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IPE.com 1/Jan/05: With a wide range of options open to them in Eastern Europe, some investors are asking why they should consider the Baltic States; amongst the smallest markets in the region.

However, while each is different, perceptions of the area are very much on the up and they are increasingly seen as leaders in reform and economic growth. But is this enough to generate future activity and performance?

Helped by the general buoyancy of demand for commercial property and the expansion of the EU, the east has enjoyed a significant re-rating among investors, moving from being a high-risk play to a serious option as a value-added market.

The Baltics have one big plus and one big minus. Relative size is their negative, investors want markets where they can build a critical mass and gain economies of scale. For many therefore, the Baltics are best targeted via an indirect vehicle rather than directly. On the positive side meanwhile, they are leading reformers, with strong recent economic growth and are judged to be relatively efficient and easily accessible for foreign investors.

Estonia is the most advanced Baltic market and in fact has the most efficient property market structure in Eastern Europe. It does however suffers due to its small size, as its better risk rating became somewhat less significant due to the progression of other states and a change in investors’ tolerance of risk. Latvia and Lithuania meanwhile moved up our ranking and while less developed than the Czech Republic, Hungary or Poland – the leaders in Central Europe – they are expected to continue to converge at a rapid pace.

In terms of a regional comparison, Estonia is one of the most developed shopping centre markets but on all other counts, modern stock levels are low by regional standards. Estonia, despite being the smallest market, has clearly seen most recent activity. Aside from having a larger modern market due to development over recent years, it has also enjoyed a higher level of office take-up and a greater number of new arrivals among cross-border retailers. However the other markets are now set to catch up, particularly Lthuanian capital Vilnius which has a higher level of development activity in both office and retail sectors.

Investment in new facilities is however a key feature of all of these markets. With relative advantages in labour skills and cost as well as the appeal of the historic centres of their key cities, all three expect more inward investment. The importance of their local markets will also grow, due to increasing purchasing power and urbanisation.

On the back of this, the Baltic States expect to see steady growth in the level of property demand and market activity. How this translates into property performance is a separate question however– with new supply blunting or reversing rental growth as vacancy levels have climbed – to in excess of 10% in Vilnius and Estonian capital Tallinn and over 20% in Riga. New centres in the retail sector also have to compete hard for tenants.

Rental costs tend to be higher in Vilnius and lower in Tallinn – reflecting the greater availability of stock in Estonia. Growth trends have however been quite divergent, with office rents down over the past two years in Vilnius and Riga as development has improved, while Estonia has seen rising industrial rents and Latvia, rising retail rents. Rents in general still stand below other areas of Eastern Europe meanwhile – a further comparative advantage in attracting occupiers.

Yields are similar across the markets (albeit tending to be lower in Vilnius and higher in Tallinn) and whilst lower than the Eastern European average and down over the past one to two years, they are still attractive in comparison to the levels now seen in Central Europe. Yields are expected to continue to decline, as market size and liquidity improves and more foreign tenants arrive in the market. This would bring more stock to the market and hence opportunities for incoming investors. However, this will take time and for the near term, higher risk-taking investors will dominate activity.

Investors do benefit from a typically lower level of costs – including transfer taxes – but they will still expect a yield premium in smaller markets such as the Baltics and the relative security of local leases (often with short termination periods and a lack of indexation in Estonia) will also impact. As a result, the future development of these markets will be steady. Their relative size will restrict the number of investors ready to include them in their investment planning but this will erode over time as buyers start to consider European investment more on a regional than a country basis.

In the shorter term, development opportunities will attract interest, especially in Riga and Vilnius, and standing investment in the retail and office sectors are likely to draw private foreign buyers – particularly given the higher yields and attractive setting of the key cities. Hence while there will be some risks as these markets mature, they do offer both short and medium term investment opportunities – when seen in the context of their regional competitors in the east or, as they would increasingly like to be seen, in comparison with the EU as a whole.

By David Hutchings
David Hutchings is head of research at Cushman & Wakefield Healey & Baker

Abridged from Investment and Pensions Europe