Analytics, EU – Baltic States, Financial Services, Investments, Latvia, Legislation, Real Estate

For comparison: the market of Dubai fell last year by another 12% (48% in 2009), and analysts estimate that it will fall in 2011 for a further 5-10%; the Spanish market continues to fall – by 6% in 2010 reaching a fall of 30% compared with the peak pre-crisis indicators (experts expect a further fall of 20% in this market over the next five years); a complete stagnation after a 10% decline was observed in 2010 in the market of Cyprus, the real estate in Bulgaria dropped by 11% in 2010, in Lithuania – by 4% on the average.

A good exception is Israel, where the market grew last year by 19%, and according to analysts it will grow in 2011. The Estonian market fared well: here the prices increased by 20% from the autumn of 2009 till the end of 2010. This was achieved, above all, owing to the entry of Estonia into euro zone. Chinese market is growing very actively: the prices increased by 50% just only in Hong Kong, the markets of Beijing and Shanghai show impressive growth. But according to experts, the Chinese market is overheated by about 30% and is a time bomb that might again bring down the world economy in 2012.

As we see, the Latvian market shows positive trends on this background.

Dynamics of average prices per square meter of mass housing in Riga in 2010

The main reason for such market behaviour is, above all, the depth of its decline in 2007-2009 caused by a number of fundamental reasons stated in previous reviews (see www.century21.lv). Optimism in the market based on a large scale on the only psychological factor – the belief of the majority of population that "it cannot be worse" – was the main driver of its growth in September 2009, since there were no objective economic reasons for this. However, by this time, housing prices became roughly consistent with the level of real income of country residents.

The second reason was the sharp reduction in market supply. Many, including banks, that got the mortgaged property, left the market at that time not wanting to sell at reduced prices. As a result, experts estimate that the property worth 2 billion lats was taken out of the market. And if the supply falls, there become less housing on the market and it becomes more called-for.

Actually, there are not much buyers left. According to the public opinion poll service DnB NORD Latvian barometer, only 3% of the population were ready to buy real estate in September 2009. Another 4% would like to buy, but they had lack of means. However, these three per cent were enough to sustain a growing trend.

However, passing the price barrier of 550 EUR/m2 by late spring, the market reached a new qualitative level. Firstly, the supply increased by 15% on the average. As the market went back to the price level of 2003-2004, those who bought their apartments during this period were able to return there, as well as the banks that credited these customers and who became the owners of apartments due to the crisis. Secondly, the demand decreased by 0.5% – those who operated the amounts of 10-20 thousand euros left the market.

A balance was disturbed. The level of 580 EUR/m2 reached by the market in the summer of 2010 became the line of resistance which could not be overcome. A turn and a smooth fall movement to 3,5% took place. The experts of Century21Baltwest predicted this trend already in September of the last year[1]. Then the mood of market participants was very optimistic, but  objective preconditions indicated the opposite.

Today, the number of optimists in Latvia who believe that in 2011 the market will grow, also declined, yet insignificantly. According to SEB-indicator of housing prices, in December 2009 they were 38%, which is by 1,4% less than a month earlier. The number of those who believe that the market in the coming year will fall, increased by 1% and makes up 16% now.

Approximately 29% (30% in a previous month) believe that the prices within a year will stay at today's level[2].

The company Century21Baltwest estimates that if the government's economic policy will remain the same as today, we will see smooth fluctuations in the price range 550 – 600 Euros per 1 sq. km. meter in the next six months due to above reasons, but later under the influence of macroeconomic factors the market can overcome the resistance line and start a new round of growth.

Which macroeconomic indicators are implied? Those which can bring serious foreign investors to the market. This will give growth in exports, state budget, increase of tax revenues, etc. The first "swallow" was a decision of an international ratings agency Standard & Poor's to raise a credit rating of Latvia from BB to BB + from this year. Having received the rating of BB +, Latvia moved from the category "speculative, volatile markets" to a fundamentally different category – "attractive and stable investment markets" in the value system of international investors. This is an important moment for foreign investors who are not in the least guided by the data of rating agencies when taking decisions.

Possible positive changes of macroeconomic factors are unlikely to have a positive impact on domestic demand in the near future, rather the contrary. Tax increases, including property tax, although will not affect the market, but certainly will not encourage the purchasing power of the population. However, the situation will change within the country in future. A tight monetary policy of the authorities certainly has nothing to do with the necessary for the country economic reforms, and in the near future, it  will  finally  turn  Latvia  into  the appendage of the

European economy – a source of cheap labour. But if the authorities at some stage will be able to adequately lower taxes for investors and will not force a wage increase, the country will be able to become an attractive destination for industrial investments over time. And that means new jobs and improving the domestic demand. Obvious success of the tourism industry in Latvia which shows a good performance last year will contribute to the growth of domestic demand.

But it is a distant prospect by now. As mentioned above, it may well be preceded in 2011 by the emergence of serious foreign investors, mainly from Norway, Sweden, and Russia, focused on commercial real estate and renovation of already built houses. Investors from England and Ireland are on the way – despite all the economic difficulties they have not lost interest in investing abroad.

First of all, these investors are interested in a general potential of the country which is expressed not only in prices per square meter, but also in the level of people's lives (today it is about 30% of the living standards of Western European countries, but in 2025 this level will rise  to 75 %), GDP is in perspective, etc. It is clear that it concerns a long-term investment, so the data from international rating agencies such as Standard & Poor's are very important.

If we talk about real estate, this potential is usually expressed in three factors: a lease potential, the potential of secondary sales and, of course, the potential of increase in property values. The potential of Latvia in these three areas is huge today. Curiously enough, by its potential it is ahead of such traditional areas of investment as Spain, Portugal, and Italy where is not only a tough economic situation and still expensive real estate, but also strict post-crisis rules for receiving bank loans, but construction costs and real estate maintenance etc. are higher in 3-4 times than similar costs in Latvia. As a result, in March of the last year, according to statistics, the countries of Central and Eastern Europe (including Latvia) had the second-best indicator of investors' interest in them. Latvia is better and different from the other Eastern European countries, first of all, by its geographical position and good logistics capabilities, including air traffic, i.e., it is easier to get to Riga and it is located at a crossroads of transport corridors from East to West.

The basis for the investors' interest in Latvia is also its entry into the euro zone, which should happen within five years. It is always more profitable and wiser to invest before a state  enters into the European Monetary Union, since prices tend to rise sharply thereafter.

Thus, foreign investment should be the locomotive that can pull out in 2011 the Latvian economy, including real estate market, from the crisis swamps. So far in this regard, Latvia has nothing to boast. It is yet too early to judge how effective was the introduction into circulation of a new mechanism for attracting investment – a residence permit when making certain investments in real estate, banking or manufacturing sector. Relevant amendments to the Immigration Act[3] entered into force on 1 July 2010. Now a program "Residence permit in EU for investments" is only gaining momentum.

According to the Office of Citizenship and Migration, 121 foreigner (55 applicants + 66 family members) received last year a temporary residence permit based on acquiring a large real estate in Latvia; another 30 foreigners – on the basis of deposits to a subordinated capital of Latvian banks, 5 – on the basis of investments in a basic capital of Latvian companies.

It is too little compared with the expected number, but it must be reiterated that the process is just beginning. The Latvian government has not bothered to make any advertising, to explain the provisions of the law or to establish a network of authorized agents for this purpose. Therefore, the information is just coming to potential consumers of the product. Nevertheless, the project can be considered relatively successful, if not 55 but at least 550 real estate transactions with the purpose of obtaining a residence permit will occur a year. So, it is not yet time to consider amendments to the immigration law as a panacea.

However, can the Latvian market offer something interesting for foreign investors today? The answer to this question is unequivocal – yes!

The market of mass-produced apartments is interesting as always for its liquidity and is still underestimated. It certainly does not concern a return to the inflated "bubble" in 2004-2007, when prices reached 2'000 EUR/m2. But calculations show that a ratio of population incomes in relation to real estate prices in Sweden, Spain, UK, USA, and Latvia, the square meter of typical housing in Riga today is undervalued at least by 250 EUR. Taking into consideration that the revenue of the inhabitants of Latvia because of a large proportion of Gray economy are higher than those indicated in the state statistical reports, this potential is even bigger. It seems that the gradual emergence of the domestic market mentioned above, as well as the revival of the mortgage which has already begun in the country, will lead the market of typical housing to the level of adequate market valuation within two or three years.

An interesting situation is developing in the commercial property market. This market has virtually ceased to exist a year ago – investors unwilling to invest in unpromising assets with low profitability left the market. Sellers were not ready to reduce prices, as well. Today, investors are gradually returning, the owners wishing to sell their property are returning to earth – the burden of debt instruments becomes more and more unbearable for them.

As a result, interesting objects targeted at different investors began to appear on the market. You can buy an enterprise dealing with road surfaces production or food production, a restaurant, a large shopping or office centre (an incredible thing in Latvia for many years). And  prices are very attractive: the average cost of 1 sq. m of commercial real estate in Riga is now EUR 1'000/m2, but in regions it falls to EUR 300/m2. However, only commercial property that generates cash flow is in demand today. It is natural – in today's difficult market an investor wants to get the best. But such objects, although in small numbers, also exist. Their income also almost matches the world standards today – 8-10%, but in small projects it can reach 20% per annum. By the way, today many lucrative commercial objects, especially of a small and medium level, are sold not because their owners can not cope with a total credit load, but in connection with emigration – they leave the country and go to their children who study outside Latvia and who are going to settle there after graduation.

Usually, there is one problem which arises during a sale. It lies in substantiation of  buyer's declared income. The root of evil is in the prevalence of Gray schemes of business operation. The smaller it is, the bigger is the proportion of the income hidden from taxation.

These are the realities of today's Latvia, and such is the price paid by the State which follows the tight monetary schemes of the IMF and raises taxes.

The requirements of buyers are simple – they want to make sure that the assets they purchase actually bring the profit to the owner which forms the selling price. So today, many potential sellers of commercial real estate face a difficult decision: in order to sell their asset to an investor, they must provide real transparency of their business. Otherwise they must sell it at reduced prices or refuse from realisation at all.

The liquidity of commercial objects is provided in general by a positive development in a rental market. This progress became most clearly evident in the second half of the year – the rental market grew in whole by 30%, and this concerns not only commercial but also residential property.

Today, a two-bedroom apartment in Riga, depending on the status and location, can be rented for $200 – $700 per month. Practically there are no more cases of renting an apartment only for household costs, which was quite widespread in 2008-2009. Offices, depending on the category and location, are rented today for 2 – 12 EUR/m2 month; trade areas – from 5 to 27 EUR/m2 per month depending on the same factors. The owners of commercial buildings, especially of the higher categories, refuse from the so-called crisis discount agreements which they concluded last year to retain their customers. However, as we see, the potential for growth is far from exhausted. There are enough of free premises for rent, and the prices can grow, too.

It is interesting that there was a price fall in a resort real estate sector. Most importantly, the price of new buildings has fallen, primarily due to pressure on the developers from the banks- creditors. If prior to September 2010 prices for Jurmala new projects were kept at least at the level of EUR2'000/m2, and even grew slightly in July and August, a fall to EUR1'800-1'700 was observed in September. At the Vidzeme seaside (Carnikava-Saulkrasti, etc.) the prices dropped to EUR1'400-1'200 / m2. As a rule, the secondary market appears after new buildings. Therefore, next year we should expect a gradual decline in prices in this sector, with inevitable  jumps in a summer period. However, the decline in prices does not mean a roll-back of the market. Prices just gradually come to their market values. Previously, actual sale prices were sometimes different in several times from the quotes, as well. This market segment most actively resisted the market trends, but objective circumstances still prevail. Now the perception of the market participants come into compliance with the market itself.

There is another situation on the market of Riga new buildings. However, there are not much new buildings in Riga today. Most of the completed projects were launched in 2007, before the global collapse of the market, when construction costs were at least 1.5 times higher than today. This explains why not all new buildings are presented today on the market. About 20 homes in the capital of Latvia are empty or leased with option to purchase. And this happens while there are 8 000 needy families just in Riga in the queue for municipal housing.

Today, the average price of an apartment in new projects is 1'000-1'200 EUR/m2, which is approximately by 20% higher than at the beginning of the last year. This is the sector in which foreign investors, primarily from Russia, are interested. The most popular ones for them are the apartments in a good condition from 80 to 150 sq. m in a quiet centre or in Old Riga, in new or renovated homes. Ideally, apartments should also have a parking lot near his home. However, there are not much of such proposals in the centre, so the demand for housing in the Old City exceeds the supply, and sometimes the prices surpass the city-wide ones more than by 2-2,5 times.

An interesting situation took place in 2010 on the land market in Latvia. The fact is that foreigners (mainly from the Scandinavian countries) purchased almost 25'000 hectares of  agricultural land and forest land during a year. This is a great figure.

Things reached the point that the minister of agriculture, Janis Duklavs expressed concern that peasants will soon have to rent the land from foreign owners. This danger is even greater because on the 1 May 2011 all restrictions on the purchase of land by foreigners-citizens of the European Union will be removed.

In this regard, the minister even declared his intention to appeal to the European Commission asking to increase the term of restrictions on the sale of agricultural holdings for a three-year period. It appeared, however, that mostly mortgage lands were sold, which were by that time owned by the banks. In order not to spoil their reports, banks preferred to sell these lands to their subsidiaries and affiliates. And, since the Latvian banks are mainly of a Scandinavian origin, the sale of assets to the same Scandinavian companies is logical. Obviously, these lands continue to be owned de facto by the same bank capital, they just formally belong to other companies now. But something else is obvious as well: these lands are being prepared for a real sale over the next five years. Most likely, the same Swedish and Norwegian funds will be the buyers, which already show great interest in such purchases. If so, then the land will indeed be leased to the same Latvian peasants, so activation of the land market and land rental is in future. All this give grounds for cautious optimism. One year ago we thought that the participants of the Latvian real estate market will have exactly such feeling when entering the new year 2011.