Membership has its privileges

As Romania and Bulgaria gear up for EU accession, their real estate markets are becoming increasingly active, but that doesn't mean a shortage of risks. By Aaron Lovell

In April 2005, the European Parliament approved the singing of its latest Treaty of Accession, which continued to pave the way for Romania and Bulgaria to enter the European Union. Over the next two years, the parliaments of Europe ratified the treaty, but it was not until a few months ago that the European Commission actually confirmed that Romania and Bulgaria would soon join the EU.

“Our conclusion is that both countries are in a position to take on the rights and obligations of European Union membership on 1 January 2007,” commission president Jose Manuel Barroso announced in September.

The last few years have represented the end of a long battle. Both countries formally submitted their application for EU membership in 1995 and are technically still part of the accession class of 2004, which includes Poland, the Czech Republic, Slovakia and Slovenia. Yet after more than a decade, neither Romania nor Bulgaria is out of the woods. Bulgaria, for one, will still face “accompanying measures” once it joins the EU, which means that officials will continue to measure progress in the realm of judicial system reform, corruption and the struggle against organized crime. And in early November, German chancellor Andrea Merkel warned that her government may demand additional measures from both countries when Germany takes over the EU presidency in January 2007.

But like the former communist countries that joined the EU in 2004, Romania and Bulgaria have much to celebrate. Their economies are growing, foreign investment is increasing and interest in their domestic property markets continues to heat up. In fact, even as the countries complete the few remaining steps to EU accession, their real estate markets remain as active as any in Western Europe.

PLENTY OF DEPTH
A country of 22 million people, Romania is roughly the size of the US state of Oregon. Considered by most real estate players in the region to have more developed property markets than neighboring Bulgaria, the country has attracted more than €212 million ($270 million) in real estate investment in the first half of 2006, according to broker Richard Ellis. This capital inflow surpasses the lows of 2005 and almost tops the entire investment seen in 2004.

Investors point to falling yields as proof of the growing interest in Romanian property, where most of the deal activity, approximately 75 percent, has been in the office sector. But investors are looking for opportunities everywhere.

“The country had been robbed of everything during the harsh Communist regime,” says Roger Peters, head of the real estate investment program at Athens-based Global Finance Emerging Property Fund, a closed-end fund that develops properties in Romania, Bulgaria and Serbia. “Everything from that 50-year era is obsolete. Therefore, you have to rebuild everything.”

That makes the residential sector, which is dominated by old, Soviet-era apartment buildings, an attractive play for some investors. Another benefit is the country's high rate of homeownership: Peters estimates that around 90 percent of residents own a home, many of whom inherited their property after the fall of the Ceausescu regime in 1989, giving them built-in equity to upgrade to nicer dwellings.

In addition to Global Finance, another firm active in the country is European Future Group, led by Canadian developer Jeff Kirby, who has been active in the region for more than four years. The firm recently launched the European Future Fund, which is currently raising more than €200 million for investment largely in Romanian real estate.

“We have a verified deal pipeline of €590 million and a further €700 million in negotiation or under contract,” says Kirby. “We still tend to remain more opportunity-driven, because the market is still so immature.” His firm is largely looking for former industrial parcels near city centers to redevelop into mixed-use projects, but it is also developing a group of logistics centers across the region.

When it became apparent Romania would be entering the EU, prices increased dramatically, Kirby says. Since then, people have increasingly become comfortable with the country and, as companies move in, they need logistics and office space.

“There is still a lot of depth in the market in my view,” he adds.

GED Capital, a private equity firm focused on southeastern Europe and the Iberian Peninsula, has been active in Romania for more than a decade, although most of its focus has been on traditional private equity investments. Nevertheless, some of their portfolio companies have incorporated a significant real estate component, like Continental Hotels, a group of ten three-star properties the firm acquired in 1996.

Late last year, GED entered into a joint venture with private equity firm Warburg Pincus to invest €50 million in a Romanian property company called Real Estate Development. Bucharest-based GED head Robert Luke says the attractiveness in investing in a developer was the ability to harvest profits not only from the company itself, but from its completed properties.

“Although a number of developers had started up [in Romania], some of them were pretty amateurish,” Luke says. In late October, the firm announced the sale of its Harborside project to ImmoEast, the CEE-focused arm of Austrian property fund Immofinanz.

“Yields have come plunging down over the last year,” says Luke. “People are equating Romania with Central European countries, but there are still some risks that need to be taken into account.”

Despite those risks, however, the country's economic fundamentals have been strong. Luke says the Romanian economy will most likely grow by 7 percent in the near future, outpacing the country's rate of inflation, which is approximately 6 percent.

A DEVELOPER'S MARKET
Bulgaria, Romania's neighbor to the south, emerged from behind the Iron Curtain in late 1989 with the fall of Todor Zhivkov. Long known for its ski destinations in the Pirin Mountains and coastal resorts along the Black Sea, the country is now seeing an increase in second-home sales as its economy continues to improve.

According to broker Colliers International, Bulgarian GDP rose by 5.6 percent in the first quarter of 2006, compared to the same period in the prior year, while overall unemployment decreased to 9.6 percent in May. Some players maintain that unemployment in the capital city of Sofia is lower than the national averages.

A decade of steady growth has been reflected in the country's real estate markets. Richard Ellis says that, in the first half of 2006, Bulgaria saw seven completed property deals, valued at more than €155 million, in the retail, office and hotel sectors. Shopping malls, in particular, have been a popular investment; a number of large retail centers have been developed in recent years, two of which are located outside of Sofia.

“Bulgaria is still not an investor's market,” says Georgi Kirov, the manager for investment and corporate advisory services at Colliers Bulgaria in Sofia. “It's a developer's market.”

As companies in Bulgaria continue to expand, Kirov says they are increasingly looking for larger offices. Because of the growing demand, there is a tremendous pipeline of supply coming online, which could double the available office space in three to four years.

Meanwhile, the housing sector is also seeing a large increase in supply. Colliers says that, as new housing stock outpaces demand, the residential sector is the most dynamic segment in Sofia's property market.“We would not call it a bubble,” says Kirov. “But we do think it's overheated.”

As the rental market remains small—most Bulgarians would rather own than rent—the residential play is one of capital growth. And less than Romania, where investors are increasingly casting an eye toward secondary cities, foreign investment in Bulgaria is largely focused on Sofia. Nevertheless, some groups, including London-based Charles Lewis Sofia Property Fund, have been investing near the ski resort areas of Dobrinishte and Bansko—reportedly Europe's fastest growing ski resort—in addition to the upper-class suburbs southwest of Sofia near Vitosha mountain.

“The story behind Bulgaria is profit margins,” says Loraine Pinel, one of the fund's managers. “People have bought land, but have not had the money to develop it.” Pinel's Guernsey-based fund has closed on €52 million for investment in Bulgarian residential property, encouraged by the country's stable, relatively low inflation rate and growing economy. She adds that another attractive factor has been the non-existent currency risk.

At the same time, a large proportion of the population is still living in Soviet-style high-rise apartments and, Pinel notes, many of these residents are looking to move to newer accommodations. “It's a domestic story,” she says. “You're selling to the locals.”

The Bulgarian retail sector has also been grabbing headlines. GE Real Estate worked with Dublin-based Quinlan Private on a two-stage investment in the Mall of Sofia, a 33,500-square-meter mixed-use retail development that sports a two-level shopping center, a cinema, a supermarket and a five-floor office component.

Karim Habra, managing director of GE Real Estate Central Europe, says his firm first invested in Warsaw and Prague in 1999 and later acquired 16 hypermarkets from French group Casino, including outlets in Bulgaria. “What attracted us were the high yields,” he says of the firm's CEE portfolio, which is currently weighted towards retail. He says the group plans to begin looking at more office investments in Bulgaria and is currently looking at two investments in Romania.

Habra also says that, while yields have come down, there are real estate plays outside of new development: Firms that believe in rental growth can acquire and hold for the long-term or try to buy Class-B assets and reposition them in the market.

Much more so than Romania, however, Bulgaria still has its challenges on a macro-economic level. Some market participants contend that the country's trade deficit is a lingering problem, while others point out that corruption and organized crime are still major concerns—something that the EU has noted and will be monitoring.

THE PRICE OF MEMBERSHIP
Asked about how the EU accession is affecting the real estate of Romania and Bulgaria, Global Finance's Peters responds, “It's making things more expensive.”

Peters' firm, which focuses largely on development, says that there is a lot of capital in each market chasing relatively few deals. “You find there is not much to buy and—if there is—it's too expensive,” he says.

Many investors speak of higher prices and lower yields—seemingly the hallmarks of EU accession in Central Europe. Habra of GE Real Estate says Romania is in roughly the same place Poland was a few years ago, prior to its own accession on May 1, 2004.

“The EU accession has been much more factored into pricing [in Bulgaria and Romania] than it was in Poland,“ he says of the class of 2007. “These are markets that are developing very quickly.”

In Bulgaria, residential prices have been creeping upwards throughout the accession process. “I think its going to continue to have an effect [on pricing],” Habra says. “I think we're starting to see an increase as January 2007 approaches.”

With the markets moving as fast as they are in Romania and Bulgaria, mistakes can be easily made. “One general mistake by early firms was buying Class-A [properties] that became Class-B over time,” Habra says, as the overall quality of the country's commercial properties improved.

Yet even as opportunistic investors rail against the rising prices brought about by EU accession, most recognize the significant impact that the accession process has had on the investment environment, including the fact that laws and regulations are increasingly brought into line with the rest of the EU.

“[Accession] sets up a rulebook and it sets up a series of hurdles which make the country more investor-friendly,” says Paul Kennedy, the head of research at Invesco Real Estate. The firm has a core vehicle investing in Central Europe and is looking to possibly acquire assets in Romania and Bulgaria as the current crop of opportunistic investors look for an exit.

“Arrival, in terms of European Union membership, matters a lot less than the journey,” he says.