Overview of the Residential Property Market in Prague

By Erik Webb Dempsey, Property In Prague, s.r.o.

Strength of the interest in the Czech residential property market, particularly in Prague, has recently escalated to new heights. This phenomenon is commonly attributed to many factors including EU membership, the overall Czech economy compared to its neighbours, strong growth within the Czech middle class, overall lack of quality housing supply relevant to demand, low interest rates and the ever increasing availability of mortgage financing.

To better predict the future of the Czech housing market, it is useful to look at how the commercial real estate market evolved. It is my contention that the commercial cycle appears to be about a decade ahead of the housing market cycle.

A short history of the market’s development

In the early years after the revolution Prague experienced a severe shortage of quality commercial space. Rental prices soared as businesses of all kinds fought over quality, prestigious and/or efficient workplaces. A vacancy was more likely due to a lazy real estate agent than anything else. As a result, many developers leaped on the opportunity to meet this demand.

Thirteen years, later the supply of quality commercial space has more or less caught up with and, arguably, surpassed demand. Beginning in about 1999, the market began experiencing a major decrease in rental prices on top of a shift towards the larger and more efficient floor plates of both office and retail space located outside of the Prague City Centre. Vacancy rates increased above 15% and rental prices fell by 30-50% in most cases.

Speaking with perfect hindsight, none of this should come as a surprise as the Czech commercial property market is simply following classic Supply/Demand Economics. In the case of commercial properties, it took about 10 years for the Supply/Demand functions to equalize. Many experienced commercial estate agents will agree that Prague hit a bottoming out period according to the classic 7 year cycle that is commonly witnessed in modern real estate markets throughout the world.

The demand for housing on the other hand went relatively unanswered in the early years. Even today there are essentially two distinct price levels (and hence markets) for rental housing: regulated and market. This is largely due to the fact that 90% of the renting Czech population lives in regulated housing. The communists may have deprived the people of their freedom of speech, but every almost every citizen had a roof over their head.

On the supply side, government system changes after 1989 led to the abolition of State subsidies for housing construction. This meant that housing starts and construction in progress were suddenly interrupted. The number of dwellings finished in 1993 decreased by more than 50 percent to a level of 3 dwellings per 1,000 inhabitants (West European countries have app. 6-7 dwellings completed annually per 1,000 inhabitants). In Europe one third of the building industry is targeted to residential housing construction. In the Czech Republic it comprises less than 10 percent.

In the early years, most Czechs were not immediately inclined to move straight into luxury flats or villas; especially since their regulated rents were nominal (often less than EUR 50/month for a 2 bedroom flat regardless of location). Even if you could get a mortgage, it didn’t make financial sense because the monthly payment would be 10-50 times the regulated rental payment for an equivalent property.

Thus, market prices in the early years were driven largely by expatriates seeking their fortunes in the new economies or transferred to the country by their employers; often with healthy “hardship” allowances and company-paid housing. Luxury refurbished housing rented at unprecedented price levels with EUR 5-8,000/month not unusual. Landlords with half-decent flats were suddenly generating income at 1.5-10 times the national average wage. Older couples commonly moved to the countryside to make way for an expat tenant that would finance their retirement. Tenants of rent controlled apartments costing them CZK 1,000/month [then ~30 USD] would illegally sublet their flat for CZK 10,000/month or more (still a common practice).

Expatriate demand for housing kept rental prices for quality housing in Prague at West European levels up until about the year 2000. Gradually, the senior and middle expatriate managers were being replaced by equally qualified Czechs who now had 10 years of “market economy” experience plus westernised training. It no longer made sense for companies to pay the “expat salaries” that were commonly 5-50 times the cost for perfectly equivalent or better Czech talent. The exodus of expatriates was further exacerbated by the collapse of the “dot-com” boom (from which the author also fell victim) and a globally weakened economy that continues to this day.

Now and into the future…

The result now is an oversupply of “luxury” rentals. Rental prices for luxury flats and villas in Prague have fallen 20-70% with the top end units getting hit the hardest. Still there is no shortage of real estate agents pushing rents for 80-100 sq. m. (~840-1,050 sq. ft.) 2 bedroom flats close to the centre for EUR 2-4,000/month. Even if such flats do achieve these high rents, the prospect of growth in the medium term (5-years) is nil with a larger probability of decline. Sale prices for the same flats, however, are skyrocketing and have shown strong growth in the range of 20-60% per annum for at least the past 2 or 3 years.

Ignoring the negative outlook for luxury rental units, the prospects for capital growth on residential housing investments remain strong now and into the future. Smaller, low cost rental flats (under EUR 500/month) are in greatest demand; a problem compounded by the fact that many real estate agents don’t feature cheaper housing since the commissions are not incentivising enough.

A young and growing middle class that is moving away from their parents’ rent-controlled flat is creating greater and greater demand pressure for modern, quality, yet affordable housing. The portion of disposable income spent on non-regulated rental housing by Czechs is not disproportionate to that of other European nations which average about 30%. However, it is common to see Czech spending 50%+ of their net incomes on mortgage payments.

In response to this increasing demand, new construction starts have been increasing astronomically since about 2000. The number of started dwellings is particularly strong in multi-unit buildings which increased by 155.1% last year. Despite this rapid growth, the Czech statistical office estimates that there is a need to finish approximately 50,000 dwellings annually until 2010 (i.e. to reach a level of approximately 5 dwellings per 1,000 inhabitants). Other estimates show 20,000 dwellings a year will be removed from the housing market (due to age and deteriorated condition). Permits for construction of only 23,700 apartment units were issued from Jan.-Nov. 2002, up by 6.7% year-on-year. Combined with the weak supply expected over the next 7 years, the strong growth within the Czech middle class, low interest rates and the ever increasing availability of mortgage financing; the facts indicate continuous strong demand pressures overriding supply for the long-term.

Our own forecast is that we will see steady growth in prices around the 20% per annum range for the next 2-3 years possibly falling to the 10-15% range by about 2008. Despite the rapid growth in the past, I still believe there is plenty of room for further steady growth well into the future. If we refer back to the discussion on the commercial market, it took about 10 years for the supply to catch up with demand. I would say the residential market is in its comparative 3rd year. Thus we should see about another 7 years before prices take on a correction period. That’s what I think. Please don’t send me nasty e-mails just because you disagree.

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.

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.