European investors look east for profits

The French and Dutch “no” votes were, in part, a protest against the sluggish eurozone economy, which is expected to grow by only 1.2% this year, according to the Paris-based Organisation for Economic Co-operation and Development. This figure masks an even deeper malaise: Italy is in recession and unemployment in France and Germany is running at about 10%.

In contrast, many of the 10 eastern European and Baltic states that joined the EU on May 1 last year are growing at more than three times the pace of “old” Europe. The economies of the Czech Republic, Poland and Slovakia are expanding by about 4% a year, while Estonia, Latvia and Lithuania, known as the “Baltic tigers”, are enjoying growth of more than 6% as foreign investment floods in.

Companies are tempted to eastern Europe by labour costs that are about 40% of those in Germany and by low flat-rate taxes. Slovakia has a rate of 19% on corporate profits and personal income, Poland is set to introduce a flat tax of 18% in 2008, and Estonia has a rate of 24%. These compare with an average of more than 30% in western Europe.

The French “no” vote was a protest against economic malaise, but it was also an objection to the liberal economic policies espoused by the likes of Britain and Poland to get the eurozone moving again.

Martin Robertson of the Scottish Investment Trust, a global-growth fund, said: “Western European citizens are unhappy and are taking it out on their politicians. Their economic model is in disarray, unemployment is high and the social safety net is disintegrating. They are fighting the Anglo-Saxonisation of their economy with one hand and ‘new’ Europe, with its low-wage, low-tax dynamism, with the other. Unfortunately the world has moved on. Old Europe will have to change or face the consequences of being overtaken by the ‘new’.”

Many investors are therefore looking to new rather than old Europe, but they must tread carefully. We assess eastern European property and stock markets.

Property

Property prices in many eastern European countries that have recently joined the EU, or are due to join in the near future, have been soaring. Prime flats in Sofia, the Bulgarian capital, have been rising by about 30% a year for the past few years. Bulgaria and Romania are due to become EU members in 2007, although the process may be thrown into doubt following last week’s “no” votes.

Nick Dare, director of Letterstone, a property consultant specialising in eastern Europe, said: “When countries join the EU, their housing markets go through a two-stage process. First, international companies move in and bring with them expatriates who want to rent historic properties in city centres. Second, the wealth filters down to locals who start to demand a better standard of property. At the same time, interest rates come down, stimulating the local mortgage market.”

In the Czech and Polish capitals of Prague and Warsaw, this process is already well advanced and some prime properties are out of reach for British investors, let alone locals. A prime flat near the centre of Prague costs ?350,000 to ?400,000 (£236,000 to £270,000).

Dare said: “There are signs that the top end of the Prague and Warsaw markets have peaked, and prices have fallen in some cases.”

However, he said money could still be made lower down the housing ladder, particularly in less developed markets such as Bratislava in Slovakia and Sofia in Bulgaria.

You can buy a two-bed flat on the edge of Bratislava that will appeal to locals for as little as ?70,000 and let it for a yield of 8% to 10%. Mortgage rates in Slovakia are about 4.5% in the local currency.

“It’s a much better bet to buy properties that you’ll be able to sell or rent to locals, rather than expatriates, if you want a sustainable investment for the long term,” said Dare.

Be aware that prices in Bratislava have already shot up by about 20% a year over the past few years as investors have latched on to its growth potential, especially as it is becoming popular with workers commuting to Vienna. However, Dare thinks it can maintain its strong growth for another couple of years — although you should not expect it to continue indefinitely. As the market matures, growth rates will slow.

Bulgaria has been proving popular because prices are lower and yields can be up to 8%. Loan rates, however, are about 7.5% — and EU membership is not certain.

Dominic Farrell of Beware the Sharks, a property company, said: “I fear Bulgaria and Romania could be the next property scandals. People have piled in because of the promise of strong growth when the countries become EU members, but accession is far from a done deal. French and Dutch voters made it clear they disliked the eastward expansion of the EU.”

Investors should also beware of areas that have been heavily promoted to British and Irish buyers. John Howell of John Howell & Co, a firm of solicitors, said: “Investors have piled into off-plan developments on the Black Sea in Bulgaria, and some parts of Budapest in Hungary, and hope to sell them when they are completed in two years. But sell to whom? I am not sure there will be sufficient demand from other investors or locals to soak up the supply, which could depress prices.”

Solicitors also warn that you may encounter problems with ownership, especially in former war zones such as Cyprus and Croatia. A recent court ruling in Northern Cyprus allowed a dispossessed Greek Cypriot to reclaim land that had been bought by a British couple.

Investors should also consider how they will own the property — in their own name or in that of a company — because that could make a big difference to returns. Howell said: “The tax rates on income and capital gains could be very different.”

Many investors borrow against the value of their homes in Britain to raise the money for an eastern European property, but you should leave some equity in the property.

If you need a mortgage, you are unlikely to find a British bank that will lend on eastern European property, but you can usually borrow in euros or the local currency from a local bank. However, you may need a deposit of at least 30%.

Now could be a good time for sterling investors to buy in euros because you will get more for your pound. Sterling is worth ?1.48 at present, compared with ?1.41 at the start of the year. And if you borrow in euros, interest rates are unlikely to rise for some time because of the weak eurozone economy.

Investment

Stock markets in “new” Europe have performed strongly over the past few years as investors have piled in to reap the benefits of EU accession.

The Estonian market returned 82% in sterling terms in the year following accession last May, according to Fidelity, while the Czech Republic gained nearly 75%. London’s FTSE All-Share returned 10% over this period.

However, many professional investors have been taking profits because of fears of a bubble.

Credit Suisse First Boston’s Jonathan Garner cut the investment bank’s stake in the Czech Republic, Hungary and Poland in February, warning they had become more expensive than western European markets.

Last week’s “no” votes have added more uncertainty: they have cast a shadow over the liberal economic policies of many of the new European states and over the expansion of the EU to the east. Many eastern European countries may have already joined the EU, but they are not yet in the eurozone.

Raj Shant, manager of Newton’s Continental European fund, said: “Eastern European markets are quite expensive; in fact, I think they are overpriced considering the level of risk.

“Investors are assuming that their economies will remain flexible, they will join the eurozone and will continue to grow at a heady pace. But there are risks. If the EU becomes more protectionist as a result of last week’s ‘no’ votes, it could threaten the flexibility of ‘new’ Europe.”

Turkey could be the biggest loser from last week’s votes. Richard Batley at Schroders, the fund manager, said: “Polls showed many voters were angry at the lack of consultation on the starting of EU accession talks with Turkey. The likely election of a German government in September that is against Turkish accession would place another bolt on the EU’s eastern door.”

Some professional investors prefer markets in the sluggish west to the dynamic east. Shant, for example, has recently been buying German companies that have cut costs by moving operations to cheaper states in eastern Europe.

Even the threat of moving east has enabled companies to boost profits; Siemens and Daimler Chrysler used plans to move operations to eastern Europe to persuade German workers to work longer for the same pay.

However, most professionals agree that, over the longer term, eastern European markets should grow faster than those in the west. They have a long way to catch up: the value of their economies per capita is still about 50% of the EU average.

You could invest in an eastern European fund such as Jupiter Emerging Markets or Baring Eastern Europe, but you must be prepared to take risks.

If you are more cautious, you can get exposure to “new” Europe through a mainstream European fund or through western European companies that are expanding in the east, such as Austria’s Erste Bank.

EASTERN EUROPEAN PROPERTY COMPARED
City/ Country	Typical price(£)¹	Typical gross yield	Typical mortgage rate²
Sofia Bulgaria	34,400 - 47,200	7-8%	7.5%
Bratislava Slovakia	49,900 - 62,000	8-10%	4.5%³
Budapest Hungary	58,700 - 78,300	6-8%	5%
Warsaw Poland	64,800 - 86,400	5-7%	3.85%
1For a two-bed property that will appeal to the local market converted at a rate of 1.48 euros to the pound. 2In euros unless otherwise stated. 3In Slovakian koruny Source: Letterstone

HOW EASTERN EUROPEAN FUNDS COMPARE
Fund	Initial charge	Annual fee	1-year return
Credit Suisse European Frontiers	5.25%	1.5%	35%
Jupiter Emerging European Opps	5.5%	1.5%	37%
Baring Emerging Europe	-	0.8%	37%
Eastern European Trust	-	1.1%	39%
* Investment trust; your broker may charge dealing fees. Source: Financial Express