The Prague Real Estate Market - Part 2

The EU and the effect of foreign interests in the Czech market

One cannot discuss the future of the Czech housing market without mentioning the effect of the Czech Republic’s entry into the EU on housing prices. I’ve heard countless points of view ranging from total boom (most often) to total collapse of the market (one instance). The most commonly heard statement is that “prices of housing will jump in May 2004 when the Czech Republic officially joins.”

My own contention takes the economics position that the value associated with EU entry has already been priced in to the aggregate valuations we are seeing now. This means that we will not at all see a “sudden spike” in prices come 1-May, 2004. The real danger for the market was that EU entry might have been rejected by Czech voters in the June 2003 referendum. Had entry not been passed we would have seen a collapse of real estate prices as all of the EU’s anticipated value would have suddenly been nullified.

Despite the hype, foreigners currently only represent about 1-2% of purchasing activity in the housing sector. Consequently their spending power is not materially moving the market, particularly outside of Prague. Nonetheless, foreign interest is likely to fuel strong steady growth in residential property prices into the future. The greatest appeal is towards foreigners looking for greater yields than their homelands are able to offer. This is particularly the case in the UK where there seems to be a consensus that the market has topped out. Recent availability of mortgage financing to foreigners has further fuelled those individuals employing the “buy-to-let” strategy.

Foreigners are currently only allowed to purchase property in the Czech Republic via a Czech registered legal entity which they may 100% own or control (e.g. a limited liability company, “s.r.o.”). Even after EU entry in 2004, this rule will apply for an additional 5 years.

Owning property through a company does provide some administrative barriers and additional costs to owning vs. Czech nationals. One of the biggest disadvantages is the taxation when it comes time to sell: direct property owners (i.e. Czech individuals) are not liable for tax on gains realised from the sale of a property if held for 5 years or more (2 years if they actually lived in it). Companies are liable for corporate tax (currently 31% reducing to 28% in 2004 and 24% by 2006) on profits from the sale regardless of period of ownership. Still this is a better deal than in the UK, for example, where capital gains taxes pinch upwards of 40% and more.

Investment strategy
Recently, gross investment yields (defined as annual gross rental value / purchase price) on residential housing in general have been squeezed to a typical retail level of 8%. Yields in the city centre are even less and one cannot ignore the high vacancy rates of luxury flats. A year ago yields of 10-12% could be reasonably expected. Falling yields are the natural result of sale prices growing faster than rental rates. Theoretically they are indicative of a maturing and stabilised economy. The lowered rate of return is simply reflecting the lowered risk of investing into the Czech Republic. Still, knowledgeable investors recognise that the risk/return ratio of the Czech property market is far more attractive than that of Western Europe.

It should be emphasised that the 8% gross yield is for investors who buy straight from the first English speaking real estate agent they meet. Those savvy enough to learn enough Czech vocabulary to study the offerings on the Czech-language real estate publications and web-sites eg. http://www.bytyvpraze.cz/ will find many diamonds in the rough. I can sum up my own experience by saying “I’ve never seen a GREAT deal in English.” I emphasise word “great” because most of the deals I’ve seen in English are not necessarily “bad” deals, but they are definitely not what I would consider “great.” If one takes the time, 10-15% gross yield properties can be found on a routine basis and do not necessarily have thick strings attached.

For those seeking to employ the leveraged “buy-to-let” strategy of investing into rental properties, my advice is to bet on properties that Czechs can afford as opposed to counting on some big-spending expatriate. This could be typified as smaller 50-75 sq. m. properties outside the Prague city centre leasing for under CZK 15,000. For a given investment of say GBP 100,000 it is better to own several of these smaller flats than a single large expensive one. We know of at least on developer in Prague that recently sold out all of its 50-75 sq. m 1 and 2 bedroom flats and subsequently decided to split up its remaining larger flats into smaller units because they just didn’t sell.

For those intending to use bank loans to leverage their investments, it should be mentioned that interest only loans are currently not available in the Czech Republic. Interest on Czech Crown denominated loans is currently available at rates under 5% and financing is typically available on up to 75-80% of the underlying properties value. The fact that principle must be added into the monthly payment means that leveraging over 50-60% of the investment will result in a negative cash flow.

Bio
Erik Dempsey, who has lived and worked in the Czech Republic for 10 years, is a partner of the real estate advisory firm, Property In Prague. He is also a founding partner of an investment mutual fund aiming to purchase and manage a portfolio of residential flats within Prague. Mr. Dempsey can be contacted at the email address erik@propertyinprague.com

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