Q&A – Otis Spencer

In the mid-1990s, Chicago-based Heitman became one of the first major property players to invest in Central Europe. The firm formed a JV in 1996 to develop the Warsaw Financial Center, a 32-story office building that was the tallest building in Eastern Europe. In 2000, the firm launched Heitman Central Europe Property Partners to focus on Poland and the Czech Republic, which closed on $125 million. Slovakia and Hungary were added to the mandate for the second fund, which closed on €175 million in 2002. By the time Heitman launched its third vehicle on €350 million in 2005, it was also looking for opportunities in Estonia, Latvia, Lithuania, Slovenia, Romania and Bulgaria. Otis Spencer, the firm's Warsaw-based portfolio manager, spoke with PERE about the evolution of Heitman's strategy in the region and where the firm is looking for value as competition grows.

How has Heitman’s fund strategy changed since it launched its first vehicle in 2000?

When Heitman launched its initial Central European fund, the strategy and the targeted returns were more opportunistic than its current fund, Heitman European Property Partners III. Basically, some years ago there was such a lack of capital in the market that investors had much more choice in terms of potential properties and partners. For example, a property that would be classified as a core investment today could be acquired on terms, and by utilizing the appropriate leverage, generated investors opportunistic returns. Now with Fund III, the strategy has changed somewhat in that there is much more of a focus on value-add opportunities and non-traditional property classes, things like for-sale residential development. With the emergence and availability of mortgages for a lot of the people of Central Europe, the goal of home ownership is achievable and has created an interesting opportunity. As a result, with Fund III we are pursuing a diversified strategy of acquiring income-producing properties and entering into more residential development joint ventures.

What residential development have you been doing recently?
In Fund II and Fund III, we’re working with the Engel organization, an Israeli developer with local offices throughout the CEE region, and we have a residential development program with them across the region: Poland, Hungary, Czech Republic and now in Bulgaria. More specifically, we’re working with Hines on an individual project in an affluent suburb of Warsaw called Wilanow. There is need for better quality housing product in these converging economies. If you drive around Warsaw, you see a lot of Communist-style buildings: very grey, sometimes drab, and generally the living areas are rather small. Units consisting of between 40 and 50 square meters are not uncommon. In the type of unit we’re developing with Hines, the average size is about 90 square meters. Our experience indicates that people’s incomes are increasing and that they are increasing the size of their families, so there is significant demand of higher-end residential units in Warsaw.

How has the EU accession of the CEE countries affected the real estate markets?
The risk premium has gone down. Cap rates in Romania and Bulgaria have dropped dramatically. When I first started looking in Romania in spring 2005, we were thinking double-digit cap rates, around 10 to 11 percent. There had not been a lot of transactions done in Bucharest or Sofia, because the markets were not that developed and there was not a lot of debt for the market, so an 11 percent cap rate was not unheard of. Within nine months, it dropped down to single digits. People could see they were getting closer to the EU accession, so it came on the radar screen of many of the Western European buyers. Now it’s around 8 percent. If you can find a decent asset in Bucharest for 8 percent, you’ll have three or four bidders for it.

What other sorts of projects are you working on?
We are doing an aggregation strategy on two fronts to take advantage of the large funds that are targeting the region. They’ve got small teams and they’re looking for transactions in the range of $50 million to $100 million plus. They like to buy portfolios. Our strategy is to play into that with High Street Retail, which [invests in] well-located, single shops in certain cities across Poland. We will create a portfolio and then sell that portfolio and achieve the portfolio premium. We’re doing the same thing with the Central European Office Fund, buying small office properties across the region. We have recently acquired properties in Sofia and Prague. They have international covenants, but the deal size is much smaller, so they’re below the radar screen of your typical institutional real estate buyer. We’ll do a transaction like one recently finalized in Sofia—an €8.6 million transaction. You get two buildings—all great tenants and good covenants—and then aggregate with six to eight additional other properties into a portfolio of €100 million. You can sell that and achieve a portfolio premium.

Are there sufficient exit markets across CEE?
Right now there is a lot of liquidity. Currently, exiting an investment is not a problem. You’ve got the typical core buyers out here from the German open-ended funds and the Austrian core-type buyers, but you’ve also got a lot of opportunistic buyers from Spain, Ireland and the UK. What is also an exit—which you’ll see in Bulgaria, for example—is the REIT market. They’ve got REIT legislation, so these REITs are active buyers of single assets and portfolios. That’s a trend we’re seeing more and more—the securitization of real estate. Also, in all of these markets, banks are stumbling over themselves to provide debt facilities.