by Phil Hudson
Tricky old business, Europe; full of intrigue, funny food, funny languages and, worst of all, funny money. Best “wait and see”; better still, wait for things to improve here. Is this truly the attitude of UK property professionals towards expansion in Eastern Europe?
Central Europeans cannot afford to wait: there is internally convertible currency in Poland, Czechoslovakia and Hungary; wholly western-owned companies are permitted in the same three countries; full profit repatriation is permissible in Hungary and Czechoslovakia; ability of foreigners to own land is in place, again in all three countries, and tax holidays of up to six years are available. Also there are increasing signs of Russia having “turned the corner”, to use Douglas Hurd’s phrase — Gorbachev had devolved key responsibilities to the more radical and democratic republics in return for their support, clearing the way for the sweeping economic reforms so often debated. The commercial climate is ripe for major inward investment and, while we wallow in yet another trough of the property roller coaster and wonder at our withering navels, great deals are being put together, but rarely by the British.
A year ago office rents were thought sure to have hit their peak in Budapest. A year later and they have doubled. All the central European countries are matching Hungarian rates, while Moscow has raced ahead. The largest takers of space to date are the major accountants. Fortified by the Thatcher years of privatisation and financial stringency they are the advisers in demand and with the ears of governments. In the absence of property specialists, the accountants are poaching surveyors and providing land valuations for the considerable assets available for privatisation. Across the whole of Eastern Europe multinational companies are forced to work from hotels, offices in the outskirts, houses and flats — almost anything with a phone. All the major western companies are piling in, initially opening representative offices to assess the market.
Offices
Hungary is at the forefront of providing the required products. Perceiving a need for offices, the Hungarian Ministry of Finance encouraged the development of a series of International Trade Centres (ITCs). There are now five in operation. ITC I and II are right in Budapest’s core in Vaci utca. Together they form a 125,000-sq ft mixed development involving offices, retail and parking. It is fully let with rents up to $21 per sq ft pa, including services. ITC III is on Erzebet ter, formerly Engels ter, and is also fully let on the same terms.
The most ambitious Hungarian scheme to date is the East-West Business Centre. The 227,000-sq ft office and retail development was fully prelet before opening. Approximately 70 to 80 tenants were expected for the 195,000-sq ft lettable space, but in fact it was let to only 42, with an average of 5,400 sq ft each. These include Barclays, Nomura, Berliner, DHL, Reuters and Arthur Andersen. Swedish contractors Skanska took a 54% share in the joint venture. According to Mr Shultz, Skanska’s manager in Budapest, the offices were fully let before completion, with an average rent of $29 per sq ft pa. Budapest’s Eighth District Council have a 12% interest in the joint venture based on the land as a contribution in kind.
Czechoslovakia has some way to go to catch Hungary. However, it should be remembered that Czechoslovakia had the most hard-line regime in Central Europe. Hungary started liberalising some 23 years ago, and Poland 10 years ago; even the Soviet Union began reform some six years ago. The Czechs appreciate the enormous interest which the West has in Prague, but equally they appreciate the stunning beauty of their city. It is rare for a building to be demolished in central Prague.
For this reason, the chief interest to date has been the pursuit of large, unused sites near the centre. French contractors CBC have secured a large tract of land, Karline, between the new Tesnov Atrium Hotel and the river. By far the most exciting site, however, is the main station site adjacent to the parliament building and Wenceslas Square. A development competition has been organised for the State Railway and the results should be known soon; at least one UK developer was involved.
A Dutch and French consortium has an option on Smikov, another enormous urban renewal site on the river. There is a certain amount of controversy about this, however, because a competition was not held to select the developer. Competitions give legitimacy to a project.
The Czechs appear to be moving carefully and assuredly and they look set to outstrip all their neighbours before too long. Already the mighty Volkswagen have shown their confidence in the country with a £3.5 bn investment package in Skoda.
In Poland there is a wonderful irony in the way in which the use of buildings has changed. The Communist Party headquarters is now the Stock Exchange, with offices to let at $31 per sq ft pa. Stalin’s Palace of Culture now has a casino in the basement and is topped by a controversial neon advert for Digital. Offices in the tower were on offer for $31 per sq ft pa.
Moscow has “Perestroika” and not just Gorbachev’s kind. There is also an astute development joint venture in Moscow called “Perestroika”. The American real estate company. Worsham Group, own 52% of the joint venture, while Mosinstroy and other Russian interests own 40% and 8% respectively. Having Mosinstroy on board is critical because they are the infrastructure monopoly of Mossoviet (Moscow Council) and have access to all the local authority levels of power. Moscow’s chief architect sits on Perestroika’s board. Having profits funnelled from a specific project to Perestroika and then on to Mosinstroy and Mossoviet is effective. It leaves Perestroika free to strike deals with the local councils. Great store is set on the “political dynamics” and the need to gather wide support for a project.
Their 25,000-sq ft Pushkin Square office opened in 1990 and is fully let to tenants such as BASF, Mitsui and Baker McKenzie. However, one problem concerned the impromptu building of an ethnic (Armenian) restaurant in the court between the office and Pushkin Square. By all accounts the restaurant had no permissions, but Perestroika felt unable to remove it because of the bad PR — “rich capitalists remove poor Soviets” Perestroika rarely work on a capital pay-back of more than five years — three to four years is the norm. Office rents in Moscow are typically $60 to $80 per sq ft.
Hotels
While the man in the street has rediscovered gambling with lotto in Hungary and Warsaw, the new entrepreneurs have discovered casinos. Visit a casino in Hungary or Poland and you will see that it is the locals who place the bets and the westerners who turn the wheel. In fact, it is often German money behind the venture, while the staff are British. Hoteliers clearly do not see Eastern Europe as a gamble. They have been circling the capital cities for some time, mobbing their prey and making their kills, constantly ready to swoop. Local labour costs, payment in hard currency and shortage of capacity all conspire to make the market irresistible.
The growth in visitors has been phenomenal, particularly in the Central European countries. Hungary had 37.6m last year — a 50% increase on 1989. The Czechs experienced the same phenomenon in 1990 — a 50% increase on 1989. Tourist growth shows a similar pattern. Boeing’s projections outline a doubling of air traffic every 10 years over the next two decades.
Even before the changes, the previous authorities had recognised the tremendous shortfall in hotel facilities, especially in the four-and five-star categories. Each capital city has plans to extend its bed capacity by 10,000 in the next five to 10 years. Top room rates reflect the shortage. Prague currently achieves the top rates at $265 per night (for a single room), followed by Moscow. This will not be the case for much longer, though — the opulent Metropole in Moscow intends to charge $330, and Budapest and Warsaw follow with $195 and $180 respectively.
The most celebrated deal in Eastern Europe is the Marriott in Warsaw. Negotiations began in 1985 after the original project ground to a halt some years before. The new deal was struck before the changes and so had to cope with very difficult circumstances: soft currencies, almost impossible profit repatriation, no land tenure and so on.
LOT, Poland’s national airline, wanted to finish the 43-storey building and they approached Austrian Bank Girozentrale. In turn, Girozentrale involved Ilbau, also of Austria, and a search for a hotelier resulted in Marriott’s inclusion. A joint venture was formed between LOT with 50% equity, Ilbau with 25% and Marriott also with 25%. Room charges were to be paid in hard currency by credit card through an account in the West. The major source of income never entered the country. The LIM Centre (LOT, Ilbau, Marriott) consists of 520 rooms, 11 restaurants and bars, 70,000 sq ft of offices for LOT, 127,000 sq ft of offices and 42,000 sq ft of retail. The hotel is said to be achieving 80% occupancy and the offices are fully let at rates up to $31 per sq ft pa — if you can get one.
Perhaps the most remarkable project in Moscow is the recently opened 185-room Pullman Iris. The plan is in the shape of an eye, topped by an iris. Fyodorov, the Soviet backer of the scheme, is perhaps best known for his pioneering of mass production eye operations, where patients are arranged conveyor-belt fashion. The hotel is next to his hospital on the outskirts of the city, not far from the airport. It is, partially at least, intended to cater for his western patients who previously had to risk the then hazardous Moscow market. Prices are $200 per night, but most of the guests are businessmen. The joint venture, which has an equity base of $18m, is made up of French contractors Bouygues (25%), French hotel group Pullman (6%), Credit Lyonnais (13%), the eye hospital (49%), and VEB, the Soviet trade bank (7%).
The ultimate symbol of the new Russia, however, is the 398-room Metropole, which sits majestically under the walls of Kitay Gorod in Moscow. It has been refurbished and is set to become one of the world’s great hotels. After four years on site, it is rumoured that the reasons for delay include subsidence, disputes about the difference between “refurbishment” and “rebuilding” and difficulties in finding an operator. It is Moscow’s first five-star hotel and fit for a Tsar, with 5 kilos of gold in its furnishings and the presidential suite costing $1,260 per night.
Budapest’s top hotel will be the Grand Hotel Corvinus Kempinsky. Six months ago it was a great hole in the heart of Pest. Now the bulk of the building is in place and it is to open in 1992. At inception the joint-venture Society Anonyme had an equity split of 50% western and 50% eastern. The western side is made up of Kempinsky Hotels, Del Con Finance and Advanta Investment Group, while on the eastern side the consortium comprises the Budapest Municipal Authority, Commercial & Credit Bank, the Hungarian Insurance Co, the State Development Bank, Ibusz Travel Consultancy and foreign trade company Huniker. The equity split is now 57%/43%, in favour of the western side. The feasibility study assumes a rate of $250 per night for a single room and the land was valued at 15% of the joint venture. Construction costs amounted to about $150,000 per room. Although the agreement was struck while the Communists maintained power, it has been unaffected by the changes.
All the major international hoteliers are putting together schemes right across Eastern Europe. After all, they could not afford to miss payment in hard currency, tax holidays, shortage of hotel supply, rising hotel demand, low labour costs, confidence in the political direction and willing funders. In Prague you will find Accor, Hyatt, Intercontinental and Vienna International (Diplomat Hotel), while in Budapest there are branches of Kempinsky, Hyatt, Hilton International, Conrad Hilton, Penta, Accor’s Novotel, Best Hotels, Hotel Inns, Pullman International and Ramada. Present in Warsaw are Trusthouse Forte, Marriott, Hyatt, Radisson, Pullman, Conrad Hilton, Accor, Sheraton, Holiday Inn and Intercontinental, while in Moscow the list includes the Savoy, Finnair, Penta, Accor, Sheraton, Taj Group, Radisson, Grupe Sol, Conrad Hilton, International Hilton, Kempinsky and Ramada. Clearly, something remarkable is happening in the East.
Residential
A year ago I predicted that there would be limited scope for residential work. This has turned out to be something of an understatement. This sector is perhaps the most vibrant of all. Faced with little or no office facilities and western hotel bills, companies have been forced into the residential market with dramatic effect. Houses and apartments have been changing hands for more than $300,000 in Budapest, Warsaw and Prague. The companies have been generally well satisfied with their moves, seeing them turn into highly profitable ventures in their own right.
Risk appraisal
So does investment in Eastern Europe justify the risk? With current rents and capital pay-back at between three and five years in the Soviet Union and five and 10 years in Central Europe, the returns are clearly there. But the question remains: is it a bubble market and will rents collapse in two to three years when new stock comes on stream? The shortage of hotel beds is so comprehensive that it is difficult to conceive of a room-rate or occupancy collapse. The short answer is that there is little way of telling if office rents will collapse.
Comparisons with South America are quite erroneous. The central European countries are immediately adjacent to the largest consumer market in the world, they have a far better infrastructure than South America, their education is essentially good, their governments are democratic, culturally they identify directly with Western Europe and the democratic market economy, there is already massive interest by the multinationals and, perhaps most crucial of all, there is political will in the West to ensure that Central Europe does not degenerate into financial and social chaos. This commitment is financially backed with major aid and soft loan facilities. Perhaps the most direct comparison is the experience of Spain in the 1970s and 1980s. Madrid’s office rents continue to figure highly in the European rent league.
Legal systems
According to one Russian lawyer and businessman, Sergei Sovkolnsky-Mestechkin, business is not crippled by the “law wars” between the union and the republics. To the contrary, the separate bodies of law actually provide opportunities. There is enormous scope in the drafting of joint-venture constitutions to arrange accounting methods quite legally to take advantage of four wide-ranging exchange rates. Soviet and republican law seems very much like a group of islands. You can boat around them, embark and disembark as you please.
Central European law can be grouped together when it comes to Western investments. This is not to say they are the same, but it is certainly the case that all three countries see the need for such investment. They all see joint venture as the key to bringing in Western investment and they are all prepared to concentrate the benefits into this mode of operation. Initially, caution was the order of the day: 50% maximum Western involvement, no land ownership, tough registration requirements, currency restrictions and poor profit repatriation.
Hungary made the break and went for the investment market: no maximum percentage of foreign participation, land ownership permitted, faster and easier joint-venture registrations, currency relaxations, internal convertibility, full profit repatriation and tax breaks. Seeing the competition, Poland responded and Czechoslovakia followed. Hungary still has the most attractive package, but Poland is not far behind and Czechoslovakia is catching up quickly.
Company law is one thing, enforcement is another. Central Europe, closely advised by Western consultants, has set up tax regimes at breakneck speeds, but does not have the inspection systems to follow.
While it is unlikely that this is a conscious decision, it certainly has the effect of promoting free enterprise to an even greater degree. Tax collection efficiency is a secondary issue when compared with Western investment and employment promotion.
Land ownership
This continues to be sufficiently problematic to deter the faint-hearted. Czechoslovakia has been constantly criticised for its decision wherever possible physically to return land to its former owners. This appears to be a disincentive to investors fearful of former owners coming forward.
Cut-off dates for claims have been set and, some eight months or so into the programme, the plan seems to be in advance of anything else in Eastern Europe.
Hungary has been much praised for its pragmatic approach. It has agonised for months over its compensation system and a consensus has been achieved only to see it referred to the Supreme Court, who are thought likely to throw the new law out on the basis of its “unconstitutionality”.
Poland has quite different land problems. Outside Warsaw most of the land is in private ownership following communist redistribution and it is electorally impossible to dispossess the current occupiers to restore it to the former owners. Warsaw was so devastated in the war and it has been so comprehensively replanned that it is impractical to seek to restore the property to former owners.
The position in the Soviet Union is at least clearer on the issue of restitution — 74 years of undiluted communism has meant that it is a dead issue. Privatisation of land is very much on the agenda.
There is a very strong theme running through all Eastern European countries. Land which remains in state hands is likely to be disposed of by the district authorities and not the municipal ones. Joint-venture deals involving land need to take account of this.
Conclusion
The 20th century is known as the American century; could the 21st century be that of the Russians? The Germans, Austrians and Finns stand out as the deal-makers, with the Swedes, French and Italians not far behind. The former three have one thing in common, they have all had experience of Soviet occupation. To know the system is to know the opportunities.
From the UK viewpoint, Eastern Europe seems terribly foreign. We are more familiar with America, the Middle East, the Caribbean, Australia and Hong Kong. Yet Warsaw and Budapest are the same distance from London as is Rome. Prague is closer than Vienna and hardly further than Milan.
It can be argued that this country invented speculative real estate development in the 18th century. Two years ago our reticence on Eastern Europe would be forgivable. Now, with our property markets in the depths of a trough, our short-sightedness is inexcusable.
