THE COMING REAL ESTATE BUST IN EASTERN EUROPE
by Krassimir Petrov, PhD. December 19, 2007
As a diligent student of speculative manias and bubbles, I have been blessed to witness two bubbles during my 10-year stay in the Unites States. As a Ph.D. student in economics  in the period of 1995-2000, I have witnessed the blow-off stage of the dotcom-telecom bubble; as a corporate employee in a software-telecom company in the period of 2000-2004, I have witnessed the bust of the dotcom-telecom bubble and the simultaneous blowing of the real estate bubble.
Today, as I write this, I am once again witnessing another wild speculative bubble. This time, it is in Eastern European real estate.
When in late 2004 I returned back home in Bulgaria, people everywhere told me that real estate was definitely the best investment in Bulgaria; I even learned that real estate is also the safest investment - every Bulgarian knows the ultimate truth of real estate investing - real estate prices never go down. Anytime I tried to object, people interrupted me and taught me that this was just textbook stuff that didn't apply to Bulgaria; for them, this wasn't the time to be theoretical, but to make money in real estate - average annual gains in previous years ran about 25-35%, and things were only to get better: Bulgaria was to enter the EU in 2007, so Western Europeans would madly rush to buy our real estate at sky-high prices and make us all rich.
Everybody was convinced that real estate prices in Sofia, the capital of Bulgaria, will reach those of Prague and Budapest, which in turn were supposed to reach those of Rome and Berlin in the not too distant future. Everyone was "investing" in real estate, of course with borrowed money. The really smart and better educated were buying two or more properties, using the first one as a collateral for the second, and the second one as a collateral for the third; they were the undisputed geniuses that invented the way to financially pyramid one asset on top of another; many of them, however, have never heard of Charles Ponzi and Ponzi Schemes.
The ultimate objects of speculation were resort properties on the Black Sea, where the majority of Western and rich Eastern Europeans will spend their Summer vacations. God has blessed our Black Sea with beautiful scenery, sandy beaches, and a perfect climate; and property prices proved it - they surpassed their comparables in Dubai and rivaled those in Florida's Miami Beach. Everywhere people assured me that this was not a bubble, but sound financial investing based on solid fundamentals.
Fundamental analysis, however, indicates that that real estate in Bulgaria is indeed grossly overvalued. Let me explain:
Real estate has two fundamental indicators that serve the serious analyst as guideposts: (1) the rent-to-price ratio and (2) the price-to-income ratio. The first indicator, rent-to-price, divides annual rent from the property to its purchase price, thus the yield or current return of the investment. U.S. history for over hundred years suggests a normal yield of around 10-12%; yields of 15-20% suggest that the property is undervalued, while yields of 6-8% or lower suggest overvaluation and bubble territory. Over the last 3-4 years, yields in Bulgaria hover in the 3-4% range, suggesting a strong bubble, with properties overvalued about 3-4 times the "normal".
The second indicator, price-to-income ratio, tells how many years of pre-tax annual earnings are necessary for a household to purchase a house. The historical rule of thumb is that one annual income indicates undervalued properties, two annual incomes - normal valuation, and three annual incomes - overvaluation and bubble territory. Currently, this ratio for most regional markets in the economy is around 7-9, which is once again indicative that real estate is overvalued roughly 3-4 times.
Thus, both indicators confirm that there is a real estate bubble across the country, although no analyst in Bulgaria would actually perform this analysis. Interestingly, when analysts are confronted with the fact that real estate earns less than a bank deposit, they immediately respond that rising prices more than compensate for the low yield. So much for the rock-solid fundamentals of the real estate sector.
Macroeconomic fundamentals look absolutely terrific from one point of view and downright terrible from another. I'm very worried by steady money supply growth rates of 30%; mainstream economists counter that the Bulgarian monetary system is based on a currency board, so inflation is impossible, because the government does not print "unbacked" currency.
Even worse, I worry that credit has been expanding steadily for many years at a phenomenal 50% (yes, fifty percent!!) rate, thus driving a wild boom destined to turn into bust sometime in the future. Mainstream analysts would counter that the initial credit base 5-8 years ago was abnormally low, so that the credit/banking system has a lot of catching up to do; moreover, they point out that these healthy credit growth rates indicate strengthening confidence in our banking system.
For many years mortgage growth was 70-80%, which makes me firmly believe that a wild real estate bubble mania is in the making, which one day will inevitably burst. I also worry that current account deficits have reached nightmare proportions at 20% (twenty percent) of GDP, so the collapse of the currency board and the economy is nigh and certain. Finally, I point to the nightmare proportions of our foreign debt, currently standing at 100% of GDP. Mainstream economists complacently respond that strong mortgage growth underpins growth in the real estate sector and the macroeconomy and that trade deficits don't matter - we are now part of larger Europe. Thus a sound analysis indicates that the economy is bound to collapse in the near future, while modern governmentally-sponsored analysis concludes complacently that everything is great and will only get even better.
This gets us to Eastern Europe. One may confidently claim that practically all of Eastern Europe, mostly for similar reasons, has a giant real estate bubble that is beginning to crack. The interested reader should refer to Ambrose Evans-Pritchard's "Overheating sees house price downturn in Europe".
Finally, here is what the big picture looks like: the real estate bubble gradient runs from the U.K. to Bulgaria. And here is the explanation. Early in the decade, the genesis of the bubble was in Great Britain. Weak German and French economies forced for many years the European Central Bank to keep abnormally low interest rates and fuel real estate bubbles across the stronger Mediterranean economies (Spain, Portugal, France, Greece), and later on in Western Europe. These bubbles in turn spread across Eastern Europe, first in the Czech Republic, Poland, and Hungary, and later on in the Baltic countries (Latvia, Lithuania, Estonia) and the Balkans (Romania, Serbia, Bulgaria). For all practical investment purposes, the real estate bubble has not spared a single country in Europe.
Investor beware – stay out of Eastern Europe's real estate. The bust is coming!
 My doctorate degree is from the Ohio State University, Dec. 1999
 Sterling Commerce, a software company fully acquired by SBC Communications at the peak of the bubble in March 2000.
 I am born and raised in Bulgaria
 This, however, is Minsky's definition of "speculative investment".
 One may correctly point out that the genesis of the bubble was actually in the United States, spreading from there to the U.K.
© 2007 Krassimir Petrov, Ph.D.