and several more on the drawing board. The increase in suburban shopping centers, in fact, has driven down CBD retail rents somewhat; monthly rents currently are between $10.50 psf and $13 psf in prime areas.

Angela Kyster, managing director of CB Richard Ellis’ Budapest office, says that enough shopping centers are opening that a wait-and-see attitude might be advisable until it’s possible to see how much space the market can support.

CBD retail developers also are hindered somewhat by a particular bureaucratic practice. In the past, space wasn’t leased; rather, nontransferable "rights to use" were sold by municipalities. Developers of new space are able to provide more-standard leases, which have proven more popular.

Demand for office space has tightened up, although preletting is as common as in the Czech Republic. Within the last few years, the country has clarified rules for foreign ownership, putting some limitations on farmland acquisition.

Ernst & Young reports that the Hungarian government welcomes investments in infrastructure, energy, and tourism, particularly if developers offer infrastructure investments as part of a wider industrial package. The development of entrepreneurial zones—the first of which has been established in Zahony—also could be attractive to foreign investors, according to Ernst & Young.

The next big wave of development will be speculative industrial projects, Kyster predicts. Many existing facilities were state owned and were out of date and inefficient. Kyster foresees new stock being developed for light industrial use. She also sees potential in outright investment purchases as well as build-to-suit deals, particularly in the office and industrial sectors.

Poland. With nearly 39 million people, Poland is the largest of the three countries. Its stable economy and government—combined with high yields—are attracting more international investors than ever, reports Ernst & Young. However, the company also points out that government regulation, a complex bureaucracy, and unclear property ownership still make some potential investors wary. A restitution bill currently is pending that would help clarify property ownership issues.

In 1994, John Kontrabecki, president of TKG International, a San Mateo, California-based developer, decided to build the 500,000-square-foot (sf) Warsaw Distribution Center in 1994 in Poland after several years of researching Eastern European countries. "Everyone I knew who was interested in doing business in the region was looking at me strangely, because the favorites were Budapest and Prague. But all that has changed. Today, Poland has the greatest amount of foreign investment and the fastest-growing economy in the region."

Indeed, office rental rates in Warsaw are among the highest in Europe due to the lack of suitable space. Although 3.5 million square meters—37.7 million sf—of office space exists in the city, only about 10 percent to 15 percent is high quality—particularly important to international corporations. Vacancy rates are only about 2 percent, and monthly rents range from $2.30 psf to $4.60 psf (excluding common space and service charges), according to several sources. Yields for prime office buildings, according to Jones Lang Wootton, are between 12 percent and 14 percent.

Warsaw currently has five modern shopping centers, with about 2.5 million sf of retail space expected to come on line in the next three years. However, development outside the CBD is less expensive and more readily available.

The biggest retail wave follows Poles’ tendency to spend a hefty percentage of disposable income on food (36 percent): Eight 110,000-sf to 130,000-sf food markets were built in the Warsaw area in the last two years, the Jones Lang Wootton report says.

Kathleen Rose, CCIM, managing partner of Glogistics, an East Granby, Connecticut, consulting firm, agrees that European retailers are eager to enter the market, but says U.S. retail-entertainment companies are considering the area as well.

Chicago-based financier Sam Zell, along with Credit Suisse First Boston, recently agreed to invest $60 million to develop movie theaters and retail entertainment in Poland, published reports say.

Learning the Ropes
The Central and Eastern European region looked very tempting to developers immediately following the fall of communism, but business activity at the time proved that caution was necessary. "The first wave [of investors] thought this was virgin territory," Flynn says. "Now you’re seeing far-better capitalized, stronger organizations that are going there, who know the game and have learned the mechanisms."

The "mechanisms" include everything from vague or antiquated—or nonexistent—laws to complicated financing arrangements to sluggish government bureaucracies. "The bureaucracy here in the U.S. is more transparent; it’s responsive to needs, questions, demands, public records," says Flynn. "It’s not that way there." But with the support of the municipality, the development process can move rapidly, he says.

However, be prepared for differences in Eastern European legal systems. "The aspect of the law that relates to conflict resolution is not very well developed, so if you do have a dispute with a contractor, there aren’t established mechanisms for resolving the dispute automatically," Kontrabecki says.

Real estate professionals working in the market agree that it’s essential to have good local contacts and reliable legal advice. "Without a competent real estate attorney I wouldn’t do a single thing," Kic says. "Title transfer—the entire matter of ownership—is different than what we think of in the U.S. There are perpetual leases, 99-year leases, mineral rights to consider."

Financing
Financing remains a thorny issue since capital still isn’t abundant in these countries.

"This isn’t the kind of market where you can put a piece of property under option and take 90 days to run around and arrange financing," Kontrabecki adds. "It can take you a year or a year and a half...so you’d better have a clear idea of where the money’s going to come from before you enter into contracts to purchase property and attempt to begin development."

In fact, investors and developers may want to look outside these countries for financing. "I wouldn’t try to finance locally," Flynn says. "I would probably either try to use an Austrian, German, Dutch, French, or British bank—or if you had contacts [in the U.S.], banks from this environment. By and large, the banking systems have not been as well developed as they are here.

Construction costs on projects are similar to costs in other parts of Europe. "Quality building material is as expensive as anywhere else in Europe, but labor and initial purchase costs are far cheaper," Gradl says.

Another important economic consideration is the countries’ entry into the European Union. Most seem to agree that it will happen; estimates vary as to when, ranging from within five years to 10 years. "That will probably lessen your profit spread to some degree," Flynn says, "but it will stabilize those markets and currencies."

Know Before You Go
Approaching the area, Kic says, "should be no different than if you’re approaching New York from Texas. You have to have a local person even if just to find out about the local market."

Those familiar with the market emphasize the importance of developing local contacts in addition to attorneys. Flynn recommends starting out by talking to the local American embassy to find out "about the integrity of the kinds of players that you ought to be attracting." Rose adds a basic caution for all foreign business: "Be really sure you don’t make any assumptions based on your experience in the United States." Despite the three countries’ eagerness to develop Western-style real estate practices, "You can’t assume that you can impose upon your foreign constituents our way of doing business," she says.

Sarah Hoban

Sarah Hoban is a business writer based in Chicago.

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