What Prevents Big Investors from Entering the Baltic Real Estate Market?

                                              

 

First of all, it is necessary to point out that construction and classical development companies (mainly dealing with the development and realization of projects) differ from the major part of investment funds, which try to invest in the finished (!) projects that are already put into operation and have long-term contracts with tenants. In fact their objective is not to purchase a real estate, but to valuate and purchase a stable (!) cash flow. Investment funds can be divided into the following: target (core) that have potential for the development (core plus) and funds that are fully focusing their attention on the development (development). As a rule the pension funds of large companies (e.g. General Electric), the insurance companies and banks make investments in the core funds. The strategy of these funds limits not only their choice of projects, both on the profile and level of risks, but also their requirements on the yield of the project can be low. Core plus funds can belong to the various companies or private investors and their main objective is the maintenance of high yield of projects for gaining profit to shareholders at controlled risks and diversification of investments: for example, one project shall not include more than 20-25 % of the fund’s actives. Independent experts are often invited to the Board of investment funds for ensuring the transparency of work and increasing the trust of shareholders. Real estate consultants are also often involved in the selection of projects and their further estimation.

 

Carrying out valuations during the preparation of investment offers and memorandums, Colliers International often faces a problem in the Baltic States when the potential seller (the owner of the Project) is not ready to accept standard international principles of evaluation of the real cost of the project, especially if the sum significantly differs from the sellers expectations and his presumption about the sum that should be paid by the investor. Why such situations occur?

 

 

The commercial real estate market started its development in the Baltics approximately 5 years ago: it is rather short period of time if compared to the Western Europe and Scandinavia (more than 30 years) and even the Eastern Europe (around 10 years).

 

In this respect, the main experience of the local companies owning and developing real estate projects is mostly related to the purchasing and construction, as well as selling of not ready (!) projects to other companies for their further development on the basis of market prices and growing demand. Experienced western developers before beginning the project agree at preliminary stage on investment sale conditions in order to decrease risks and ease financing. Only now it is possible to find the first Pan-Baltic developers with history, portfolio of constructed projects and positive reputation. However, they do not express an interest in selling their projects because of the possibility to attract inexpensive bank financing under their mortgage for development of new projects in the Baltics, the Balkans, Ukraine and Russia.

 

 

For the last 2 years the prices on the land and construction services (including the growth of materials and wages) have had a multiply growth. This certainly affects the cost price of the new projects. The real estate market is also influenced by a large number of companies and private players that come from other market sectors (trade, transit, processing and manufacturing) and do not have an experience with the real estate, but show a great interest in the development of the residential and commercial real estate and create a certain agiotage when purchasing the land and non-constructed projects at various finishing stages.

 

 

As a result, there often are the cases when Projects do not have elaborated construction technology and necessary technical equipment, lack competent entrance and relevant parking and have a lot of unused space. This increases the cost of the project and does not bring additional incomes. The chosen location of the project and obvious discrepancy of the chosen profile to an existing environment often raises doubtful concerns and impacts the attraction of investments. The constructed building also defines the cost of the land. In such cases price and liquidity of the Greenfield can be much higher than the price of the developed land. Accordingly, the further growth of the developed land is impossible without demolishing of buildings or its capital reconstruction.

 

 

As it was already mentioned, the main project cost estimation parameter for the investment fund is the stable cash flow ensured by the rent payments and services offered in a building.

 

A certain guarantee for the investor can be a long-term rental contract with a reliable tenant that is, legally speaking, competently composed, and preferably has financial history and well-developed/developing business. It should be stated in the contract that early termination of the contract is not possible without payment of an indemnity.

 

 

Professional work on the real estate market requires not only knowledge, but also a planned action programme and a definition of the main tasks – a preferable profit rate, acceptable risk level, the time of getting involved in the project and the time of leaving it. A longer history of the development of the European market shows that there are pros and cons in each market sector - for the investor the main thing is stability and for the developer further movement and development.

 

For the part of Baltic developers one of the arguments for refusing to sell is the absence of new projects where it would be possible to invest the funds received. However, as already mentioned before, several companies have stepped out from the Baltic region and actively develop projects in other countries, which is mainly facilitated by rough expansion of the Baltic banks to the East.

 

 

One of the main risks for the future investor is the loss or essential decrease of cash flow, which will certainly impact the plans and parameters of the fund - the smaller is the fund, the higher is the risk.  Core plus funds are interested in purchasing of "problematic" projects, which in future will require reconstruction or repeated lease-out to the new companies as this can significantly increase the profitableness of projects.

 

There are three types of yields - current yield, i.е. is an annual rent income from the invested capital; capital gain, i.е. a difference between the purchase of a project and its sale; Internal Rate of Return, which combines both in a joint rate of an average annual yield.

 

Conservative investors are more oriented to current yield and less to capital profit. Developers are oriented to capital profit, i.e. to a difference between the sale price of the project after the end of construction and the construction expenses because in the developed countries developers seldom own projects after the end of construction.

 

Currently we observe the tendency of creation of several interesting and professional projects in all three countries: it is facilitated by developers’ desire not to repeat someone else's mistakes and to pay more attention to the project at a preliminary stage of designing.

Forward transactions have been observed as well: when funds buy projects before the beginning or during construction work in order to record purchase conditions. This all shows that large investment funds will appear in the nearest future.