By Simon Tweddle, Property Secrets' Chief Analyst

It is well known that most CEE rental markets - in their current phase of development, at least - are weaker than what we are used to in more developed markets, such as the UK or Ireland.

The question many investors are now asking is:

Why are the rental yields in CEE currently lower than my financing costs?

The answer, in short is that yields are low because capital growth is so excellent.
This is so important to focus on, because whether an investment is worthwhile ultimately depends not on cashflow, but on strong capital growth.

Let's look at some rental market fundamentals.

Whether people decide to rent or buy comes down to the relative affordability of each.

The long term average is for renting and buying to cost approximately the same.

On either side of the balance of the long term average there exist opportunities for investors.

In central and Eastern Europe, where wages are on the rise and people have more and more money to spend, plus there is a strong desire for home ownership, people are prepared to pay a premium (compared with renting) in order to buy their own home.

And when there is more demand to buy than to rent, rents will hit a ceiling (or even fall a little), whereas buying prices will rise.

As buying prices increase and rents stay the same, so rental yields become compressed . In other words they get smaller and smaller.

Typically rents can fall to around 50 per cent of the cost of buying, and in high growth markets to even less than this.

High yields OR high growth

It's one of the fundamental facts of property - you can't have high capital growth and yields way above the borrowing rate. It's either one or the other.

What this means for investors is that low rental yields are very often a sign of very high capital growth markets.

Certainly this is the case in the CEE markets we are active in.

Eventually, of course, prices will rise so much that it becomes increasingly attractive to rent. Attractive, that is, in the sense that people can either no longer afford to buy, or they think it is too expensive to buy.

Therefore, demand shifts from buying to renting.

This has the effect (a bit like a piece of elastic being stretched) in slowing down price growth and forcing up rents.

This increased rental demand often quickly breaks through the previous rental price ceilings, leading to a rapid increase in rents - a bit like a share price breaking through a support level in a stock market due to a shift in sentiment.

As this happens, rental yields start to increase again and capital growth slows down.

Falling rental yields are therefore only ever a short-term phenomenon.

Once they reach a certain tipping point, people will simply start to rent because it is so cheap relative to buying. This, in turn, will gradually push up yields.

In many CEE markets, where there is large capital growth and falling yields, those investors who can afford to cashflow their investments in the short-term -through disposable income or from other cash positive investments - will benefit from very large capital growth.

And in the medium term be well positioned to take advantage of the predicted increase in rental yield.

What voids can I expect realistically?

It is too early to tell what voids there will be in the long term in our developments.

Though, as the markets mature and stabilise, we expect voids to tend towards what you may expect in the UK - around 4 weeks per annum.

In new developments, in the short term, voids will always be high, due to some fundamental factors:

1. It can take a number of months from when the final payment is drawn down from the mortgage to when the property is handed over, fully registered in the land registry and made tenant ready - for example, by installing a kitchen. In Poland this process can take around 4-6 months.
2. New developments tend to suffer from a degree of oversupply as most units complete at the same time all the rental units come onto the market at the same time. So landlords have to compete for a given number of potential tenants. Often this means taking a slightly lower rent in the short term, just to get the property let as tenants have a lot of choice. This fact highlights the importance of being able to differentiate your property from the others, either with a better finish or better view, etc.

This additional void period is something we account for in our cashflow projections for each deal and is something investors need to account for when investing in CEE.

Will rents be what PS predicted?

Of the PS units that have been let so far rents have been approximately 25% less in Poland than we predicted and around the same as we predicted in the Czech Republic. Although, obviously, this again depends on the specific unit and how it is finished. It is too early to assess developments in other markets.

Full details are available through our Letting and Management strategy reports.

How have the rental markets in CEE developed over the last few years?

Many CEE markets have seen unprecedented levels of price growth over the last few years, yet their rental markets have remained relatively static.

Typically, people have either lived at home or in a multiple-room, shared apartment, to save money, until they can afford to buy.

Whilst there has been steady migration to the cities this has not been enough so far to stimulate the rental market.

Affordability to buy new property has been, and still is, high, so renting has not been a very attractive option.

This will gradually change as purchase prices become less affordable and many more people are forced to rent.

In the Czech Republic, which has probably the best rental market in CEE, this has already started to happen.

The market has already been through a boom followed by a period of consolidation and now is more mature as a result.

For example, in Brno, yields are very healthy and void periods are already very low. We expect to see a similar trend take place in Poland in the next couple of years and in Romania a little further down the line.

Poland and Romania both have large, young (18-45) workforces, which is putting inevitable pressures on housing.

Salary growth is very high (almost double figures) in many CEE countries. This is predicted to filter into the rental market at a similar growth rate over the medium term.

Furthermore, the size of the average household is decreasing, putting further pressure on demand for rental property.

Overall the trend is very positive and rental markets won't remain static forever.

Do low yields matter?

In the short term it can be very painful to have high void periods and lower than expected yields, especially for those investors with multiple units, as it requires monthly cash injections to support the mortgage payments.

But the upside of this is that capital growth rates have been very high. So, if investors can hold out and ride the bumps of an immature rental market, the capital growth will be worth it.

And, let's not forget, it is capital growth where the real money is made.

As the market matures and the movement of labour becomes more fluid we can expect rental rates to increase. Often rents in a market are held down by an imaginary ceiling price. Though, when a critical point is reached, rental prices break through this ceiling and the rental landscape is completely transformed.

A classic example of this is what took place in Valencia just a few years ago where there had been huge capital growth and a static rental market until, almost overnight, the prices in rents almost doubled as the supply-demand equation tipped.

We predict a similar scenario playing out across rental markets in CEE.

When exactly this will happen is impossible to predict, but, in the meantime, it's worth being in the market, rather than watching from the sidelines, to take advantage of the spectacular capital growth rates we're seeing across CEE right now.