NOVEMBER 29, 2000








There has been an enormous increase in real estate development, and in real estate lending, in Central Europe over the last four years. Most experts agree that this increase cannot be justified by current economic growth levels. Conditions in the region mirror in several important respects the conditions in Southeast Asia prior to the financial crisis in 1997. According to the Bank of International Settlements, an increase of bank real estate lending of over 20% for a period of over three years is a strong indicator of an impending financial crisis. This rate has been far exceeded in Hungary, Poland, and the Czech Republic, though, unfortunately, Central European bank regulators currently lack access to sufficient information to assess the degree of their risk exposure to a downturn in the property markets.

Beyond the observable explosion in mega-mall development in the region, there are several additional reasons to suspect that Central Europe is in the midst of a potentially financially damaging speculative real estate bubble. First, a dramatic series of mergers and acquisitions among banks has created increased pressure to lend to gain market share throughout the region. Secondly, a dramatic series of mergers and acquisitions among the big retailers has put pressure on retailer managers to invest in capturing new prime retail locations in the hope of controlling long term market share, even if at the expense of short term profitability. Third, developers are trying to put their buildings in now, before a tighter, Western-European-style regulatory framework is adopted by Central European governments.

The recent takeover of many Central European banks by Western European banks may help to shore up the already badly weakened Central European financial systems. These banks are still ultimately chartered nationally, however, and the risks of a potential collapse are still disproportionately borne by Central European taxpayers.

The dramatic expansion of new real estate properties will not only reduce the profitability of new developments, it also reduces the value of all existing properties. Therefore, not only are real estate loans in jeopardy, but also corporate loans which have used existing real property as collateral. And these effects tend to snowball.

While the special conditions of these transitional economies make it extremely difficult to assess the degree to which these developments represent a significant risk of financial system collapse in the near or medium term, sufficient evidence exists to encourage national governments, bank regulators from within the CEE and inside the EU, and public interest groups within the CEE countries to explore the matter further, and to consider adopting measures which would minimize the potential risks.

The recent pattern of economic crisis in Asia could be replicated in Central Europe. A speculative real estate bubble bursts, and property values drop sharply. As international investors flee the market, currency speculators sell the local currencies heavily, sending them into free fall. Many businesses find themselves unable to repay loans in international currencies because all of their revenues are in local currencies. The loans go into default. Banks, seizing their real estate collateral, find it worth far less than its assessed worth. Economic growth stops, and the already fragile Central European banking system has to be bailed out yet again by the already heavily burdened Central European taxpayers. While this nightmare scenario could be wrong, there are sufficient warning signs that governments and the EU should begin to act now to avert such a crisis.

It must be noted also that the Central European retail and financial markets are small change for international banks and retailers. If they lose money on these investments, but at the same time their competitors also lose money, this in the long run is likely to be a successful takeover strategy for international capital. Therefore, domestic economic interests, in order to protect themselves, should move forcefully now to avoid the sort of speculative bubble which in the end is likely to crush their indigenous businesses and clear the field for international capital.

The above mentioned developments have serious (mostly negative) effect on the state of the environment. This is the reason why environmental organizations are becoming more and more interested in this issue.

The report recommends that governments consider the following measures:

I. Increase the current Solvency Ratio in CEE countries from 8% to 10%.

The ratio of bank capital to its risk-weighted assets is set in the EU at 8%. Many experts feel that this level, which is sufficient in mature capitalist economies, is insufficient for the much more volatile Central European economies. The EU level is inadequate in Central Europe because banking regulation is very weak, inter-bank information systems on defaulted creditors are not yet fully established, underwriting criteria are not yet standardized, corporate ownership and property ownership are non-transparent, and the private banking system has no history of weathering a downturn in the property market, so bank regulators have no real idea as to what sort of capital cushion is necessary to avoid a financial crisis. The fact that average lease terms are much shorter in the CEE than in Western Europe, and the fact that leases can be broken unilaterally by the tenant with six months notice are also causes of concern.

II. The 100% risk weight for home mortgages in the CEEC should be maintained for the time being.

There is discussion of reducing the risk weight on home mortgages to 50%, as it is in many Western countries. While the legal obstacles faced by banks in repossessing homes in the case of a default have been removed, substantial political obstacles remain which make repossession difficult if not impossible to implement in practice.

III. CEE bank regulators should adopt the EU's Large Exposures Directive, which limits a single bank's lending for a single project to 10% of its total capital.

In Poland and other CEE countries, large exposures are limited to 25% of bank capital. This is particularly threatening because large exposures are often difficult to detect given the lack of transparency of corporate ownership.

IV. The Loan to Value (LTV) Ratios should be set by national governments at 60% for new commercial real estate developments.

Currently LTVs in most CEE countries is between 70% and 80%. The Urban Institute recommends it be reduced to 60%.

V. Total New Commercial Real Estate Lending Should be Limited to 20% of a Bank's total Loan Portfolio.

Because real estate plays a dual role as a corporate activity in itself and as collateral for bank loans, banks collectively have a vested interest in maintaining the value of their collateral by avoiding unsustainable levels of real estate development. As such, restricting total lending for new real estate developments is one mechanism.

VI. The Above, and Tightening Banking Supervision should be a primary condition for Accession to the EU.

Experts claim that the following improvements to CEE banking supervision are needed:

a. A special body at central banks needs to be established to specifically supervise real estate lending

b. consistent underwriting rules need to be established

c. reporting requirements to bank regulators need to clarify a host of data ambiguities

d. disaggregated information on commercial versus residential real estate loans needs to be collected by regulators, as does information on loans for new developments versus loans for the acquisition of existing properties.

e. changes of underwriting criteria need to be reported to bank regulators.

f. uniform property appraisal principles need to be established.

g. a system of certifying and licensing real estate appraisers needs to be established.

h. corporate and real estate ownership needs to be made fully transparent.

While these measures are likely to be unpopular and may slow economic growth in the short term, in the long term the growth ramifications of a collapsed financial system are much more serious. Economic growth in Latin America was negligible for almost a decade as a result of their debt debacle.

These financial risks are also not evenly distributed between foreign economic interests and domestic economic interests, nor between urban and suburban areas. Generally, downtown businesses continue to be dominated by domestic entrepreneurs and much of the land is owned by District Governments, while most of the new retail development at the ex-urban periphery is foreign owned or dominated. The gradual devaluation of urban land at the expense of auto-dependent ex-urban land is also a devaluation of indigenously owned land and retail at the expense of foreign owned land and retail. In the event of a real estate sector-initiated economic crisis, the greater financial strength of foreign investors would undoubtedly allow them to use the crisis to consolidate their economic domination of the region.





Table of Contents






The Basle Capital Accord, the EU Solvency Directive

and the EU Own-Funds Directive 13

The Capital Adequacy Directive, the Connected

Lending Exposure Directive, and Large Exposures

Directive 16

Home Country Banking Supervision

and Host Country Risk in the CEE 17






Commercial Developments Initiated by Central

European Entrepreneurs or Joint Ventures 19

Commercial Developers Initiated by Foreign

Retailers and Foreign Banks 21










There is currently a significant risk that the excessively rapid pace of real estate development in Central Europe will lead to a sudden economic downturn. National governments and bank regulators in the region should initiate a serious inquiry into the matter, and propose some remedial measures now before a crisis begins.

A large share of direct foreign investment is currently going into retail sector real estate development in Central Europe. One might argue that real estate investment is a more secure form of direct foreign investment than other alternatives, because in the case of a downturn in the economy, or during a time of capital flight, at the end of the day there are still physical assets on the ground which cannot be removed from the country. Certainly, this would be a valid argument were the investment going to housing, brown field redevelopments, and the rehabilitation of existing buildings and infrastructure. While some of this is occurring, the majority of new developments are, in the words of one industry expert, "tin sheds on the interstate."

There are several reasons why an explosion of real estate investment should cause greater alarm than, say, an explosion of investment into light industrial production or high technology industries. The first is historical experience. While there are a plethora of causes of financial and economic crisis, and while economists have thus far failed to identify a consistent set of indicators on which a viable predictive model could be based, (Hawkins & Klau, BIS, 2000) nonetheless, in an alarming number of cases, a sudden surge in new real estate development has been the catalyst for a major banking or economic crisis. According to the Bank of International Settlements,

"Unusual asset price movements, rapid growth of lending especially for property transactions and for financing of stock market positions, capital inflows: these are some of the tell-tale signals of a credit-financed asset price boom which may prove to be unstable." (Honohan, 1997, p. 15)

In the US Savings and Loan debacle in the mid-1980s, weakening of banking regulation led to a burst of speculative real estate development lending. "The majority of the hundreds of bank liquidations that occurred in the U.S. between 1985 and 1994 can be traced to bad real estate loans, especially commercial real estate loans." (Handorf, the Urban Institute, 1998, p. i) Tightening monetary policy and the collapse of real estate prices ultimately destroyed the entire US Savings and Loan industry, at a cost to the U.S. taxpayers of $500 billion, or $2000 per person. The collapse of real estate prices in Japan also set off the major banking crisis there in the early 1990s, and Japan has yet to fully recover from its effects. In Thailand "in early 1997, the fall in prices of real estate (which were used as collateral for credit) landed the majority of financial firms in serious trouble." (Singh, 1999) This led to the speculative attack on the Thai baht, which sparked the Southeast Asian economic crisis of 1997. The same pattern occurred in Malaysia: "Anticipating a glut in real estate businesses due to overcapacity and short-term borrowing, the speculative attack on the ringgit began which seriously weakened it." (Singh, 1999)

Real estate investment is more closely linked to financial crisis than other forms of investment for several reasons. Since Ricardo, economists have held that land rents in aggregate should reflect the economic activity on that land. Unlike other forms of direct investment, it does not really generate economic growth per se, it only houses it. The aggregate economic value of real estate holdings is a simple function of the total economic activity divided by the available real estate for housing this economic activity. If available real estate expands faster than the economic growth rate, ultimately the value of real estate per unit should fall.

Unfortunately, real estate developers do not respond to long term economic fundamentals, i.e. the needs of businesses and people for homes and shops, they respond to the attractiveness of real estate as a financial asset compared to the rates of return they think they can earn from other investments. If property values are rising, developers invest. The real estate market is increasingly functioning like a stock market, that is, the investments are bought and sold in an internationalized financial market place. As such, real estate is increasingly subject to speculative bubbles, and these bubbles tend to burst.

This problem is more directly linked to the solvency of thrift institutions than speculative bubbles in other areas of investment because banks generally use real estate as collateral on all corporate lending. The dramatic expansion of new real estate properties will not only reduce the profitability of new developments, it also reduces the value of all existing properties. Therefore, not only are real estate loans in jeopardy, but also corporate loans which have used existing real property as collateral. And these effects tend to snowball. In the case of the Malaysia crisis, as one leading analyst put it, "The rush by bankers to shun property collateral will itself produce the collapse in value that will devour bank capital." (Euromoney Magazine, June 10, 1998)

Growing awareness of these problems in the US and other developed countries has led to increasingly tight regulation of real estate finance. Unfortunately, in Central Europe, where regulations are only now catching up o Western European standards, and where bank supervision is notoriously weak, few of these regulations exist.

According to the Bank of International Settlements, two major indicators of an impending financial crisis are an increase of over 20% of aggregate bank lending to commercial property for longer than two years, and a major deviation between market real estate prices and long term trends. (Honohan, 1997) Unfortunately, in Central Europe, most central banks do not have basic information about the degree to which their national banking systems are making real estate development loans, as compared to other loans. (Lea, 1997; Handorf, 1998) As such, they have no clear sense of their risk exposure to a real estate market collapse. Nonetheless, the data available gives sufficient cause for alarm. In Budapest alone the total Gross Letable Area (GLA) of shopping malls with a non-food retail element of greater than 5000 square meters has risen from 15,000 m2 in 1996 to 285,800 in 2000. This has been greater than a 70% annual increase over a period of four years. GLA is projected to further increase by an additional 207,000 mM2 by 2003, an additional 20% per year increase. The office market has also grown by over 30% a year for the last three years. (Colliers, Hungary Real Estate Review 2000). In the Czech Republic, the number of retail stores has more than doubled in the last 9 years, with most of the growth occurring in the last three years. In terms of square meters of retail space per capita, the Czech Republic had 0.3 m2 at the time of the transition, and it had risen to 0.8 last year. It is projected to rise to 1.2 before stabilizing. (Incoma, interview) Colliers predicts there will be another 40-60

Source: Colliers

hypermarkets in the Czech Republic by 2002, many of them in secondary cities. The Czech Rrepublic already has more than double the European average number of retail stores per 10,000 inhabitants, and a larger number of shopping malls than Italy. Office space in the Czech Republic expanded by 30% in 1999 alone, and over 22% in Prague. Expansion of just under 20% annually is expected until 2002, with the exception of 2000. (Colliers, Czech Republic, 2000) Growth in Poland was slower prior to 1999, but has expanded much faster in 1999 and 2000 than the other two countries, and is projected to continue at over 20% growth per year until 2002. (Jones Lange Lasalle, 2000).

In each country, roughly 70% of the funding for these developments is coming from bank financing. As such, there is little doubt that real estate development in Central Europe is on a scale well beyond what was witnessed in Asia prior to 1997.

Clearly the peculiarities of those economies in transition from socialism explains some of the unprecedented growth levels. The relative shortage of retail and office space in Central Europe at the time of the transition warranted a significant expansion of retail and office capacity in Central Europe. But the fact that nobody knows what the market can realistically absorb, the fact that most industry insiders feel the market is already near saturation, and the fact that new developments already on line will nearly double the existing available retail and office space in the next three years, are sufficient cause of alarm. When polling experts about the degree of current market saturation, responses ranged from 40% saturation to 120% saturation. This is an alarming degree of uncertainty.

Adding to this concern, interviews with long term investors indicate that the current level of investment into the region is not being driven by a rational expectation about returns on their investments into real property. GDP growth in the region can certainly not warrant the current level of development. After years of negative GDP growth, both Hungary and Poland have been growing at around 4% a year for roughly four or five years. In the Czech Republic GDP growth has been negative for the last two years, and aggregate growth from 1996 - 2001 is likely to be under 1%. This level of economic growth would seem insufficient to justify a tripling or more of office and retail space. This sharp divergence between long term economic growth and the growth of real properties should cause some concerns regarding the stability of the banking system.

Several factors explain why the current real estate development market may be overshooting sustainable levels of development. One analyst from Doughty Hanson of London indicated that the Central European property market is peculiar in that most new developments are directly financed by major retailers rather than real estate developers. These retailers are currently undergoing a rapid process of mergers and acquisitions within Western Europe, being driven in part by the growing power of trans-national retailers in an increasingly economically unified Europe. Thus far, the largest of these retailers, the U.S.-based Wal-Mart, has not entered the market, though rumors that it was trying to acquire Metro were all over the trade presses in the summer of 2000. Faced with potential competition from the giant Wal-Mart, these mergers and acquisitions are both predatory and defensive in nature. In such a climate, and with retailers becoming involved as direct property developers, these retailers are more concerned about long term domination of an increasingly oligopolistic market, and are less concerned about short term profits. Interviews with middle-level managers at these firms indicate that management is being encouraged to dramatically expand market share, even if at the expense of profits. Carrefour's Polish subsidiary, for example, earned only a 3% return on operations in 1999, (Carrefour, Annual Report, 1999) yet opened an additional 7 mega malls, more than doubling their previous total, in 1999. They have made statements that they would like to control 60% of the market eventually. In Spain, a merger between Carrefour and another company was blocked on the grounds of anti-competitive behavior, and such suits may become increasingly common in Western Europe.

At the same time, banks in the region are also going through a process of rapid banking mergers and market expansion. Competition for market share has created enormous pressure for banks to lend. In 1997 - 1998 alone, there were $38 billion worth of bank mergers in Europe, and another $44 billion in mergers among non-bank financial institutions; a 100% increase over 1995-1996. Under increasingly heated inter-bank competition, the pressure on mid-level bank managers to make loans at the expense of proper due-diligence and risk assessment increases. Some commentators also believe this growing competition both between banks, and between banks focused on traditional lending and investment banks, is putting downward pressure on banking profits in Europe as a whole. According to White," bank profits in continental Europe are already under pressure and there are some grounds for believing that these pressures could intensify sharply and quickly." (White, BIS, 1998)

Another destabilizing factor for real estate development is the lack of a stable regulatory climate. (Lea, et. al, 1997) Many developers have said that they are trying to build as many big box shopping malls in Central Europe now before Western European-style restrictions on big box retail developments are brought down by local, municipal, and even national governments. In Western Germany, new developments of over 1200 square meters require special permission from the local government and the developer must demonstrate that the project will not have an adverse impact on local retailers, generate local nuisances, and other restrictions. No similar restrictions apply in most of Central Europe, but similar legislation has been submitted to the Polish Parliament and the Slovakian Parliament, mainly by right wing nationalist groups, and in Hungary the Budapest City Supervisor has proposed placing new, much tighter restrictions on the sale of land to foreigners. Local retailers associations have said that they have lost up to 60% of their business in neighborhoods where big box retailers have been established, creating a volatile political climate, and hence a potentially volatile regulatory environment. Developer/retailer efforts to get their facilities built before tight new regulations are passed is further fueling a speculative bubble.

Additionally, the globalization and securitization of financial markets in the last decade has made it extremely easy for investment capital to move from one location to another rapidly, and to pull out just as rapidly. The Central European real estate market in the last three years has been what financial regulators call a 'hot spot,' attracting an enormous amount of international investment. The first developers and international retailers to enter the market were earning rates of return in the 10-12% range, compared to rates of return in the 5% to 8% range in most of Western Europe. News of these dramatic returns rapidly spreads to the institutional investors. With recent volatility in Western stock markets, increasingly mobile funds are being put into real estate. These institutional investors have, in turn, borrowed over $3 billion from the EBRD at low interest rates and probably from the EIB as well via "Global Loans." The EBRD justifies this massive increase in real estate sector lending as part of its efforts to 'transform' the land and securities markets, but it may also be contributing to a highly unstable speculative bubble.

It is an open secret that of the hundreds of malls that have been and will be constructed in Central Europe in recent years, many of them will not survive. The question is, when many of these new developments fail, who is left exposed, and what will be the economic effects. In the balance of the article, we will try to flesh out some possible areas of risk, and suggest possible measures to reduce this risk.

The recent pattern of economic crisis in Asia could be replicated in Central Europe. A speculative real estate bubble bursts, and property values drop sharply. As international investors flee the market, currency speculators sell the local currencies heavily, sending them into free fall. Many businesses find themselves unable to repay loans in international currencies because all of their revenues are in local currencies. The loans go into default. Banks, seizing their real estate collateral, find it worth far less than its assessed worth. Economic growth stops, and the already fragile Central European banking system has to be bailed out yet again by the already heavily burdened Central European taxpayers. While this nightmare scenario could be wrong, there are sufficient warning signs that governments and the EU should begin to act now to avert such a crisis. This should start with a preliminary investigation by ministries of finance of the current level of financial and economic exposure to a sudden downturn in the real estate sector. The European Union's Banking Advisory Committee could require this as part of their accession negotiations.

The aim of this very preliminary statement is not to answer but to raise the question, in the hopes that competent professionals and policy makers will focus on the issue and consider some of the possible prevention mechanisms suggested.

II. Major Bank Failures in the CEEC from 1992 to 2000

Claiming that Central Europe may face a considerable financial crisis in the next several years is a bit like shouting fire in a building that has already burned to the ground. There have been major bank failures in virtually all of the Central European countries, with the most spectacular ones occurring in Hungary in 1998 and in the Czech Republic in 1999. Thus far, however, these bank failures have not led to a serious economic crisis. The danger now is that the burning building may set the rest of the city on fire.

In the CEE countries, the domestic banks were all state owned until the 1990s. Governments after the transition allowed private companies to start banks under a lax regulatory system. Many of the small new banks that were set up right after 1990 failed. In the Czech Republic, immediately after the transition, an enormous number of small new undercapitalized banks were created between 1990 and 1993, many of them mainly set up to channel funds to politically connected but capital-short nascent Czech businessmen who would never have been able to get financing from a functioning banking system. By 1996, 20 banks had gone bankrupt, and some of them were banks of significant size. The largest was the Czech Republic's sixth largest bank, Agrobanka, the collapse of which cost the Czech taxpayers over $500 million, though the exact figures are disputed. (Fejtek, 1999) Anecdotally, a lot of the bad loans that drove these banks into bankruptcy were as follows. The bank's management would lend a large some of money to an industrial or other commercial venture initiated by one of the old cronies of the bank management. This loan would be backed by a piece of real estate that was written in the bank's books to be worth maybe several million Euros. When the business collapsed, (often because the business subcontracted all its work to a construction company or other company which made the real profits) the bank took control of the property. But when they looked at the property, they found it was actually worth far less than it was written up in the books. Often the bank's shareholders were directly involved in the business which received the loan. "Another important source of bad credit was shareholder fraud. The culprit's idea was to borrow from his own bank and to never pay it back. This phenomenon was given a now much used and fashionable name: 'Tunneling'." (Krcalova & Geussova, 1998) This sort of problem persisted into the mid-1990s, when many of the national banking regulations were tightened and strengthened.

Also in the early 1990s, the states began to privatize the big state banks through either voucher schemes (Czech Republic) or through public sale of stocks (Hungary & Poland). Virtually all of the CEE state banks were in default at the time of transition due to the collapse of the CEE economies. Hungary went farther than the Czech Republic or Poland in privatizing its banks. As part of the privatization deals, between 1992 and 1996, the Hungarian government covered bad loans from before the transition and from the 1990 - 1994 period with US$3 billion in funds from the sale of bonds which are being paid in the short term by an influx of foreign capital and in the long term by Hungarian taxpayers. Many of the banks were sold to large strategic investors, and foreigners as of 1999 owned something like 60% of all banking assets in Hungary.

OTP, however, which was responsible for 50% of retail banking and 90% of home mortgages, was sold to a large number of small Hungarian investors. The EBRD bought a 2% stake in OTP, to partially monitor the bank's management, but insiders claim that the bank is still largely in the hands of the old management team. Postabank, the old postal bank, was also privatized to mostly small Hungarian investors, with the state and the old management team retaining de-facto control. These two banks also continued to sit on a lot of the bad debt from the pre-1994 period, some of it loans to old state enterprises, and some of it in defaulted mortgage loans where the banks were unable to foreclose on the properties for political reasons. Over 35% of OTP's pre-1989 loans are in default, roughly 30% of the loans it made after 1993 are in default, and even about 10% of its new 'market rate' loans are also in default. Both banks remained subject to political pressure to make loans that would not normally have been approved by a private bank, and the management teams also tended to lack capitalist banking experience. (Budapest Business Journal, 1998; Anderson & Kegels, 1998; Bonin, et. al. 1998; interviews)

Postabank, in particular, tried to grow out of these deficits, becoming involved in risky ventures to try and reap big profits, and the projects failed. In 1998, Postabank, had to be rescued with a $1 billion bailout, and it was returned to public control. It has yet to be reprivatized. In 1999 another major bank, Realbank, was bailed out by the state and taken over temporarily. OTP is somewhat more financially stable. OTP's bond rating recently improved mainly because a large number of its bad loans were transferred to the state.

In the Czech Republic, state ownership of the old state banks remained for much longer. Komercni Bank, the largest old state bank, is still not privatized (as of November 2000), and has received over $1.2 billion in taxpayer bailouts since 1996. Ceska Sporitelna, the old state savings bank, was recently privatized by selling a 52% stake to the Austrian Erste Bank. To make this possible, the Czech Government essentially took over EURO 920 million of non-performing loans, transferring them to the Konsolidacni Banka, and the rest of the portfolio was given loan guarantees. CSOB, another large state bank, was sold to KBC, a large Belgian Bank, only in 1998. IPB, the last of the four big state banks, was nominally sold to Nomura, but Nomura, which owned only 40%, used its ownership stake to buy off all its valuable assets, and never took over the management of the bank. In 1999 there was a run on IPB bank. The Czech Government convinced CSOB, recently taken over by the Belgian bank KBC, to take over IPB, but the Czech Government had to take over all of the non-performing loans, and guarantee the rest. While the exact costs have yet to be calculated (they are still disputed in the US S & L debacle as well), it is estimated that taxpayer bank bailouts have already exceeded the level of taxpayer bailouts per capita spent in the US during the S & L bailout.

In Poland, the situation is similar. Many of the banks have already been privatized, with the state taking over responsibility for the non-performing loans. The large state savings bank, PKO, remains in state hands but is likely to be sold to a strategic foreign investor in the near future.

Many experts believe, reasonably, that the recent spate of foreign take-overs of CEE banks by much better capitalized foreign banks should increase the stability of the CEE banking system. These international banks, with much more diversified portfolios and access to cheaper international credit, are much less exposed to a regional real estate collapse than the national banks. Ffurthermore, many of the weak or missing national banking regulations that made the egregious financial malfeasance of the mid-1990s possible has been rectified, and the banking regulatory framework, at least on paper, is increasingly being harmonized with EU directives. Actual bank supervision remains weak, but it is clearly better than it was five years ago.

However, just because an international bank would not be as severely threatened by a Central European property market collapse, they might allow their local branch banks, or the banks they own in the region, collapse rather than choose to bail them out. Experts more focused on the recent trends in the real estate industry are decidedly less sanguine, and have raised a host of concerns about whether adopting EU banking supervision laws, appropriate in the mature capitalist economies of Western Europe, will be sufficient to avoid a major crisis in the much more volatile and risky Central European economies. (Lea, 1997; Handorf, 1998)

III. The Case for Tighter Real Estate Lending Regulation in Central Europe than is Required by the EU.

While banking regulations vary significantly from country to country, most of the wealthiest countries, or the G-10, are signers of the Basle Capital Accord of 1988, which was revised in 1991, 1994, 1995, and 1996. The larger countries within the EU are also signers of this accord. Within the EU, a spate of directives were passed which translated and extended the Basle Capital Accord into Community Banking Directives. This, in turn, is eventually translated into national legislation in all EU countries. EU countries have translated most of the EU Banking Directives into national law, and the CEE countries are at various stages of translating these directives into law.

III.1. The Basle Capital Accord, the EU Solvency Directive and the EU Own-Funds Directive

The Basle Accord stipulates that the ratio of a bank's 'capital' to its risk-weighted assets be 8%. Basically, it means that for every $8.00 of equity capital invested in the bank, the bank can make loans of up to $100.00. This element of the Basle Accord was translated into the EU's Solvency Directive of 1989. This ratio, however, is meaningless unless 'capital' and 'risk-weighted assets are defined.' These are defined in the Accord and in the EU's Own Funds Directive.

The Accord and the Own Funds Directive define "Capital" very specifically. Capital is the difference between a bank's assets (projected loan and interest repayments, real estate, and any other stocks and bonds the bank may own) less the bank's liabilities (the money the bank owes to its depositors and money it owes to other creditors). It divides 'capital' into Tier I, or "Core Capital", and Tier II, or Subsidiary Capital. Tier I capital must consist of the cash reserves (from the original sale of equity) plus the after tax retained earnings (i.e. the bank's annual profits less dividends). Core Capital must consist of 4% of the 8% of total capital reserves. The other 4% of the capital reserves can be comprised of very secure investments. The percentage of these investments which can be counted as 'capital' is determined based on the risk of these investments. Investments in treasury bills from or loans to OECD governments are secure enough to be counted as part of the bank's 'capital,' with a 0% risk weight. Other relatively secure investments can only partially be considered 'capital'. This generally includes bonds and loans to sub-national governments and public enterprises within the OECD countries, and certain types of subordinated debt that have some elements of an equity investment. (In other words, in a bankruptcy, these lenders are paid last, just before the equity investors). Residential home mortgages are recognized in the Accord as being sufficiently secure to have 50% of the value of the loan recognized as part of the bank's capital, because in the case of a default, the bank has the house itself as collateral. The balance of a bank's 'risk-weighted assets' are given a 100% risk weight, meaning that they do not contribute to a bank's capital. This would include projected revenues from loans to private companies for various types of businesses and other, riskier assets that the bank may have. ("International Convergence of Capital Measurement and Capital Standards", the Basle Capital Accord; Bonin, et. al, 1998; World Bank, 1996)

The BIS points out that:

"The capital requirements against risk assets chosen by the industrial country regulators were calibrated for industrial countries whose economies are generally larger and less vulnerable to exogenous shocks: furthermore, these ratios were adopted under pressure of international regulatory competition. They are not tough enough for most developing countries." (Honohan, p. 20)

The solvency ratio of 8% was agreed upon based on decades of experience from previous financial crises about the level of capital that a bank needs to retain in reserve in case of a significant level of loan defaults. The level is set based on historical experience in mature capitalist markets. There is therefore considerable question about whether this level is appropriate in the much more volatile Central European market, where there have been numerous bank failures in recent years, banking regulation is very weak, the lack of banking information systems such as on previously defaulted creditors, the lack of standardized underwriting criteria, the lack of transparency of ownership, and finally the lack of a private banking history which has weathered a significant downturn in the property cycle. All these concerns argue for a more conservative capital adequacy requirement for CEE countries. (Lea, 1997)

Some real-estate specific regulatory issues are also of concern in Central Europe. First, the average length of commercial leases is considerably shorter in Central Europe (3 - 5 years) than in continental Europe (5 - 10 years) and in Britain (10-15 years). Most of these leases in Central Europe also contain escape clauses which allow tenants to end a lease with six months notice. Numerous studies have shown that in a time of economic crisis, real estate loans in countries where commercial lessees have the option to abandon the lease are far riskier than in countries where lessees remain liable for the full term of the lease. Additionally, in much of Central Europe, in bankruptcy claims, tax authorities have priority over banks, increasing the risk of real estate lending in the CEE. (Lea, 1997; Handorf, 1998)

The U.S. Savings and Loan Crisis: Lessons for Central Europe

The importance of the Basle Accord and the Solvency and Own-Funds Directives can be highlighted by what happened in the US S & L debacle. Prior to 1980, in the US the solvency ratio for savings and loans was 5% of their insured deposits. This amount was lower than the 8% in the Basle Accord because S & Ls in the US were only allowed to make loans for home mortgages, which were relatively stable compared to loans for businesses and commercial real estate. Before financial deregulation in the US, the only way these savings banks could increase their 'capital' was by ‘retained earnings’, namely their profits, or the difference between what they were paying their depositors and what they were earning from their borrowers. As this was relatively low risk, new S & Ls were given 25 years to reach this 5% target. (Mayer, 1992)

The S & L's initially got into financial trouble because of a dramatic tightening in monetary policy in 1980. The mortgage lending business is risky mainly because to attract depositors a thrift has to pay market interest rates, but the revenues were mainly from long term fixed interest loans. When real interest rates shot up in 1980, S & L's were having to pay high interest rates to attract depositors, but their revenues on past loans were well below these interest rates. They therefore pressed government regulators to allow them to make loans to riskier commercial real estate developments at higher interest rates, and to reduce their solvency requirements to help them 'grow' out of the crisis. As a result, the 1982 deregulation measures reduced solvency requirements from 5% to 3%, and S & Ls were allowed to invest in commercial real estate speculation. Because of numerous regulatory loopholes introduced in the deregulation measures, however, a person with a $0.15 investment could raise and on-lend $99.85 of other people’s money. For example, because the nature of 'capital' and how it was risk weighted had not yet been carefully defined, S & Ls were using stocks they held in real estate holding companies as part of their 'capital'. By passing worthless properties back and forth between the bank and the holding company, the value of the property could be artificially inflated, which in turn would dramatically increase the amount of money the bank could on-loan relative to their initial capital investment. Through these various tricks, the functional solvency ratio could be brought down to only 0.15%, rather than 3%. (Mayer, 1992)

At the same time, it became legal for S & Ls to raise money not only from small depositors but also by borrowing money from other banks through 'brokered-funds.' These brokered funds were not backed by depositors insurance. Initially, the amount of brokered funds was regulated to 5% of total deposits, but later this constraint was dropped all together. As a result, when these banks went bankrupt, the level of exposure was many times higher than what was covered by depositors insurance. With so little of their 'own-funds' at stake in a bank, bank owners were willing to lend to extremely risky projects. Thus, while the deregulation was not the cause of the crisis, the scale of the crisis was much worse than had the solvency ratios been maintained. (Mayer, 1992)

The Solvency Directive and the Own-Funds Directives essentially treat commercial real estate as any other loan to a private company, with a 100% risk weight. Special treatment is reserved for residential mortgage loans which, because families are loathe to lose their homes, and the fact that the banks can easily take control of the home as collateral, these directives give a 50% risk weighting to home mortgages under certain conditions.

In Poland and most of the other CEE countries, commercial real estate and residential loans are given a risk factor of 100% because of the legal difficulties of retaking control of residential property in the case of a default, and because the CEE countries have not, until recently, had a common database of individuals who have defaulted on loans in the past. This has depressed the home mortgage market, and there is considerable pressure to phase in a reduced risk weighting eventually to the accepted 50%. Most analysts, however, feel that this would be premature. (Handorf, 1998)

III.2. The Capital Adequacy Directive, the Connected Lending Exposure Directive, and Large Exposures Directive.

Traditionally, banks made money by collecting deposits from firms and individuals and loaning out these funds to companies and home buyers. Their profits came from the difference between the interest rates paid to depositors and paid by borrowers. Increasingly, however, normal banks are behaving more like investment banks, investing their fund into stocks, bonds, and other financial instruments. These assets that the bank purchases on its own account are called the bank's 'trade book.' Because this activity exposes the depositors of the bank to certain 'market risks,' (i.e. if the stock market collapses, the bank's assets might rapidly devalue), it became necessary to also regulate this activity. This is what led to some revisions in the Basle Capital Accord and to the passage of the EU's Capital Adequacy Directive (CAD). This directive creates certain regulations which are binding not only on the investment activity of banks, but also on the activity of investment banks. Whereas the Basle Accord and the Own-Funds and Solvency Directives of the EU are primarily aimed at reducing the risks related to defaults on their loan portfolio, the CAD is rather aimed at insulating banks from the 'market' risks of their investment activity. The approach of the CAD is similar to that of the other two directives, requiring a certain level of capital to be held in reserve against potential losses in the market value. Defining the relative risks of different financial instruments is complex and increasingly depends on internal bank determinations and the determinations of the rating agencies.

Connected lending means lending to a firm that is owned by the same people as the bank. This problem was endemic during the S & L crisis, and in the early years of transition in the CEE countries. In the EU it is regulated by the Connected Lending Exposure Directive, which states that a bank cannot lend more than 25% of the value of its core capital to a company which is owned by the same company as the bank.

The Large Exposures Directive is related to another abuse that was endemic in the S & L crisis. Sometimes real estate developers will create a bank just to finance a single real estate development. If the real estate development makes money, they profit twice. If the real estate development goes bankrupt, the bank also goes bankrupt, and the depositors are bailed out by the taxpayers. The owners fly in their private plane to a nice island in the Caribbean with all their private profits which are protected from seizure by the corporate veil. Another way Bank regulators have tried to stop this sort of thing was to limit the amount of money that a bank can lend to a single project as a share of its total assets. The large exposures directive limits lending on a single project to 10% of a bank's total capital.

Currently in Poland, Article 71 of the Banking Act allows banks to extend credit to one borrower or group of related borrowers equal to 25% of capital, though loans over 10% require government approval. According to the Urban Institute,

"Given the lack of empirical data associated with commercial real estate volatility in Poland and the incomplete data base currently available from a complete business and real estate cycle, any percentage threshold must be derived qualitatively. Until more complete market data is available and until the credit/appraisal/legal/economic issues discussed previously are resolved, the NBP should consider limiting commercial loans to one borrower to 15% or 10% of capital." (Handorf, 1998)

III.3. Home Country Banking Supervision and Host-Country Risk in the CEE

According to the EU Second Banking Directive, the solvency supervision of a CEE Branch or subsidiary of an EU-based bank, rests with the home country of the parent bank. The host CEE country may not have rights to certain information that would be necessary to make its own independent determination of the solvency of the bank. At the same time, the economic and financial risk of a default of an EU-based bank in a CEE country falls disproportionately on the host country. (Dermine, 2000) CEE-registered branches of foreign banks or wholly-owned subsidiaries have to pay into domestic depositors insurance funds, but depositors insurance may be insufficient to bail out depositors if several banks were to collapse at once. It is also generally not sufficient to protect a country from the serious economic fallout of a major banking crisis. Most depositors insurance does not cover all deposits. In the Czech Republic depositors are only insured up to 80% of the value of their deposits to a maximum of 100,000Kc per account ($2500). In Hungary they are insured in full up to $10,000. In fact, however, in most major failures to date, the governments have bailed out all the depositors above and beyond what was covered by depositors insurance. Furthermore, banks may have significant unserviceable debts beyond what they owe to depositors. Banks can raise capital from other sources, such as the sale of bonds or inter-bank borrowing. As a result, bailing out a failed bank is generally far more expensive than bailing out its depositors. For large banks, governments often are willing to bail out the entire bank. In the case of the failure of a branch bank of a larger foreign bank, while in theory the parent company might be expected to bail out its failing national branch office, it is not generally under any legal obligation to do so. When Citibank Philippines failed in the early 1980s, many of the depositors were surprised that they were not bailed out by the parent company in New York.

The home country or the EU as a whole may be induced to bail out a large failing bank under certain circumstances, but the decision will be highly political. While the EU decided to bail out Credit Lyonnaise, the British Govt allowed Barclay Bank to fail. Some banks, such as the Dutch, Swiss, and Belgian banks, are so large relative to their home country's GDP, that a major bank failure would be crippling on their taxpayers, which reduces the chances of a full bailout. If KBC bank of Belgium failed, which recently took control of K & H Bank in Hungary as well as a major stake in ABN-AMRO's Hungarian branch, it would cost Belgian taxpayers 2.35% of GDP. These ratios can become quite large when these banks continue to acquire other banks through mergers and acquisitions.

This situation has led some leading banking experts within the EU to call for the development of a supra-national banking regulatory body at least within the EU or as a minimum within the EURO countries. (White, 1998; Dermine, 2000) Currently, however, no such supra-national banking regulatory body exists.

IV. National Financial Regulatory Best Practice in the Real Estate Sector of Relevance to the CEE

Some EU and Western countries have developed fairly specific rules for lending in the real estate sector to help national regulators deal with the inherent problems of lending to the sector. Canada and the US both have restrictions on the total percentage of a bank's portfolio that can be taken up by real estate loans. In the US the FDIC (Federal Depositors Insurance Corporation) Improvement Act also developed a set of underwriting guidelines which established specific loan-to-value (LTV) ratios for different types of investment. FDIC was able to enforce these regulations by refusing to grant depositors insurance for non-compliance.

LTVs are simply the percentage of a real estate development project that is funded by equity investments relative to bank loans. In the US, since 1991, the LTV is 65% for raw land loans, 75% for land development loans, 80% for commercial multifamily and non-residential construction loans, and 85% for small scale residential and improved property loans. In Central Europe today, the standard LTV for commercial real estate is between 70%-80%. According to the Urban Institute (Handorf, 1998), the bond rating agencies in Central Europe grade bonds on commercial real estate with a LTV ratio of 70% as a BBB/BB loan, a relatively high risk bond. According to Handorf, "the National Bank of Poland would be well advised to recommend banks and mortgage banks originating commercial real estate loans with an LTV not to exceed 60%, (as) stated [sic] in the Act on Mortgage Bonds and Mortgage Banks." (Handorf, 1998).

There are also a host of banking supervision issues within the CEE countries which need to be changed to be brought into line with EU and US standard practice. For a review of these recommended changes, see Handorf, 1998 (available at Polish Housing web site)

These include the set-up of a special body at the central banks to specifically supervise real estate lending, the development of consistent underwriting rules, change the reporting requirements of banks to clarify a host of data ambiguities, disaggregating of information on commercial versus residential real estate loans and of new developments versus existing property transactions, require reporting on changes of underwriting standards, the development of uniform appraisal principles, and the establishment of a certification and licensing system for appraisers. (Handorf, 1998)

V. Assessing Current Financial Sector Risks in Central Europe:

A Few Case Studies

Several factors make assessing the current level of exposure of the CEE financial systems to a downturn in the property market difficult, particularly for outsiders. First, collecting information about how most real estate is currently financed in Central Europe is difficult. Second, an increasing amount of real estate is being financed through equity investments and direct financial instruments rather than through traditional bank loans, what is called 'disintermediation.'

There remain today basically two types of financial systems. First, there are those like Germany and Japan which are heavily dominated by the banking system, where banks actually sit on the Boards of many large companies which they either directly own or to which they make substantial loans. At the other extreme is the US and Great Britain, where an increasing amount of corporate finance is coming rather from equity and bond markets, and the banks are playing less of a role. In recent years, the share of corporate investment finance coming from 'direct' sources (stocks and the bond market) has grown at the expense of the banking sector. Europe, in other words, is becoming more like the US.

The ramifications of this change for the overall stability of the banking system is not well known. On the one hand, direct investors are not protected by depositors insurance, and in theory should help insulate the taxpayers from the vicissitudes of the market. On the other hand, it seems to have led to a much greater level of exchange rate volatility, as increasingly footloose investment capital can be pulled out of a country very rapidly, driving exchange rates into a nose-dive, and putting in jeopardy those loans in foreign currencies where revenues are all in domestic currencies, like with real estate development.

Real estate financing in Central Europe tends to follow some fairly predictable patterns. These patterns are largely determined by the home country of the principal investor. If the principal investor is Polish, Hungarian, or Czech, their method of financing is likely to be markedly different than if their home country is Germany. Austrian and German investors, meanwhile, use different financing methods than British, US, or French investors.

V.1. Commercial Developments Initiated by Central European Entrepreneurs or Joint Ventures

It makes sense to begin the rough outlines of real estate finance in the CEEC with local capital, as this started somewhat earlier. In Budapest, Mammut I was built entirely by two Hungarian entrepreneurs and a local venture capitalist. One used to work for Microsoft, and one was a shoe wholesaler. They were able to get bank financing, but they had to come up with 40% of their own equity investment, and the bank loan was only for 60% of the financing. The financing probably mainly came from one of the Hungarian banksthe Hungarian Foreign Trade Bank (Magyar Kulkereskedelmi Bank) which was privatized to a German bank. (Postabank or OTP) but this could not be verified. The way they raised this financing was to sell some of the spaces in the mall to investors or retailers, who took ownership of these spaces, like a condominium owner. Mammut had a lot of trouble as it was not architecturally well designed, had a weak tenant mix, and its management was inexperienced, but it now appears to be making money. It is located near Moszkva Ter, in a central location in Budapest well served by public transportation. Now that Mammut I has proven to be economically successful by some measures, banks are willing tothe Eurohypo, the Hungarian Foreign Trade Bank and Deutsche Bank (Hungary) are giving loans to its expansion, Mammut II, with a lower (20%) equity investment.

The Polus Center was the first development in Hungary by TriGranit, a joint venture between the Canadian/American developer Trizek Hahn (Peter Munk) and Arcadon (owned by Sandor Demjian). Initially they also had to come up with 40% of the financing for the Polus Center. This mall also sold the spaces in the mall to investors in the retail condominium style to raise the equity capital. This method of financing undermines the ability of the mall management to control the tenant mix. Nonetheless, Trizek Hahn was able to attract Tesco to the Polus Center as an anchor tenant. The mall, on the outskirts of town but served by a bus and near some underserved public housing estates, appears now to be reasonably successful. Trizek Hahn also got a loan from the EBRD, the particulars of which we have been unable to determine.

The West End City Center is one of the most discussed mall developments in Hungary. Located at the Nyugati (West) Rail Station, it could not be better served by public transport. West End City Center was also developed by Trizek Hahn/TriGranit. It is particularly unusual in several ways. Most unusual was that the project found bank financing despite the lack of an anchor tenant. The tenant mix, according to critics, is bad, with no anchor tenant, an over-abundance of shoe stores, and only one small grocery store. Some 10% of the units were also sold, mainly to the shop keepers who had to be relocated by the mall's construction. The land, which was railway land, was owned by the National Government rather than the district government or the municipality. According to industry insiders, loan for the project came primarily from the state-owned banks, either OTP or Postabank. Today, West End City Center is owned by Prudential, the US-based insurance company, AIG-CAT, a New York-based investor, and TriGranit, the Hungarian subsidiary of Trizek Hahn. Currently the leaseholders are on rent strike and are trying to get their rents reduced. Exposed in this case seems to be the local branch of the international investor (TriGranit), institutional US investors, and the national banks, (probably OTP or Postabank but unconfirmed). This same development team is now planning to develop the massive Millennium City Center in Budapest, which will house the new national theater, a chain of hotels, offices, and retail.

A small handful of local entrepreneurs are basically crooks that were able to fool a major bank into funding a risky venture, where the main profits went to the construction companies involved, which would profit even if the mall was a failure. One such notorious project was the Roszhadom Rozsadomb development in Budapest District II, which was financed by an assumedly unsuspecting Italian bank CIB.

In Prague, there are roughly 9 shopping malls in more central locations, most of them developed with local capital, and many of them are suffering as the result of lacking an anchor tenant. It is likely that many of these were developed with the support of the larger banks that remained in state hands until recently. (Colliers, Czech Republic 2000)

In Warsaw, there was an interesting attempt by Polish retailers and food suppliers to set up a cooperative supermarket in downtown Warsaw, called LAND. There was originally a location where there was a food bazaar, with kiosks with Polish food, all very low overhead. They joined together and created a cooperative to build a building. This dramatically increased their overheads, and now the building is only 60% rented, and the original investors are near bankruptcy. The main problems are bad architectural design, lack of an anchor tenant, and no major supermarket. If they have loans from any banks, they are certain to be from Polish national banks rather than foreign banks. (Int. w/ Suchorzewski)

Some 68% of the high street retail in Budapest is still owned by local municipal governments, but an increasing number are now being sold. (Colliers, Hungary 2000) Prague (and Poland?) have gone farther towards privatizing retail facilities in downtown locations. Most purchases of land by downtown oriented developers are financed by local entrepreneurs and backed with loans from national (rather than international) banks. A significant devaluation of downtown property values would therefore hit district governments (though the value of these assets are as yet largely unrealized as long-term commercial leaseholders have not seen their rents appreciate to commercial levels yet, and will not until 2003 at the earliest). It would also hit smaller indigenous retailers and the national banks that support them.

V.2. Commercial Developments Initiated by Foreign Retailers and Foreign Banks

The developments stirring up the most controversy in Central Europe are the developments by foreign big-box retailers. The number of big private sector participants in this business is fairly limited. Basically, there are three or four main corporate participants in the process: a) the big retailers, b) the banks, c) the construction companies, and d) the land assembly companies.

Basically, the following companies are the primary players in the Central European big box retail market: Auchanm, (French) Carrefour (also part-owner of Geant), (French), Tesco (British), Metro and its subsidiaries (Dutch/German), and Ahold (Dutch/German). These retailers tend to have both food stores, light-industrial products, and often DIY (Do-It-Yourself) stores. These retailers will tend to have a large big-box retail outlet which is primarily for their anchor store, but there will be a small mall with some other retailers and increasingly a multi-plex cinema. There are also an increasing number of highway-side stand alone retailers, most notably IKEA (Swedish/Danish), Baumax (German), and Praktiker (owned by Metro). Each of these companies would set up a national branch of their company in each CEEC country.

In terms of banks, for developments where the anchor tenant is a big international retailer, the bank is inevitably either a foreign branch bank or a foreign-owned national bank. The Austrian banks have been involved the longest, though German and Belgian banks are also increasingly involved. Bank involvement falls into two types: those banks which are primarily real estate lenders, and those who have a relationship with a large corporate client, and are mainly lending to their client, regardless of the fact that the loan is going to real estate development. Austria Bank/Creditanstalt which this year again merged with Hypovereins Bank, is a major real estate lender which is frequently mentioned in the Czech Republic and Poland, and probably works mainly with Aholt and Metro. Also mentioned is Handlowy Bank in Poland, which is 75% owned by Citibank, and which in turn owns a 25% stake in Metro-Poland. The Belgian bank KBC, which owns K & H bank in Hungary, ABN-AMRO-Hungary, CSOB and now IPC in the Czech Republic, is also involved, probably with the French retailers. Each of these banks would also either set up a branch bank in each CEEC country, or they would buy out an existing bank.

The German and Austrian banks would generally then set up a leasing company. The leasing company would be a wholly owned subsidiary of the bank. The bank would provide the equity capital and the loan to construct the development. The leasing company's investment is secured because it has maybe a 10 year lease to buy agreement with an anchor tenant, one of the big international retailers mentioned above. While the lessee would be the national branch of the international retailer, the bank would not move forward unless it had a guarantee from the parent company. Often, because it is extremely difficult to determine which in a nexus of various holding companies actually has the real estate assets, and which companies are basically empty shells, guarantees are generally required by the bank with several of the parent companies of these international retailers. Metro AG, for example, recently transferred much of its actual real estate holdings to a separate company, owned largely by the same people but not part of the consolidated Metro AG companies. (Metro Annual Report, notes, 1999) Over a period of ten years or so, the local branch of the international retailer will buy the property and eventually become the owner of the property. As the big international retailers have to reflect these guarantees in their balance sheets, they are increasingly reluctant to give these guarantees, and it seems that more developments may be occurring without parent company guarantees.

The reason for this arrangement appears to be that it is very difficult in Central Europe for a bank to get a property back from an owner when the owner is in default on a loan. Therefore, in this way, the local bank's leasing company retains ownership of the property and does not have to go to court in case of a default. Because the markets in Central Europe are extremely volatile, none of the banks would be willing to grant loans for such a long period as 20 years.

Under this scenario, as the banks themselves remain owners of the properties, they want to have some sense of how profitable the investment is likely to be. Basically, the bank has experts who estimate the value of the location, the property, the incomes in the area, the level of existing and planned competition, and they compare their own estimates of projected revenues to those of the retailer. This would only be done on developments over 800-1000 square meters. The fact that they are willing to do this indicates that the banks, in the case of a property market downturn, would be considerably exposed. Their exposure is limited primarily by the strength of the lease and its guarantee with the parent company retailer, and hence on the financial soundness of the parent retailer.

Another scenario would be that a big foreign developer, like Trizek Hahn, or Stanifer, or Tishman Spier, would set up a joint venture with a big international retailer. The Olympia Mall in Brno, for example, is a joint venture between Stanifer (75%) and Aholt (25%). Trizek Hahn used to own a share but they cashed out of the project. Olympia, the corporation, sets up a wholly owned subsidiary which develops and manages the mall. Aholt, as the anchor tenant, basically ensures that the mall will be a success by signing some sort of long term lease with the mall. Once the anchor is in, other small retailers will agree to sign leases. The mall will use the lease agreements to secure loans from banks. This bank is likely to be a bank with a relationship with Aholt. With a large international retailer on board, the share of equity to loan is likely to be 20%/80%.

Analyzing the land assembly and construction part of the mall development project becomes quite murky, as it is in this realm that quasi legal activity sometimes takes place. Some of the construction companies that actually construct the malls would be local branches of international construction companies, and some would be wholly-owned or partially owned subsidiaries of the international retailers. Ilbau is an Austrian construction company that has been involved in several mall development projects, like Ivako in Krakow. Metro uses the company GBS to assemble land for its planned development in Krakow, which it owns, and it uses BV to develop and construct the mall, which it also owns. At some point, these companies merged. Sometimes these construction and land assembly companies are the same company, sometimes these functions are split, mainly for political and legal reasons. Sometimes they are owned by the big international developer or retailer, under a national name, mainly as a way of getting around restrictions on foreign ownership of land. Sometimes they are owned by the banks. Bank Austria/Creditanstalt owns a real estate developer in Hungary.

These land development and construction firms may be foreign-owned and operated by local entrepreneurs, usually with political connections, or they may be indigenously owned. Some of them are probably directly or indirectly owned by members of the local government, or by the political parties, or both. Basically, they are responsible for buying and assembling land from farmers or old industrial estates, getting the zoning regulations changed to allow the development and taking care of any other political or regulatory obstacles. They then resell the land, often for as much as 100 times the original cost. The profits are divided somehow between the owners of this company and 'contributions' to the political parties. This is particularly clear in Poland, but seems to be the pattern regionally.

Most of these developments are financed in foreign currency. International retailers are able to get lower interest rates from international bankers than they could get from local nationally-owned banks mainly because they have a better credit rating and therefore can lend at lower interest rates. It also has to do with the fact that borrowing in Czech currency is problematic because the relationship between the interest rate and the exchange rate is biased in favor of international borrowing.

Because most of the revenues from the developments are in local currencies, and most of the loans are in international currencies, there is a certain risk that a sudden shift in the exchange rate would make these loans very difficult to service. Whether the large loans are protected by either foreign exchange futures contracts or some sort of government exchange rate guarantees would be important to a determination of risk exposure.

Once these developments are in place, the big retailers frequently sell their equity investment in the real estate to institutional investors. In this way, they retain the risks associated with any long term leases they are holding but insulate themselves against a property market collapse somewhat. The retailers also are increasingly selling their real estate as a cheaper way of financing their next major development. As the retailers are more concerned about controlling strategic locations than they are concerned about profiting from land price increases, they are cashing out of their real estate ownership as quickly as possible.

At this point, the international investment banks get involved. These international investment banks increasingly have loans and equity investments from the International Financial Institutions. The EBRD, the IFC, and the EIB have all been channeling both equity investments and loans to these financial intermediaries. The Export Credit institutions of the home country governments also are involved, according to some industry insiders. They are basically lending money to financial intermediaries who are buying the right to collect the revenue streams promised by long term lease contracts, and reselling these to smaller scale investors or larger institutional investors. Some big developers are large and powerful enough to issue bonds or sell stock in their own name, allowing them to raise capital by bypassing the banks. Some of the larger ones are Heitman International and Trizek Hahn of Chicago, Pioneer Group of Boston, and Doughty Hanson of London. The specific link between these investment banks and the financing of specific malls, with the exception of Trizek Hahn, has been difficult to identify. The general trend seems to be that once the development is completed and leased, these retailers and developers are reselling either the ownership or the lease revenue rights to longer term investors, such as Prudential and the Travelers.

VI. The Spatial Political Economy of Real Estate Risk

While there is plenty of international capital being invested into central urban areas, and some domestic capital being invested into suburban areas, the split between domestic retailers and banks and international retailers and banks seems also to be a split between downtown and ex-urban development. With downtown real estate still heavily regulated and owned by district governments, foreign developers have moved outside the major cities for their largest scale investors. Backed with cheaper credit, greater real estate development experience, and increasingly supported by IFI lending and equity investment not only into their developments but also into the trucking-based logistical systems which service these ex-urban developments, the competition between international capital and indigenous capital is taking on a clear spatial dimension. This raises two questions.

First, from the point of view of a potential real estate market collapse, who is more at risk, domestic capital in the center, or international capital at the outskirts. Of course, both are at risk, but the pockets of the international banks and developers are much deeper. History in the West teaches us that in a major economic crisis, the strongest economic players tend to remain standing at the end of the day. J.P. Morgan consolidated his banking empire more and more after each major financial crisis in the 19th Century, as more and more of his competitors failed. The Central European retail and financial markets are small change for international banks and retailers. If they lose money on these investments, but at the same time their competitors also lose money, this in the long run is likely to be a successful takeover strategy for international capital. Therefore, domestic economic interests, in order to protect themselves, should move forcefully now to avoid the sort of speculative bubble which in then end is likely to crush their indigenous businesses and clear the field for international capital.

Secondly, from the point of view of the location of this investment, the question arises whether it is better to force international capital to the periphery, where it is likely to fundamentally tilt these urban areas towards greater long term dependence on automobiles and imported oil? Or would it be better to lift certain controls on foreign investment into more central areas, particularly facilitating brown field redevelopment, even if at the more immediate expense of the indigenous retail sector? These questions will be addressed in other forthcoming working papers.


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