SSE.LT

It is a common fact for everyone that Lithuanian real estate market has been booming in recent time. Involved parties are eager to stress prosperity and enormous returns of the market. For instance, Lithuanian Development Agency whose aim is “to create the common informational Internet platform for foreign and Lithuanian business” loudly presents benefits of the market for foreign investors and local speculators. Ironically, that platform, which did the Ministry of Economy support (and I assume taxpayers’ money was involved there), has also a direct link to a private real estate company, which can further provide you a number of optimistic market’s “bubble-facts”.

I think it is a good moment to realize the underlying environment of Lithuanian real estate market. I would like to present some fresh ideas, but contradicting to official arguments, about past development of the real estate market; its intrinsic conditions; and subsequent wind up. To begin with, I would offer to take a short look at capitalization rate (cap rate) of private real estate in Lithuania.

Cap rate is defined as a return on a real estate asset, measured in percentage terms. It shows how much cash can be earned from real estate investment, if this real estate is rented in a market (Wikipedia). So, in Lithuania this rate was 4.7% for new construction and 4.2% for old renovated construction in 2q2008.

However, both these numbers are enormously low if compared to historical Lithuanian inflation rate. Even moderate 2006 4.4% inflation is larger than average country’s cap rate at that time. What can we say about 11.8% of 2q2008? Simple – real estate rent is a bad investment. Those who were renting flats in 2q2008 earned -7.4% in real term per annum. Even a simple bank deposit brings higher returns. Moreover, if one puts the yield into a power of -1, he would get a number of years required to cover real estate investment. For Lithuania the picture is the following:

Here, you will have to wait for 25 years to get back the money you have paid for a flat. One of the longest time frames in the whole Europe.

It is clear at this point that rational investor would not buy a flat to rent it in Lithuania: either the flat is too expensive, or the rent price is too miserable. The major task is to understand which of those two is true. It will help to predict future development of Lithuanian real estate market: either to expect a fall in real estate price, or a jump in rent costs.

First of all, it is obvious that price growth of real estate has significantly outpaced growth in rent costs. So, Vilnius 2-room-flat price has almost doubled since 3q2005, while rents increased by roughly 30%, and only in the 2q2008 prices have converged moderately.

Second of all, Lithuanian real estate is also one of the most expensive in Europe, if adjusted by GDP/capita. The price of a 2-room flat is 45% higher in Lithuania than average price in Europe; and more than 6 time higher than the same flat in Germany, if the same adjustment method is used. If we adjust nominal real estate price by Lithuanian GDP/capita, we find out the price of real estate in every particular country, if all countries would have the same GDP/capita rate as Lithuania’s. In other words, estimated numbers depict the relationship between country’s income and real estate prices. The same number in a power of -1 demonstrates how much property can be purchased in a country with the same relative amount of income. Once again, Lithuania is not the best investment target. To make matter worse, this depicts how much local real estate property is overvalued relative to general income level.

Third of all, one might argue that rent prices are too small, negatively influencing the cap rate, and that is why they have been lifting up since early 2008. However, while rental costs have increased in office concentrated districts, surrounding communities are becoming cheaper to live in (according to invalda.lt). Moreover, rental costs are currently 10-15 times higher than electricity, water and heating bills, depending on year’s season. The costs are too high to be affordable by general public.

Finally, where does the money for property purchases come form? Right, from banks and their innocent credits. It was fine in 2005-2006, when flat prices were rocketing. Though, it is less pleasant today when they fall. Obviously, all understand what will happen if real estate prices plunge. Personally, I would expect some 30-35% drop in nominal Lithuanian real estate price after GDP adjustment, which would correct the cap rate together with the whole real estate market. The first significant signs of slowdown emerged already in 2q2008.