Recovery may take until 2013

Will there be a mass collapse of loans on the Hungarian real estate market? What is a realistic transactional yield in Budapest today? How can Hungarian pension funds get in on the real estate development market? We spoke with Péter Kocsis, WING’s deputy-CEO, at MIPIM in Cannes.

What is your impression of this year’s MIPIM? What changes do you see, compared to previous years?

Two things for sure. One is that MIPIM has opened up. It’s surprising to me that we already have Kenya, South Africa here – in one of the rooms right now – and Montevideo, the capital of Uruguay, is holding a presentation. It’s not surprising that South Asia is here, still, the fact that the show is becoming more global is a big change. I think this is due to the fact that the money is in the rich countries and a good number of these countries are located in Western Europe. So, it is logical that they come here and present themselves, just like Budapest, Hungary, as an investment target. Another strong impression I have is that Hungary is still quite in the dark; there are very few who think that Hungary is on the investment map. Still, Hungary’s situation has, by no means, not gotten any worse; physically it is close to Western Europe, its infrastructure keeps improving and the real estate market is mature, safe, and transparent. If investors go to Poland and the Czech Republic, why wouldn’t they come to Hungary? I believe that investors will return just as soon as the first really good news start arriving, too. In regards to good news, you don’t have to expect anything unrealistic. If the GDP growth turns positive, that alone can have a very favorable effect.

After a decline of this scale, it is quite likely the economy will keep growing by itself (by around 2-3%) annually. Another question, of course, is how the budget deficit and the government’s debt will fair. It would be good if the deficit stayed low, if the next government could keep their focus on the goal of keeping the deficit down. A low-budget deficit is a matter of credibility for Hungary. At present, we belong in that classical, quite-deeply-in-debt and yet big-spending category and this must change. Otherwise, investors will avoid this country.

Do you expect the recession to be V or W shaped?

Many expect a W and this depends partly on who you talk to. Those who act as buyers are likely to be alarmist and say W. I think there is only one real uncertainty in the world today: The situation of the banks including their future, what will happen to their loans, and when and how they will be able to lend again. Of course, additionally, there is the question of expired mortgages which have been converted to securities because it is still unknown what will happen to them, who will refinance them, and what will happen when they are liquidated, specifically, how much of a disaster it will be for the market. At the same time, I don’t believe that, after the government sacrifices we’ve seen in the past two years, they would allow banks to fold. It would then have been pointless to have increased the national debt with the capital allocation that they did. We must keep to the path we started down.

The process of recovery will probably continue on until 2012 or 2013 and then the banks – obviously under stricter conditions – will once again operate independently and in a profit-oriented manner. I don’t think it will be W-shaped, I much more expect slow growth. There will be no soaring, precisely due to the banks’ situation and exaggerated capacity. There is more than enough of the necessary capacity in each segment, including labor. Unemployment needs two or three years, depending on the country, to return to pre-crisis levels. In my opinion, we can expect 2013 to be much like the year 2007, minus the liquidity bubble. Overall, I think that we are now climbing out of the hole and that is what’s most important.

Banks in 2009 did not shake off their badly performing loans en masse. Do you expect the same in 2010?

Last May, the head of one of Hungary’s larger commercial banks said that, in his opinion, the banking system’s losses in 2009 would be the same as their profits. At a bank system level, this has basically come to pass. In theory, banks will get out of problematic deals when they become truly untenable – if they need reserves and the deal is hopeless. In this case, these loans must be discontinued after a year or two. You cannot maintain those conditions indefinitely. If you don’t count these exceptionally bad projects, the not-so-spectacular cases can still be kept alive and banks – just like real estate market players – have an interest in seeing that these projects don’t cave in around them. For this reason, the owners, their auditors, and the authorities are probably not monitoring the actions of banks as strictly as they would in more peaceful times. I believe that banks will basically be able to take on some bigger losses and write-offs once their profits are bigger, too. As soon as there’s growth, they can write off the permanently bad deals from those profits.

Is WING looking to purchase similarly problematic property (distressed assets)?

We have received these kinds of offers from banks and we have looked into how such construction projects could be justified. The way we calculated it, a given bank would finance the position 100% and the new owner would provide his own portion of the capital to the property, rental, remodeling, renovation, etc. We calculated an internal rate of return (IRR) of above 20%, selling a property bought now, in 2010, only approximately five years from now. Of course, we also calculated in a yield decrease because, without that, not even this construction is doable. Basically, we came to the conclusion that, in theory, it would be possible to make a profit from such a real estate deal but the question is; why would we take on such a risky project? Although it’s true that, on paper, there is an IRR of over 20%, in reality, we would be holding an vacant property with a great deal of debt. Even for a company like WING, that takes guts to take on.

Here at MIPIM, categorizing a property as an asset has come up in many of the professional panel discussions. Many stated that a property is essentially a bond-type investment. Those who accept the bond-type definition reason that pricing should be approached on a bond-basis as well…

There are two kinds of approaches. One compares property yields to long-term, risk-free government security yields. The other is a cost-based concept. In other words, the second approach asks how much it costs to develop a square meter during a given property development. The latter is not much subscribed to by the market and, as investors, we don’t either (although as developers, we are always calculating costs).

The reason for this may be that, as an investor, it is not primarily a property one acquires but an income stream, whose value, depending on its risks, may well exceed the costs of (re)manufacturing the physical environment the property provides. When we evaluated our portfolio in the fall, it seemed to us that real transactional yields on the A-category office market are (or would be) around 8%. Many felt that they are much higher; for instance, like one study based on much earlier national bond yields. In theory, this is not a bad approach because, in the end, these incorporate the country’s risk. When thus calculating, the yield for Budapest comes out above 11%. Despite this, we said we thought the reference yield used in real transactions cannot be higher than 8% and we assumed in our models that this would decrease to 7% by 2015. We fashioned a very slow decrease. Of course, it does not mean that it will turn out that way. In the case of the logistics and hotel markets, we calculated with an additional 100 base points, compared to the office market.

During our earlier conversation, you mentioned that you think it is possible that Hungarian pension funds will enter the real estate market as investors.

This is a difficult topic. Our real estate sector is very young and, regarding funding techniques, it is essentially completely inexperienced. Real estate portfolios or real estate companies can go to the stock market but no one, with the exception of Graphisoft, ever tried that before because bank funding was the cheapest and simplest technique. As for pension funds, the current situation is quite a comfortable one as Hungarian government securities offer an attractive yield. I also find it hard to imagine that the government would encourage pension funds not to buy government securities but instead riskier assets, like property.

The current structure is good for everyone, except for real estate market players who need fresh capital and are having trouble getting it from abroad. Probably, the companies operating in the real estate sector will have to make attractive offers to pension funds. Only those few Hungarian developers or investment companies that have a good record, are considered reliable, and have a working portfolio may be suitable for this. In this case, various types of risks could be combined well: You could pair property development projects with a target income potential that would promise a significantly higher return than Hungarian government securities by the close of the project or after the sale. Of course, this would be done at some risk. Moreover, institutional investors could take direct control over their investments. In other words, they would have the opportunity to stave off danger and take advantage of opportunities which were not available on their current markets. This model has been used in Western Europe for years, although the competition amongst insurance companies there was stronger. For a real estate project, it is possible to get a EUR 20-25 million loan with EUR 10-12 million in equity. A project of that size in Budapest is considered large. For this, only HUF 1 billion in capital (50%) would be required from a pension fund. If a pension fund were to take on one project every year, or every other year, and were to invest a maximum of HUF 1 billion at a time, that would be an insignificant sum for it. Further, I do not believe that pension funds should be forced to do this through regulations, since this is not in the regulator’s interest. They are already indirectly present on the stock market; why wouldn’t they buy property and why couldn’t they become involved in real estate development?