Owning the unknowns

Nathan North, Eurobuild CEE: How has the start of the year been in terms of capital market activity in our region? Has it been quieter than usual, given all the economic and geopolitical uncertainty? And how much of a hit have CEE capital markets taken due to the situation?

Dennis Selinas, CEO, Globalworth: In terms of individual transactions for private market real estate, investors are now taking a wait-and-see approach. There’s still a lot of uncertainty about central banks’ terminal interest rates in the EU, where the market expects increases up to 4 pct. Of course, central banks are responding to the inflation and although headline inflation measures are improving, core inflation remains an issue, especially in Europe where the European Central Bank started tightening financial conditions later. Furthermore, In Europe as well as in the US, labour markets remain robust with unemployment at record levels. The question is – how capable will central banks be in bringing inflation under control and how much more will they have to increase interest rates in order to achieve their long-term target of 2 pct, if they manage it at all?

The ECB typically started to fight inflation later than the US Fed, as there is always a time-lag as it takes more time for policy reaction – and this always helps to perpetuate uncertainty. And in the EU, despite the war and the energy crisis, we’ve been able to fill our gas storage tanks and because of this, and also because of the warm winter, gas prices have declined to their pre-war levels. Although things aren’t looking so bad at the moment, the question is how things will be in winter 2023. As a result, there’s little activity going on in the capital markets, which means that there’s less funding available for real estate. Investors – insurance companies, pension funds and other holders of real estate bonds – are now overweight real estate. One AA rated US logistics company did manage a bond issue recently for a few hundred million, but this wasn’t representative of what the industry can currently do. There’s also a question mark over valuations, as there is uncertainty about when central bank interest rates will peak and (by extension) debt costs. And there is still caution related to inflation and how much we will get it under control. Real estate is in the same boat as other asset class holders in terms of bond market access. The banking market, however, is still open and quite active, and the banks have significant capacity for our sector. So there is a source of funding, of course more expensive than before but cheaper than bonds, which does allow us to look at new investments, developments and acquisitions; however, our investment criteria are much stricter. Prior to 2019, we would have looked at developments that were much more likely to withstand negative market sentiment, but now there are fewer of these that make sense. Whereas back then five investments might have met our risk-reward criteria, now it’s just one or two. We have also become more focused in terms of sectors. Logistics in Romania still has strong fundamentals, and this is where we are looking to expand our portfolio. We are currently the third largest investor in Romanian logistics with 400,000 sqm. At the same time, part of our strategy now is to expand our logistics footprint in Romania and close that gap. For offices, there are still some single-asset developers who at some point will need to sell and they will have buildings that will meet certain criteria, again buildings that are resilient because they are new, efficient and a destination for tenants whose biggest challenge is to attract their office workers back. Overall, our strategy is to expand our logistics and light industrial portfolio in Romania and to rotate our office portfolio into newer and more efficient buildings – by continuing investing in our own space and making it more attractive for tenants’ employees to return, since the office market still has low physical occupancy, although this is steadily improving. We are replacing HVAC systems and older lifts, refurbishing lobbies and collaborative work areas, as well as installing various innovative proptech solutions. Basically, we will be making the right investment to bring all of our buildings up to even higher standards and ensure that they are future-proof.

Do you think this year will see the same sort of volumes transacted as last year? What will the final figure depend upon?

In terms of expected investment volumes, it needs to be borne in mind that real estate has its own momentum. It’s sort of like the shipping industry, where whatever’s being built doesn’t stop immediately the moment the market changes – shipyards continue to work and deliver their orders. It all depends on how the demand eventually plays out. In terms of acquisitions, in Romania we had a record volume in 2022 and I think near record levels in Poland as well. There are still transactions that were being contemplated and discussed in Q4 2022, which will be carried over into Q1 2023. And those will, of course, be pared down and probably not as many them will be executed as was contemplated, considering that the bid-ask spread has widened and asset holders and sellers need more time to adjust their expectations. In Romania, for example, there were transactions contemplated at yields of around 6.5 pct prior to the beginning of the war and the big increase in inflation. Realistically, transactions should be above 7 pct (for class-A offices), because there are fewer potential buyers on the market than a year ago and they are also of a different nature, looking for more opportunistic deals. This will have a significant impact on transaction volumes in 2023. There are opportunities as well, which is what we are looking for. At some point, single-asset developers are going to be willing to exit at yields they wouldn’t have been looking at a year ago. Real estate bond yields for BBB- rated issues have decreased from 10 pct to 8–8.5 pct over the last three months, and market sentiment is improving as many believe there will be a soft landing instead of a recession, while central banks are believed to be managing inflation. However, the inflation issue is still unresolved, as core inflation remains high due to the initial impact of monetary policy, and it may take several months for the situation to work itself out. Resolving supply chain and energy-related issues will also help to alleviate inflation. While real interest rates were negative before, the long-term average should be at least 1 pct. The ECB has increased its interest rate target to 2 pct; however, inflation expectations are anchored at 3 pct. Although this is not as high as the rate expectations in the late 70s and early 80s, it is still higher than it had been. As a result, we may see real estate yields increasing to compensate for this, so that the spread between them and risk-free rates is adequate for investors to re-engage.

Are there any new real estate investment hotspots emerging? Or is the capital flowing more into established safe havens, such as Poland?

Office developers in Warsaw have actually halted further developments due to the higher costs of funding and construction, resulting in a shortage of available office space. Similarly, in Bucharest, new permits have been temporarily frozen by local public authorities, leading to a reduction in new supply. To encourage developers to start developing again, the returns on both existing and new developments will need to increase, but this will have to go through the cycle. In order for yields to increase, interest rates must also increase. For instance, it is not feasible to have 3 pct yields in Germany with interest rates at 4 pct. The biggest increases in yields are expected to occur in Western countries, where 0 pct interest rates and risk-free rates have proven to be unsustainable. Markets like Warsaw and Romania are therefore better positioned, because the prime office yield in Warsaw had been 4.5 pct at its lowest and 6.5 pct in Romania. Thus on these markets yields won’t have to go up as much as in Germany to offer investors positive real returns.

Are there any asset classes or new niches that investors and funds are interested in? Or again, are they taking a safety-first approach given the current situation, and sticking with what they are most used to?

Despite the general negative outlook, there have been some positive developments, such as in the residential-for-rent segment. This particular market has strong fundamentals, with rents increasing and the supply of new housing decreasing, while the demand for buying homes has been shrinking due to the high mortgage rates. As a result, potential buyers are being forced to rent, making the homes-for-rent sector more resilient. However, there is a need for new developments specifically designed for this sector, which are currently lacking in Romania. Some players on the market are looking to address this gap by providing the necessary product. In Poland, there have already been transactions by Scandinavian investors, in 2021/2, but the yields were pushed to very low levels. Nevertheless, with rents indexed to inflation, the returns on these investments are likely to improve. In the logistics sector, there has been a significant drop in effective rents in Poland, which has led to the withdrawal of some transactions from the market. This drop in rents is due to the highly elastic supply that allowed for the rapid introduction of many products into the market. Despite the fact that this sector has solid fundamentals and proximity to Western markets, the surplus supply has outstripped demand. As a result, the situation is now characterised by excess supply, resulting in lower rents and lower returns. In Romania, on the other hand, there is still an insufficient supply of logistics and light industrial properties, but there has been an upswing in the trend towards near-shoring. Manufacturers based in the West are now reluctant to produce goods in far-flung locations, particularly China, due to the geopolitical uncertainty. This has fuelled an increased demand for logistics space in Romania. While for the retail sector, although it is holding steady, the future is uncertain, with concerns about the impact on disposable incomes of individuals and retail consumers of a potential recession or weak economic growth. Inflation is currently high in many countries, while wages are not rising at the same rate, which further complicates matters. Predicting market conditions over the next five years is challenging given the current geopolitical uncertainty and volatile energy prices. As a result, investors are seeking greater clarity before making any major moves.

So, in terms of asset classes, no particular segment stands out as superior under the current market conditions, although there may be some potential in hotels and leisure. Another segment that is showing signs of improvement is the office sector, driven by a shortage of supply and the ongoing trend of remote working. It may take some time to achieve stability, but the key factor for success is maximum ESG compliance and having buildings that meet the highest standards to attract employees back. Thus investors are exploring innovative technologies that can enhance building efficiency, achieve energy savings for tenants, and create a more desirable workplace environment.

Could the war deter investors and funds from our region? Or could it actually have a positive impact on the real estate market here – with the influx of refugees relieving labour shortages while also boosting the demand in some segments?

The potential of a spill-over of the war in Ukraine has raised concerns about its impact on investment, but if such a conflict were to occur, it would pose a threat not only to neighbouring countries but also to Europe as a whole. Given that Romania and Poland are members of Nato, if they were dragged into the conflict it would require a reaction from other European nations, such as Germany and France. Therefore, this issue should be viewed as a pan-European phenomenon rather than just a concern for the countries bordering Ukraine. It is not a valid argument for isolating CEE countries, although it could lead to a decrease in investment from American investors across Europe. The influx of refugees might have a positive impact on the medium to long-term population growth and GDP growth trends, which could help alleviate labour shortages.

Who are likely to be the main investors? Are domestic funds and players finally going to take a more leading role?

Local capital has emerged as a significant player in the CEE real estate market, particularly in Romania, where this trend started later than in other countries in the region. As these local players continue to grow, I anticipate that they will become even more active. Despite the current slowdown in real estate investment across various regions, including the CEE, Germany and the UK, I don’t see a reason why foreign capital would be hesitant to invest in the CEE region once the market stabilises. The issue at present is the lack of data and market uncertainty, which has made investors cautious about investing in real estate. Nonetheless, the CEE region still offers strong fundamentals and attractive yields for the same level of investment risk as in Western Europe, making it an appealing destination for investors. As the CEE real estate market becomes more liquid and robust, it may attract new types of investors – such as sovereign wealth funds, which have not traditionally been active in this part of the world. While there may be a short-term pullback in investment activity in the CEE region similar to other countries, the region’s fundamentals are still attractive to investors, and this is likely to draw in new players over time.

How confident are you about the market looking into the longer term?

The current state we find ourselves in is temporary, although we are uncertain as to how long it will last. Former US government official Donald Rumsfeld famously said that there were three different categories of knowledge – the known-knowns, the known-unknowns and the unknown-unknowns. Recent events have been marked by the unknown-unknowns – situations that we knew could possibly happen but perhaps not in our lifetimes. Two unprecedented events, the pandemic and the war, occurred within two years of each other. Additionally, the world experienced historically low interest rates between 2008 and 2022 as a result of the financial crisis. The combination of these three events created a perfect storm that resulted in the worst possible situation. Without all three factors, the market reaction and the economic impact would not have been as severe. The pandemic led to an unprecedented fiscal policy response, with governments spending heavily to keep people employed despite being unproductive and confined to their homes, while the banks maintained their 0 pct interest rate policy. As a result of the pandemic, there were supply chain issues, with hundreds of ships anchored in each major port. People saved a lot of money and invested in such shady things as cryptocurrency and meme stocks, while the pent-up demand led to a spending frenzy once the lockdowns ended. This sudden surge in demand, coupled with the limited supply, was what fuelled the current inflation. Unfortunately, the initial central bank response was inadequate for dealing with this situation. However, despite the challenges, we have managed to avoid a recession and this is an encouraging outcome.

Does this mean that you’re optimistic about the CEE region’s prospects? How long could it take to get back to normal?

Despite the recent market volatility, I’m optimistic about the CEE real estate market as it boasts strong fundamentals that are still in place. Furthermore, geopolitical considerations have sparked a trend towards onshoring, which is expected to provide an additional boost to the region’s economic growth. It appears that we have experienced a relatively smooth economic downturn, but the situation could worsen if inflation isn’t bought under control and central banks are forced to significantly raise interest rates. The current situation is one of cyclical patterns compounded by unique factors, such as novel fiscal and monetary policies, the pandemic and the ongoing military conflict. Although a return to normalcy is expected, the timing remains uncertain, which has unsettled the market. The CEE region has a competitive advantage in terms of its strategic location, skilled labour force and higher GDP growth rates, making it an ideal bridge between Eastern and Western European economies. It also continues to offer higher yields for the same level of risk compared to many Western countries. As the current period of uncertainty works its way through the system over the next 6 to 12 months, I expect that the same incentives that attracted investors to the CEE region before will once again become compelling, and the region will resume its position as an attractive investment destination in the medium term.

Taking the helm

Dennis Selinas was appointed the CEO of Globalworth Group on January 1st 2023. He has over twenty years of extensive experience in the financial and property industries and has expertise of executive management, operational and financial restructuring, M&A advisory, private equity, trading and derivatives structuring in several asset classes (property, distressed debt, fixed-income, precious metals). This was gained from working for such institutions as listed property companies, private equity funds, investment banks and hedge funds in several diverse jurisdictions (the SEE region, China, Brazil, the Middle East and Western Europe). He started his career trading fixed-income derivatives at the Bank of Montreal and moved to M&A with Lazard London after graduating at the London Business School. He has held senior positions at Charlemagne Capital and Argo Capital Management and has been involved in all property aspects, including acquisition, development, portfolio disposals, financing, asset management and restructuring in the retail, office, and residential sectors. In his spare time, Dennis is passionate about photography and enjoys snowboarding and kite surfing.