Yields and liquidity on the Baltic commercial property market
News headlines are reporting on the continued decline of yields on Baltic commercial property and on the increased liquidity of the market. Many arbitrary parallels are being drawn to 2007, the peak of the previous upward cycle. Let us try to put things in wider perspective for a moment and see what the situation actually looks like.
The decline in yield levels is a hard fact, of course. Whereas the average net entrance yield for EfTEN’s first real estate fund, which began investing in 2008, was approximately 9.5%, yields have now dropped to 7.5%. At first glance, a 2.0% drop seems none too drastic. This is only the case at first glance; it is worth completing an easy-to-follow mathematical calculation. Let us take an office building with 10,000 square metres of leasable office premises. All the premises have been leased at an average rental price of EUR 10 per square metre per month, to which there will be added direct utilities costs, generating no additional revenue, nor cost, for the owner. Calculate as follows: EUR 10 / square metre / month x 12 months x 10 000 square metres = EUR 1.2 million per annum. If we divide the annual rental income by a rate of return of 9.5%, the price of the commercial building works out to be EUR 12.6 million. Division of the same earnings from rent by 7.5% results in EUR 16 million, or a 27% higher actual price, not to mention a very big change in the absolute value in euros. The implication is unambiguous: commercial property is extremely sensitive to changes in the yield level, and a 2% point change in the yield results in a hefty change in the price in euros.
Based on our experience, we can say that compared to the darkest hour of the crisis in year 2009, yields in the Baltic States have now declined at a very generalised level, regardless of the asset class (offices, retail, warehouses, logistics), by approximately 2%; in other words, whereas rental rates have remained unchanged, property prices have risen, on average, by a quarter. Naturally, the reason is the drop in the floating interest rate, euribor from 5% in 2008 to the current 0%.
As to market liquidity, under this rubric the present time is compared most to 2007. At the peak of the last boom, the Baltic States saw the completion of commercial property transactions worth approximately EUR 1 billion in total. Although 2015 has not ended yet, it may be assumed that this year will top this figure. Many are left wondering whether what we are witnessing is the next boom. The answer is: Definitely not. Rather, our Baltic commercial property market continues to be so illiquid and fragmented that foreign investors still rarely look at it. In Sweden alone, 2014 saw EUR 17 billion (!) invested in commercial property, with more than three-quarters of transactions completed by local investors. Whereas 9.5 million people live in Sweden, 6.3 live in the Baltic States.
Last spring, I attended a Scandinavian real estate seminar in Helsinki during which every Finn began their presentation by apologising to Swedish investors for Finland being such an illiquid (that is, unattractive) market. As an aside, Finland saw the completion of commercial property transactions worth EUR 4.3 billion last year. Based on this, every reader may draw their own conclusions about excessive market activity in the Baltic States.
The yield level on the best commercial buildings in the Baltic capitals have dropped to 7.0%, with levels below 7.0% being tested as of now. If the yields in the Baltic States seem low to us, they have dropped to 4.35% in Stockholm, 4.75% in Gothenburg and 5.3% in the Malmö. In Prague and Warsaw, closer to us in the context of our 20th century complex history, the yields on the best buildings are below 6%, likely to decline down to 5% due to the onslaught of cheap money.
Accordingly, there exists a clear difference between the best yield levels in centres in Old Europe and Central Eastern Europe and those in the Baltic States. Why? The reasons continue to be related to both the small size of the market and the current security situation. The latter was a hot topic 6 to 12 months ago, although it is no longer in the background, what with the world focused on the developments in Syria and in the airspace of Turkey, a member of NATO. A spread in yield levels places us on the radar screen of foreign investors, as greed is overcoming fear. Next year, this interest may be expected to continue to increase, also materialising in concrete transactions.
In 2014, we witnessed two major transactions in Baltics: Partners Group based in Zug, Switzerland, with assets under management over EUR 40 billion, acquired the assets of BPT Optima in the Baltic States and Poland in a EUR 163 million transaction. Allegedly, a transaction of approximately EUR 100 million was also completed on the Baltic market by the newcomer LNC Capital Partners, which acquired from Estonian businessmen a social housing project in Tallinn.
However, there are gaping differences in yield levels not only among the Baltic States, Scandinavia and Central Eastern Europe but also within the Baltic States itself. For reasons that are understandable, nearly all commercial property investors have focused on capitals – being the largest cities in each country, with the most liquid markets, etc. This has turned regional centres in the Baltic States into underdogs, which is perhaps understandable given our negative trend of demographics. On the other hand, every euro earned in the capital is equal to every euro earned in the regions. The difference is simply in the risk premium. EfTEN is also looking around in the regions and is prepared to invest in suitable projects in county centres, in return receiving a higher risk premium, in other words higher yield. We have done this successfully in the past and plan to do it again in the future, but definitely on a limited scale. This is perfectly understandable if the difference in the yield levels in the capital versus regional centres is approximately 1%. When the difference widens to almost 2%, attractiveness, for us, obviously increases. Why? It is worth re-reading the second paragraph.