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10 topics to follow in economy and Baltic real estate market over 2022
Inflation: for almost a decade most developed economies have lived in a very low inflationary environment. Inflation has constantly undershot the targets as set by central banks. To combat low inflation, unprecedented monetary easing has taken place – ranging from negative base rates to outright purchases of financial assets. In the euro area the ECB balance sheet has in 10 years increased by over 3 fold to 7 trillion euros. To support the government bond market, it has in past 1,5 years purchased more government bonds than euro area governments have during the same period issued.
However, from early summer 2021 inflationary pressures started to increase. With “unexpected” increase in virtually all commodity prices, supply chain bottlenecks, and shortages of different goods (incl chips), headline CPI numbers have increased to multi decade highs. Focus in recently published analyses has largely been on how high will the headline inflation rate increase in coming months, mainly due to commodity prices. In our opinion, however, it will be more relevant to understand for how long the inflation rate will remain high and how broad the price pressures will become. It is the longer-term price stability outlook that will influence central banks’ behaviour, rather than one-off and temporary supply side price hikes. Some indicators we follow to gauge the depth of inflationary environment are for example: (i) next quarterly earnings results – if earning stay healthy this could be an indication that corporate sector has managed to pass on higher commodity (input) prices to clients; (ii) wage pressures – unemployment rates are low (though partly due to people leaving labour force), which is a fertile soil for the emergence of price-wage spiral.
The behaviour of central banks: towards the end of 2021 major central banks indicated that monetary stimulus will be reduced starting from next year. However, in their statements increase in inflation is still considered as transitory and likely to subside towards the second half of 2022. For the Baltic (and other euro area) economies it is the decisions of the ECB that will have the biggest influence. It will be interesting to see how the ECB will manage to tighten private sector financial conditions while at the same time keep down debt servicing costs of highly indebted Southern European governments. That kind of a yield curve control could for example happen so that base rates are hiked ahead of market expectations, but government bond purchases are preserved or even tilted towards certain countries. Today the Euribor curve that is the main determinant of private sector borrowing costs is almost flat from 1w to 12 months at -0,5% – i.e. markets do not price in any ECB hikes for 2022. As most loan agreements in the Baltics are fixed with 0% Euribor floor, even faster than expected ECB interest rate hikes is unlikely to have much influence on borrowing costs in 2022. This could however become an issue towards 2023 should inflationary pressures remain with us for longer.
Utility bills: in the Baltics (and in most other European countries) utility bills for households and corporate sector increased to unprecedented levels in autumn 2021. Although governments are providing some relief via fiscal transfers, spending on utilities is likely to decrease disposable income at least until spring 2022. This could have a significant impact on consumer confidence, make some energy intensive business models unsustainable and slow-down business cycle recovery from pandemic.
Construction costs: due to supply-side bottlenecks and material shortages construction costs increased together with other prices in all Baltics. Should the double-digit growth rate continue also well into next year, it could start to squeeze local real estate markets as passing on such increase in an environment where utility bills are at all-times-high will prove to be challenging.
Labour component of construction cost is likely to continue increasing alongside labour shortage in all Baltics. Development and availability of materials’ component will largely determine the overall increase of construction prices. Some indicators we follow here are: (i) property sector in China – if the recent slow-down in real estate sector will also decrease demand for construction materials, this could lead to lower cost of different materials; (ii) green deal in Europe and infrastructure package in the USA – these are both resource intensive multi-year projects. Should their start be front-loaded to 2022 materials prices could continue rising further.
Rents and property yields: during the past few years rents in commercial property sector have largely moved sideways in the Baltics. In Riga historical Centre we can even observe rent level reduction in selective areas, especially in street level commercial premises. In some places rents returned even premillennial levels. Mostly it is due to significant enlargement of retail floorspace in Riga shopping centres. In addition, Riga City municipality efforts to reduce personal car use in the City centre also makes significant negative impact to rent levels in Riga centre.
At the same time property prices have increased, which has led to lower rental yield levels. Although prime property yields in Baltic capitals still offer a significant premium as compared to larger European cities, the gap is narrowing. We do not see that there is much room to pass on higher rents in 2022. The question is can rental yields continue to fall from existing levels or have we reached the bottom?
Work from home/return to office: The take-up of new office space remains low in Baltic capitals (with clear exception in Vilnius) as “working from home” remains popular. In the light of increasing construction costs this could put pressure on new speculative office developments. 2022 could be the first year in more than a decade when some new office projects start to run into troubles. Riga office market in the next few years shall be flooded with more than 200 000 m2 of new office premises. Most of them speculative. New office projects like Verde on Skanstes street 45 000 m2, Preses Nams 26 000 m2, Business Garden with its 27 000 m2 also Galio Zunda on approach with its 50 000 m2 and others are targeting office market. Z towers developer is partly switching their plans from A class office to high end residential for wealthy individuals.
Housing affordability: according to the OECD housing price increase in developed world has never outpaced income growth in so many countries at a time. The virus induced “working from home” highlighted the importance of living space and led to higher willingness to pay for housing. This coupled with favourable lending standards, higher savings rate due to pandemic and soaring stock markets have freed up additional housing equity. All this has taken property prices in many countries to the levels where increasing number of people are being squeezed out from housing market. If markets do not “self-correct” via e.g affordable rental projects, 2022 could be a year where politically driven regulations to improve housing affordability will be implemented in some countries.
In the Baltics housing affordability situation has so far been less dramatic. Since the crisis in 2008/2009 house prices generally did not outpace income growth (in Riga it has even been vice-versa). According to anecdotal evidence equity financing has covered ca 50% of housing transactions and debt servicing costs have gradually decreased. However, in 2021 situation started to change also here. Most notably in Tallinn where squeezed property supply, increased household deposit volumes and decreased lending rates caused house prices to increase well ahead of income. If increasing supply will not improve the affordability, this could increase the “popularity” of rental apartments and bring more institutions to rental market.
Demographics: over the past years a significant part of residential market demand in the Baltics has been driven by populous generation of pre-independence. This generation reached late 20s early 30s, which is often the prime age for purchasing first apartments. Going forward, a rapidly decreasing number of residents in the Baltics is reaching the so-called prime age for first property purchase (next generations are in some case ca 25% smaller). In Riga population decline in 2020 was about 20 000, at the same time Riga surrounding areas has experienced population increase of only 20% of that number.
This will also have some influence on property market. For example, in addition to somewhat decreasing overall demand, there could also take place some change in most “in-demand” property types – demand for one-bedroom apartments could gradually shift towards bigger apartments and private housing, which is more suitable for larger families.
Migration out of cities: working from home and decreasing commuting has reduced the number of people visiting city centres on a daily basis. In some larger cities companies have responded by setting up smaller offices in suburbs closer to residential areas. Although capitals in the Baltics are relatively small, it is clearly visible that businesses in city centres are less crowded as compared to pre-pandemic area. It is likely that some businesses that are specialised in serving customers in city centres (e.g some shopping centres) will continue to face significant headwinds. At the same time, as people shift their daily purchases closer to their homes, some regional centres could provide new opportunities.
New market players in commercial property market: successful exits of IT (but also some “old economy”) companies and increasing overall capital stock have in the past few years created an increasing number of so-called family offices in the Baltics. At least some of them have hired in-house property managers and are looking to directly acquire commercial properties. So far, their interest seems to be in easy-to-manage single/few tenant objects and objects in prime locations. It will be interesting to see how significant they will become in the Baltic commercial property market and will their investment criteria (including risk and return expectations) be different to existing market players.
EfTEN Capital investment team
Viktors Savins, Laurynas Zilys, Tõnu Uustalu, Kristjan Tamla and Viljar Arakas