Happy days are still here... for now

Tomasz Szpyt-Grzegórski, ‘Eurobuild CEE’: How was 2018 for you?

Paweł Dębowski, a partner at Dentons and head of the European real estate law team: It was special. The first three months were slightly slower, but then there was an accumulation of activity. It was a record year on the investment market – well over EUR 6 bln in turnover – and we didn’t see that coming. What’s equally important is that it doesn’t seem like this year will be any worse, although anything can happen and disrupt the economic situation. On the other hand, we already have around EUR 2 bln in turnover in deals contracted for H1.

Q1 and H1 are usually calmer periods...

There are several deals that have been moved from 2018 and will be finalised in the first few months of this year.

What were the most important events of 2018?

There are probably a few candidates: the total value of transactions and the entry of new investors – Asian capital is likely to be the most important. In the search for more attractive rates of return, we are seeing an increase in joint-venture transactions between the capital investor – the more passive ones – and the developer, along with the launch of projects under such arrangements. This applies to virtually all the market segments. It’s also impossible not to notice the fall in yields on the office market in Warsaw to below 5 pct, which had been unthinkable up until very recently. We have already had a few such deals, and several more are in progress.

Is 4.5 pct achievable?

I believe that it’s possible.

Where is the appetite for Polish real estate coming from?

First of all, investors are not afraid of allocating large sums of money in individual transactions in Poland. The transformation in the classification of Poland into a developed country is of great importance. Secondly, the value of individual transactions has increased accordingly. There are significantly more deals worth around EUR 100 mln or more than before. We also have significantly more portfolio agreements, especially on the warehouse market. This segment is much more dynamic than it had been previously. People are proclaiming logistics as “the new retail”. There’s a lot of truth in this, in many respects, although it has to be admitted that deals in the retail sector substantially boosted the overall volume in 2018. Thirdly, there is the inflow of new capital, mainly from Asia. And this has been having a huge impact. In 2018, more than EUR 1 bln was injected into the Polish market from this direction. We now have capital from the Philippines, South Korea, Malaysia and China. This money goes to us directly or is placed by funds based in Western Europe. At least 20–30 pct of the capital invested in Poland in 2018 came from Asia. What’s important is the fact that Poland is perceived as a stable market with high liquidity and priced at a more attractive level than Western European countries. The office sector in Warsaw is doing very well and the net absorption in this market remains consistently high despite concerns about the amount of new construction. It’s higher than Berlin, for instance.

Is the Asian interest in Polish real estate simply one example of how capital from this region perceives Europe as a whole – or is Poland particularly interesting?

Poland is being particularly singled out. Generally, Asian capital is interested in Western Europe. But let’s try taking on the perspective of someone who manages capital not from Europe but from a place a thousand kilometres away. The fact that Poland is now classified as a developed country has changed the approach to capital allocation in our country. Rates of return here are compared to those from Western Europe. If such an investor feels confident about the stability of the legal and tax system as well as the economic prospects, then it’s very likely that Poland will prove to be a more attractive market than Western Europe. In our own region, the Czech Republic could be competition for us – however, this is a very small market, with a high degree of liquidity but a small supply; which leaves Hungary as the only other rival, but the political situation there has been deterring many investors. So for Asian capital, especially from Korea, it’s clear that its preference is now for Poland and the UK.

Despite Brexit?

Yes, they are buying against the general feeling. They are convinced that even if it comes to Brexit, the foundations of the British economy are so solid that the exit from the EU shouldn’t matter in the medium term, and it certainly won’t in the long term. I think they may be right in the long run, no matter what kind of Brexit it turns out to be. They are aiming to take advantage of the current uncertainty that has led to lower prices and higher rates of return.

Is it not the case that the market is peaking and some investors are behaving as if their money was ‘burning’ a hole in their pockets? Therefore they’re looking for investment that explores newer classes of assets, such as apartments for rent and student halls. It reminds me of the situation a decade ago.

I’m probably a bigger optimist. In Western Europe, especially in Germany, rental housing is one of the main segments of the investment market. This results, in a sense, from different attitudes to our own regarding property ownership. But I wonder how much the mentality has been changing here, especially when it comes to younger Poles? Furthermore, mortgages in foreign currencies, which were popular in the past, showed that properties can become millstones, especially if the value of the złoty falls combined with a slump in property prices. Today there are basically no foreign currency mortgages, but the risk of a collapse in home prices remains. The rental property market is also being supported by the tightening of the criteria for granting mortgages. The 20 pct own contribution now required for buyers could prove to be an insurmountable obstacle for young people. The influx of people into the cities and the need to find homes – and to do so with greater flexibility – are also worth mentioning: in twelve months’ time we might want to have a bigger flat or a flat in another district because it will be closer to work from there. Institutional investors able to offer the right product will be able to successfully operate as landlords. I think that within the next year or two we will see this market sector undergo dramatic growth. It also has to be remembered that the product offered by institutional investors will differ significantly in terms of the services provided from a product that an individual landlord can supply. This upward trend can also be seen with student halls. The first platforms operating in this segment are very popular. The Polish academic sector provides high quality education, but is at the same time cheaper than in the West; thus it attracts students from Asia, the Middle East and Scandinavia. For them, private student halls are very attractive. It’s hardly surprising that they are more than 90 pct leased.

Offices, shopping centres, warehouses, hotels, student halls, apartments for rent... everything seems to be in high demand. Each boom eventually, however, comes to an end. What could happen to slow things down or even to put them into reverse?

Whatever answer i give, it will be wrong. I think that none of us can predict this. Probably, things would start to go wrong in the US and a few months later it would hit Europe. Why? There are a number of possible reasons: a drawn-out trade war with China, followed by hikes in interest rates in the US and an increase in yields on bonds – the price of a property is a derivative of the price on the bond market. If bond prices rise, this results in a correction of property prices. The appreciation of the dollar may also have an impact on the global economy, especially in developing countries, which produce 60 pct of the global GDP today (unlike ten years ago). They are, just like their business entities and the banks, indebted in this currency. The increase in the value of debt caused by the appreciation of the dollar could turn out to be disastrous for them, and due to the fact that their share in the global GDP is very significant, this could plunge us into a recession. We can already see this clearly in Turkey, where the appreciation of the dollar combined with inflation has led to the introduction of laws prohibiting shopping centre rents from being denominated in US dollars. Still, whoever predicts the dollar exchange rate at the end of 2019 would deserve more than his weight in gold. I have read the currency analyses of four banks and two of them declared the end of the dollar era to be nigh, whereas the other two predicted quite the opposite.

What could be a problem in Poland?

In Poland we could have problems with the availability of labour. The opening up of the German labour market to workers from Ukraine will not help, but we should soon be able to see what impact it might have. The fight over employees will surely lead to an increase in salaries in the private sector, while everything indicates that there will also be pay rises in the public sector. Both of these factors are inflationary, but I would personally not exaggerate the scale of the phenomenon. Another issue is to what extent we can keep our economy competitive as the price of labour grows. However, this should not be a major issue for the next two or three years. I’m more worried about the December decline in construction orders to 47.6 on the Purchasing Managers’ Index – the lowest since 2013. [A PMI of below 50 indicates a contraction of the market – ed.] This represents a fall in the number of orders, especially for foreign contractors. A declining PMI could – but doesn’t necessarily – mean a slowdown in growth. But we should take seriously the signs from Germany, where a slowdown is expected in 2020. We are very tightly bound to the economy of our western neighbour – if it slows down, we will have some problems. Our decline in PMI comes in the wake of the PMI decline of our neighbour, but in Germany it stopped at around 50 points. I also hope that interest rates will remain at the same level in Poland and that our GDP grows by more than 3 pct in 2019. That would be a very decent result.

You referred earlier to the stability of the legal and tax system. How stable is it in reality?

I think that we need to look at several aspects here. To being with, the positive aspects, such as the issuing of explanations for the VAT on commercial real estate transactions by the Ministry of Finance in December 2018.

Does this cast off the doubts that arose after the tax authorities changed the transaction taxation practice?

It’s evident that the Ministry of Finance came to understand that the issue of taxation was of tremendous importance and noted the huge drop in VAT receipts from commercial real estate transactions. The market simply avoided making such deals. Uncertainty also built up over the issue of whether the distinction between the sale of a company and of its properties would be undermined. The ministry eventually became aware of these issues and the consultations regarding the explanations were carried out very professionally. If the government adheres to the provisions of these explanations, then these problems should all be resolved within a year or two. However, it is not the case that these matters are now closed. Trust that has once been damaged cannot be rebuilt immediately by just publishing lots of explanations. Long months of compliance with these interpretations will be needed. I don’t think that in the near future someone would dare to finalise a transaction only on the basis of this new documentation. Investors will continue to rely on individual interpretations. If they are in line with the new explanations, which will also allow us to create a practice based on these new interpretations and not have to deal with refusals to refund VAT despite previously issued individual interpretations, I’m sure that the problems will disappear over time.

This is a positive. So what are the negatives?

I wouldn’t call this a negative, but the scale of the tax changes that have been coming into force since January 1st, 2019 is substantial – in fact, it is enormous. From the point of view of the real estate market, the main planks are the changes to the rules for the withholding tax in Poland, the changes in the minimum income tax for commercial real estate, the changes to transfer pricing regulations, and the improvements to the law designed to limit tax avoidance law – both GAAR and the introduction of MDR, i.e. the obligation to disclose certain tax structures. As you can see, this amounts to a massive amount of change. The reforms to the withholding tax law seem to be rather complicated, in terms of the tax collection, the return of the tax collected and the issue of the beneficial owner. The introduction of a new definition for the beneficial owner is aimed at preventing investing in Poland through entities that don’t take real economic risks and are located in jurisdictions that provide favourable provisions in double taxation conventions agreed with Poland. These provisions will, in many cases, lead to changes in the structuring of transactions and investing directly from the investor’s country. So, if someone runs a business in Poland and makes profits here, he or she should also pay taxes here. These changes will certainly increase the cost of operating in Poland and the administrative burdens involved. However, Poland is not alone in taking this approach. The new regulations reflect trends that can be seen throughout Europe and across the world. I don’t think that they will negatively impact the competitiveness of the Polish market. What I consider to be a negative aspect of these changes is the imposition of the obligation to submit tax structures implemented under the MDR as of June 26th, 2018, even though the new regulations came into force on January 1st, 2019, which I think is an example of a retroactive legislation. Another negative aspect is the use of excessive penal sanctions under the new regulations – including fines of millions of złoty and other incommensurate penalties, such as imprisonment. I think that this tendency in Poland to intimidate through the threat of incarceration is over-used and abused in all fields.

Is there anything that we really need to worry about?

The thing that is most worrying for investors, especially those based in Western Europe, is the so-called “reform” of the judiciary. Judicial reform is necessary and everyone agrees on that. This “reform”, however, is aimed at increasing the power of the executive over the judiciary through the newly appointed National Court Register and the disciplinary chamber as well as replacing presiding judges. These changes are making investors anxious, and I personally object to them and consider them unacceptable. We need to remember, however, that the most important thing from the market’s point of view is how things work in practice. I think that any judgment in an economic case that is ‘political’ would cause very serious damage to the perception of our market. However, I believe that the likelihood of such a situation is negligible. These changes, nevertheless, are raising concerns and we can expect them to have an impact on the trend for large contracts as well to lead to an increase in the number of disputes transferred to arbitration courts.

If we were to look at Poland’s development over the last thirty years, what would be considered a success?

Transformation, democracy, accession to the European Union and the re-awakening of the Polish entrepreneurial spirit.

Over the past few decades it was not possible for Polish capital to build a strong position for itself on the real estate investment market. Some attempts are being made, such as through the proposed introduction of REITs. Do we have a chance to finally achieve this?

A mechanism such as REITs would be very desirable. However, if we think about doing this seriously, then we would need to provide them with a source of capital. The stock market and open pension funds seem to be the natural solution, but they are more dead than alive. Employee Capital Plans could be the answer. But this will require time and professional management. It has to be borne in mind, however, that the return on investment in REITs is not going to be staggering, but that is not their purpose anyway. The creation of REITs is aimed at aiding the development of the Polish capital market. However, they should not be limited only to the residential market. I consider this to be an abortive idea. If it were possible to also invest in commercial real estate through REITs, it would be a very attractive form of safe long-term investment with a rate of return higher than that of treasury bonds.

What can we expect in 2019?

I’m an optimist, but in an odd way. Among my friends, I’m well-known for my pessimism towards the end of the year, which turns into optimism at the beginning of the next year. Admittedly, as far as the Polish economy as a whole is concerned, its peak might be behind us and GDP growth is likely not to be as high as in 2018. But I still expect a large inflow of capital and in H1 the investment market should show similar dynamics as it has been doing recently. ν

The icon at the helm

Paweł Dębowski is a partner in Dentons and the chairman of the European Real Estate Group. He is one of the most widely recognised and respected real estate professionals in Poland and the CEE region. In professional practice for almost 30 years, he was involved in structuring real estate deals in Poland back in the early days of the free market economy. He advises institutional clients and major international companies operating in Poland – investors, developers, lenders and construction companies. His area of specialisation covers sales and acquisitions, financing and investment projects in the real estate market, mainly in the office, retail, logistics and hospitality sectors in the region.