By Simon Tweddle, Chief Analyst, Property Secrets

Property markets, particularly those in Eastern Europe right now, develop and change over time.

There is a dynamic relationship between a property market's main characteristics of risk, reward and cashflow.

So, when one of these factors changes, it results in a relative effect on both of the other factors.

Speculative Markets

Markets typically start out at some stage as being speculative.

Capital growth rates can be +/- 100% and rental yields vary from being none existent to very high indeed.

These markets are characterised by a lack of information, poor liquidity and much uncertainty ....and thus they are very high risk.

Basement follows speculative

As markets move from being speculative into being a basement level opportunity, typically the only people who can afford to buy new build property are either expats or very wealthy locals.

Renting to expats can be very profitable but it is not a sustainable investment strategy. The only other target group in this stage are students.

There are various factors that can move a market out of the speculative phase into what we have coined as a basement opportunity phase.

Stimuli such as changes to the law, introduction of mortgages or increased political stability, and more besides, can provide the impetus.

Less risk

In the basement phase risks are much less than in a speculative phase but are nevertheless much more prevalent than in more mature markets.

Prices in this phase are often relatively cheap so anyone who can afford to buy tries to do so.

This often leads to very large price growth, which takes off slowly at first but then very rapidly accelerates.

And because most people are trying to buy, prices in the rental market are often static or fall a little. This has a dramatic effect of compressing rental yields.

In such immature markets returns on capital investment can be very high but rentals can be difficult so it is important when investing in such markets to budget for negative cashflow on a monthly basis.

Such large capital growth can only last so long. As prices rise, affordability issues come into play. This has a natural dampening effect on the market and slows the price growth down.

As the ability to buy becomes ever harder for more people, these people are then forced to rent.

Why people rent

Typically people rent for some of the following reasons:

• they don't have a good enough credit score to get a mortgage
• don't have enough money for a deposit to buy
• want to live in a certain area (usually very nice) of town (lifestyle renters) but could never afford to buy there, but could probably afford somewhere cheaper but chose not to
• have just moved to the city and need to rent until they work out where they want to buy / live permanently
• don't want to the commitment and hassle of owning their own home.

In a period of high affordability to buy and high price growth these reasons become less important and people just want to buy before prices become even more expensive.

As prices become too high more people are forced to rent for longer before they can afford to buy. This then supports the rental market.

Usually a period of high price growth is followed by a period of consolidation where the balance between renters and buyers tends back towards an equilibrium level. This is usually seen by a dramatic slow down in capital growth and the increased ability to rent out a property.

By this stage the market is usually becoming much more mature and deeper. This next phase of growth is often more steady but sustainable. There will be more financial products on the market, the middle class will have expanded and there will be a much better balance between those who can afford to buy those who have to rent, this creates a much better dynamic in the property market.

So where do our core markets fit into this model?

Let's take Prague as an example.

In the three years leading up to entry into the EU prices that started from a low base grew very rapidly.

The market was mainly driven by expats and wealthy Czechs buying in the centre of the city.

Back then the rental market was not great (unless you rented to expats) and was heavily regulated. As a foreigner you needed to set up a company to buy there and finance was a lot more difficult to come by. Prague was essentially a basement opportunity.

Post EU membership (May 2004) saw the market finally take a breather. Capital growth was only around 10% per annum and the rental market deepened. This period of consolidation last around two years.

By the end of this period better finance products had come on to the market, foreigners no longer needed to set up a company to buy and rental yields were above the finance rate.

This increased maturity in the market has allowed it to move into the next stage.

Longer second stage growth

A stage of sustained steady growth of 10-25% that will last for longer than the initial burst of growth we saw over a three year period before EU membership.

Brno is in a similar situation, where capital growth rates have been slow over the last couple of years, which allowed a strong rental market to develop.

Yields there are above the finance rate and capital growth rates have started to pick up.

This situation will not last for too much longer as capital values increase more rapidly, but if you buy right now than you effectively lock yourself into a good yield and enjoy good capital growth as it comes.

Buying in at a good yield to start with also allows you to refinance in the future more easily.

The Czech markets are going through a transition point between high yields and low growth to a period where growth will be stronger and yields will naturally be compressed; though due to the maturity of the market yields will not fall to levels that are currently being seen in Poland.

The Czech market is now much more mature and low risk. It has good finance and a much deeper rental market which means yields should be higher than before and voids lower.

What about Poland and Romania?

Romania has just entered the basement phase.

Capital growth is expected to be high, finance is weak but strengthening and the rental market will be shallow and fragmented as everyone who can afford to buy does so and those that can't stay put.

This tells us that Romania's period of very high capital growth is still to come - the introduction of better finance products will probably be the major stimulus to this growth - and the rental market will be difficult for a number of years to come.

Poland sits neatly between the Czech and Romanian markets.

Markets such as Warsaw and Krakow have seen ultra high growth over the last two years and are now starting to see more reasonable levels of growth of 10-20% as people have to wait a little longer than last year before they can afford to buy.

And the rental market is expected to show signs of picking up in the next year.

Poznan has grown strongly over the last two years but is now in the thick of a very high growth phase.

3rd tier cities such as Gliwice, Katowice or Szeczin are still priced at a low base.

Yet you can get the same finance as in the rest of Poland and economically these cities are improving.

Such 3rd tier cities are just at the start of a high growth phase.

So in Poland you have a range of markets that sit under the emerging market category that experiences very high growth, but still have relatively weak rentals.

*Graph showing a typical market growth curve and where various markets sit on that growth curve

Conclusion

So, between the markets of Czech Republic, Poland and Romania you have three different markets at different phases in their growth pattern and with different characteristics in terms of capital growth, risk and rental return.

By investing in a combination of these markets investors will have a very healthy balanced portfolio of risk, reward and cashflow.