JANUARY 2011

PERSPECTIVE

Risk and
Opportunity in CEE

Brian Klinksiek
Vice President

David Watkins, CFA

Director of European and Asian Investment Research
 PERSPECTIVE
RISK AND OPPORTUNITY IN CEE
Brian Klinksiek, Vice President
David Watkins, CFA, Director of European and Asian
Investment Research
In 2009, investors in commercial real estate in Central
and Eastern Europe (CEE) anticipated a chance to buy
stable, prime properties at pricing attractive enough to
generate returns suitable for value-add or opportunistic
funds. Despite the financial crisis and a lack of capital
in the market, that expectation turned out to be illusory.
Low interest rates, banks’ extend-and-pretend mentality,
and light-touch regulatory treatment of bank loan
portfolios virtually eliminated the supply of distressed
opportunities before it emerged.
Core investors have resumed purchases in the capital
cities of Poland and the Czech Republic (the least risky
CEE countries), stabilizing going-in yields and returns
closer to peak levels, albeit on lower rents. This has
resulted in a bifurcated market: the best properties in
the best markets have attracted capital, while weaker
properties in weaker markets struggle to do so.
Investors chasing the crowds to the former group will
likely earn core returns; investors with a higher return
profile will need to broaden their target list to include
countries with greater perceived risk. But some CEE
countries have been unfairly punished by association
with those that merit a significant risk premium; the
task is to differentiate.
This paper starts with a brief description of the events
that led to a more favorable outcome for the CEE region
and its property markets than initially envisioned by
analysts of the region. We then describe the
conclusions of our country risk analysis, highlighting the
countries we regard as offering potential opportunities.
(Supplementary discussion concerning the details of our
country risk analysis and how it has changed over
multiple iterations is provided in the appendix.) Finally,
we discuss alternatives to taking on additional country
risk, including investments in secondary cities within the
strongest countries as well as value-add strategies at
the property level such as repositioning and
development.
BETTER THAN FEARED
In October 2008, commentators saw parallels between
Iceland and countries across CEE—collapsing home
prices, large current account deficits, overextended
banking systems, and heavily indebted consumers and
Heitman 191 North Wacker Drive Chicago, IL 60606 T: 312.855.5700
JANUARY 2011 2
governments.1 Some predicted a blanket collapse of
CEE economies; their fear was reflected in a broad sell-
off the region’s equity, fixed income, and currency
markets in the early days of the financial crisis.
Pessimists fretted over the prospect of widespread
social unrest, the threat of withdrawal by foreign banks
from the region, and the risk of a wave of currency
devaluations.
But the dire predictions about the region have not come
true. This is, in part, because the international policy
response to the crisis in the financial system and CEE
appears to have worked. The European Central Bank
(ECB) provided liquidity to foreign banks, encouraging
them to keep financing their subsidiaries in the region.
The European Bank for Reconstruction and Development
(EBRD) brokered deals under its “Vienna initiative,” a
series of agreements among bank presidents not to pull
out of CEE markets. The International Monetary Fund
(IMF), European Union, and other lenders helped
countries in the region stay afloat and provided liquidity
to their banks.2
Countries with flexible exchange rates, such as Poland,
the Czech Republic, and Hungary, saw their currencies
weaken, helping to moderate the impact of the
recession by providing a boost to exports. In effect, the
exchange rate bore a portion of the economic
adjustment, a luxury not available to members of the
eurozone.3 The situation has been more difficult for the
countries with currencies pegged to the euro—Latvia,
Lithuania, Estonia, and Bulgaria—which maintained their
pegs and were thus unable to benefit from a weaker
currency. Instead, they have undertaken diligent
programs of internal devaluation, cutting wages,
pensions, and government spending, leading to a
deflationary environment that has achieved an effective
devaluation. While this process has been painful for
citizens and investors, it avoided the destabilizing,
stigmatizing wave of currency devaluations predicted by
some economists.
Despite the improved picture region-wide, wide variation
remains among CEE economies. Latvia, Lithuania, and
Ukraine suffered deep and sharp recessions, with real
GDP declines in 2009 of 18.0%, 14.8%, and 15.2%,
respectively. Poland, on the other hand, was the only
1 “Who’s Next?” in The Economist, 23 October 2008.
2 Latvia, Hungary, Romania, and Ukraine all received formal IMF funding
packages, while Poland agreed to a Flexible Credit Line, an IMF program
designed to bolster market confidence in relatively stable emerging economies.
3 The impact from weaker currencies was not uniformly a good thing, as many
consumer debts in some CEE countries are denominated in hard currencies such
as euro and Swiss franc, which caused payments to escalate when the local
currency weakened.
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 PERSPECTIVE
country in the European Union to avoid a recession,
posting positive real GDP growth of 1.8% in 2009. The
Czech Republic saw real GDP decline by 4.1%, less
severe than the decline of 4.7% experienced by its close
trading partner, Germany. The other CEE countries
performed somewhere in the middle.
But early on in the crisis, investors painted the countries
in the region with the same brush. For example, credit
default swaps (CDS) on Estonian sovereign debt peaked
in February 2009 at a spread of almost 740 basis
points, nearly 140 basis points higher than the peak
spread for heavily indebted Hungary. But Estonia’s
government had, for practical purposes, no debt. This
inconsistency “was a chance to trade bets on, in effect,
the death of a non-existent horse.”4 Since then,
Estonian CDS spreads have narrowed to a level among
the lowest in CEE as the market has come to better
reflect the variation among countries.
Recognizing that prudent investing in such a diverse
region as CEE requires a rigorous assessment of risk
and opportunity, we created a “risk scoreboard” in early
2009. This tool categorizes CEE countries according to
their exposure to a number of risks, including currency,
reliance on external financing, banking sector health,
and political stability.5 Latvia and Ukraine fell into the
riskiest category, while the Czech Republic, Poland, and
Slovakia fell into the least risky category; the other
countries were classified in between.
Looking back, our analysis turned out to be largely
correct. Commercial real estate demand fundamentals
and capital market interest roughly followed the
hierarchy of economic performance. For example, rental
rates and occupancy did not deteriorate greatly in
Investment Transaction Volume
Poland. Observing Poland’s relative outperformance, Europe 2003-2010 (Q3)
investors boosted their allocations to the country, with 16
investor demand evident even for office buildings in 15
14
secondary cities and shopping centers with functional 13
issues (more on this later). By contrast, the severe 12
recession in Ukraine and Latvia resulted in a surge in 11
10
vacancy and a downward spiral of rental rate reductions. 9
Real estate investors pulled back from these countries 8 150
and show little interest in returning to them in the near 7
to medium term.
6
5 2010 projection
STRATEGIC IMPLICATIONS 3
2
Formulating real estate investment strategies has 1
become even more complicated since we introduced the
0 0
Source: CBRE; Heitman Research
4 “Fingered by fate,” in The Economist, 18 March 2010.
5 Brian Klinksiek and David Watkins, “Central & Eastern Europe and the
Financial Crisis,” Heitman Perspective, March 2009.
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JANUARY 2011 3
country risk scoreboard. The safest strategies in the
strongest countries were the first to attract investor
interest and capital in the post-crisis world, pushing
yields back down for the best assets. As such, investors
targeting value-added returns in the region cannot just
focus on the strongest countries. They must take more
property-related risk in the stronger countries, or focus
on the countries facing more near-term difficulty.
Capital Market Conditions
Pricing for core assets in CEE approaches pre-crisis
levels. Several Class A office buildings in Warsaw and
Prague have traded at yields of between 7.0% and 7.2%,
and pricing expectations have become even richer since
then, with sub-7.0% yields now contemplated for the
best assets in those markets. Trades have occurred at
low yields even in the larger secondary cities of Poland,
where a Class A office building recently sold for a 7.5%
cap rate. Pricing is more aggressive for retail assets in
key cities. For example, Promenada, a shopping center
in suburban Warsaw, traded at a 6.5% yield despite
flaws in its layout and functionality. The investor likely
views the property as a value-add project, but the sharp
yield surprises us.
Notwithstanding the pattern of falling yields for prime
assets in the core markets, investment activity region-
wide remained sluggish. The total sales volume in CEE6
in the first nine months of 2010 was €3.2 billion;
although final 2010 figures have yet to be released, if
transaction activity continued at the same pace during
fourth quarter, 2010 volume will be about €4.3 billion.
This would be roughly the same level as 2004 and
about 23% of the volume in 2007 (the peak year).
Southeastern Europe (RO, BG, HR, SRB)
LEFT AXIS:
Eastern Europe (RU, UA)
billions of EUR RIGHT AXIS:
Central Europe (PL, CZ, HU, SK)
Western Europe billions of EUR
300
250
200
100
50
2003 2004 2005 2006 2007 2008 2009 YTD 2010
6 CEE, for the purposes of these statistics, consists of Bulgaria, Croatia, Czech
Republic, Hungary, Poland, Romania, Russia, Serbia, Slovakia, and Ukraine.
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 PERSPECTIVE JANUARY 2011 4

Fundamentally, investment volume remains muted
because a wedge divides sellers’ and buyers’ pricing
expectations for all assets but those with the safest
income streams. Banks’ low funding costs and their
reluctance to convert unrealized losses into realized
ones has not helped—their “extend and pretend”
approach has limited the volume of distressed
opportunities. Buyers are no longer able to secure high
levels of leverage, eliminating what had been a
significant driver of activity before the crisis.
lack a compelling long-term story. Conditions show little
potential for short-term improvement and opportunities
to exit the investment may be limited, even in a few
years’ time. Countries toward the upper left have
attractive current conditions but are of limited long-term
interest, based on small population, a small investable
universe, corruption, or poor governance. Those toward
the lower right have poor current conditions but benefit
from long-term significance and are expected to come
back into favor with investors.

Country Risk in 2D The Autumn 2010 CEE Risk Scoreboard in 2D

In this challenging environment, investors seeking a Health vs. Sustainability Scores
higher rate of return than that offered by core assets HEALTH SCORE
Short- to medium-
face difficult choices. One option is to expand the term prospects

opportunity set to include countries where current STABLE

CONDITIONS
Czech Republic

Slovenia Poland
conditions are less than ideal but that have bright
Slovakia
longer-term prospects. Investors with an investment Estonia
horizon of three to seven years need to be rewarded for
taking the risk that a country will revert to its longer-term Croatia Russia
trend of strong and stable growth. MODERATE
RISK

But which countries make good bets? The right Bulgaria

Lithuania Hungary

combination of current conditions and longer-term

prospects is necessary: current conditions must be
stable enough for investors to underwrite cash flows DOWNSIDE
EXPOSURE Latvia Ukraine Romania

with reasonable confidence, and longer-term trends

must suggest a foundation for sustained relevance and
a return to robust economic growth. In order to answer NICHE SECOND INVESTOR SUSTAINABILITY
SCORE
this question, we expanded and refined our risk MARKET TIER TARGET
Long-term viablity

scoreboard methodology to capture various

combinations of short-term health and long-term
prospects. We summarize short-term variables into a
composite measure we call the “health score”; we do
the same for long-term dimensions in our “sustainability
score.” (A more in-depth discussion of the scoring is
provided in the appendix.)
The following chart combines the CEE countries’ health
and sustainability scores, plotting them in two-
dimensional space.
The countries that fall toward the middle of both scores
merit further attention. These are markets with middling
current conditions but favorable long-term potential.
They may represent turnaround opportunities. We
specifically highlight two countries in the middle section
of the chart: Hungary and Russia. Both now see
significantly less investor interest than before the crisis,
representing a potential opportunity for the investor with
a longer-term view and a higher risk tolerance.

The most desirable countries are those in the upper
right.7 Czech Republic and Poland have seen the most
transaction activity and yield compression. Investors in
core properties can expect reasonably solid cash flows
and competitive bidding by multiple capital sources upon
exit. The least desirable countries are in the lower left.
Latvia and Ukraine have weak current fundamentals and
7 Not surprisingly, there is a strong positive correlation (approximately 0.67)
between the health score and the sustainability score. This suggests that
countries with strong current conditions are generally also those with strong
long-term potential.
 Russia suffered a deep recession, owing to its
exposure to the oil and gas industry and the
withdrawal of capital from the country. A rebound in
the oil price to a sustainable level in the $80-$100
range and calmer capital markets have revived its
growth prospects, despite a sweltering summer of
damaging fires. Among CEE countries, Russia
stands out because of the broad-based nature of
its recovery: growth originates from industrial
production, services, as well as the consumer
sector. A real estate recovery is also underway,

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 PERSPECTIVE
with declining vacancy rates and rents in prime
Moscow office properties growing strongly from
depressed levels.
Russia’s solid sustainability score derives from its
size. Moscow is one of the world’s largest cities
and is the cultural, business, governmental, and
transport hub of the Commonwealth of
Independent States (CIS), a region with a
population of approximately 280 million. However,
Russia scores poorly on other dimensions. In
terms of corruption and bureaucracy, the country is
not expected to compare favorably with modern,
European democracies any time soon. But a
structural undersupply of modern, quality real
estate stock and strong economic growth suggest
that an investment opportunity exists in Moscow,
and to a lesser extent, St. Petersburg.
 Hungary was one of the earliest Central European
countries to modernize and it retains key
advantages such as a well-educated workforce,
excellent infrastructure (including an extensive
network of motorways), and a strategic location
between Western and Eastern Europe. But even
before the crisis, its economy labored under
unsound government policy, most notably the
noxious combination of high taxation and a welfare
state it could not afford. On the consumer side,
borrowers took on reasonable amounts of debt, but
its denomination in foreign currencies exposed the
economy to dangerous mismatches. When the
crisis hit, Hungary’s heavily indebted government
and banks required intervention from the EU and
IMF to meet obligations and bolster investor and
depositor confidence.
Given the populist tendencies of Hungary’s new
government, prospects for improved policy in the
near term are limited. Indeed, the government is
slashing the deficit by attacking politically-
convenient targets and rolling back reforms. It is
implementing a burdensome tax on banks which
will likely dampen lending activity, and has
implemented new “crisis tax” measures aimed at
industries with a large share of foreign ownership,
such as telecoms and retail. Controversially, the
private pillar of the pension system is being
abolished, resulting in a one-off fiscal gain for the
government. The independence of a monetary
policy board is also under threat. Defiantly, the
government has ended cooperation with the IMF,
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JANUARY 2011 5
which poses risks if borrowing becomes more
difficult again.
Nevertheless, GDP has turned a corner and
economic indicators suggest that Hungary is
recovering strongly. Growth in exports and
industrial production has been particularly robust.
Real estate fundamentals in Hungary remain weak,
but we see evidence in our own Hungarian portfolio
of renewed demand. Therefore, investors need to
monitor the early signs of recovery. We expect
Hungary to return eventually to its roots as a key
market in Central Europe; investors willing to
tolerate higher risk in the near term are expected
to be rewarded with greater returns in the long run.
In addition to Russia and Hungary, Romania and Croatia
are also worth mentioning as potential targets. Romania
has a poor economic outlook in the short term, owning
primarily to a sudden and hefty increase in VAT enacted
by its beleaguered government, but its large overall
population and sizable urban centers suggest that it is a
deep market with long-term potential as a hub of
southeastern Europe. Real estate fundamentals appear
weak, but much of the vacancy is in existing stock that
is poorly located, ill-conceived, or functionally obsolete,
and will never appeal to users of modern space. Like
Romania, Croatia is also expected to be economically
soft in the near term. But its EU accession prospects
and relatively well-off consumers make it a likely
candidate for solid performance in the longer run.
The unique situation in the Baltic States merits
discussion. Investors have ignored these countries
since the start of the crisis. While Estonia, Latvia and
Lithuania suffered from the bursting of credit bubbles
and the inflexibility associated with their currency pegs,
Estonia now stands out as an economy in recovery.
Despite its small size, the country’s reputation for
minimal corruption and its low government debt give it a
good sustainability score. However, Estonia’s small
universe of institutional real estate assets limits its
appeal as a target for an executable investment
strategy.
Other Opportunities: Secondary Cities
Without venturing into riskier countries, properties in
secondary urban areas offer yield premia over those in
capital cities, allowing investors to take advantage of
the macroeconomic robustness of strong countries such
as Poland while earning a higher expected return.
Indeed, the decentralized population of Poland makes
that country particularly suited to secondary city
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 PERSPECTIVE
strategies.8 But there are negatives to investing in
smaller metropolitan areas, including greater exposure
to new supply, lower household incomes, generally
weaker demographic trends, and shallower local
economies that are dependent on a handful of
employers. As a result, these markets also carry greater
capital market uncertainty and exit risk. Furthermore,
the potential to deploy capital into such opportunities is
relatively small, suggesting they will not make up a large
portion of the ideal CEE portfolio.
We expect investment in secondary cities to work best
when focused on property types in which we have
invested with favorable results. In particular, we like
retail centers because, in most cases, they feature
similar national and international tenants regardless of
location. Shopping center performance is driven as
much by the competitive dynamics of the specific
submarket as by macroeconomic trends. Warehouse
properties in secondary cities are only attractive if their
location relative to production and population centers
and their transportation links put them on the “path of
goods movement.” Office assets outside capital cities
have typically been less favored (notwithstanding the
recent trade of an office building in a secondary Polish
city to an institutional fund), owing to exit risk, shallow
tenant markets, and the volatility associated with a
small inventory.
Other Opportunities: Development
Despite the supply overhang in some cities and property
types, a selective approach to development and
redevelopment makes sense in today’s market.
However, investors are advised to partner with only the
most experienced and best capitalized developers and
focus on the best sites. Structured investments, with
protection for investors’ equity, trade part of the upside
return in exchange for greater certainty of achieving a
base level return. Expected returns must be high
enough to compensate for the risk taken.
Development strategies worth consideration in today’s
environment include:
 Speculative office – Large blocks of office space
are increasingly difficult to find in Prague and
Warsaw, given that the development pipeline has
mostly emptied out. Large users looking to
consolidate or upgrade their space face limited
options, and some are now willing to pre-lease in
8 Other than Warsaw, Poland has seven metro areas with populations greater
than 500,000 and has about 30 more metro areas with populations greater than
100,000.
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JANUARY 2011 6
new projects. But there is a “chicken-and-egg”
problem: developers without significant preleasing
will be unable to obtain project financing, while
projects without financing are less likely to find a
pre-lease tenant. Banks want to know that the
property will have tenants, and prospective tenants
want to know that the project will actually be built.
Partnerships of developers and capital providers
that can solve this problem will be well-positioned
to profit from the opportunity to deliver appealing
space into a recovering leasing market.
 Middle-market residential – A structural shortage
of affordable housing units afflicts most CEE
countries. Widespread perceptions of overbuilding
miss the point: While there was a boom-era
oversupply of high-end units targeted at foreign
speculators, the mainstream buyer was largely
neglected, leading to a qualitative supply/demand
mismatch. Today’s lower land prices and
development costs mean that residential
developers are now able to target the mass market
that needs housing.
 Selective retail – Retail opportunities merit
pursuing, to the extent they are justified by local
demographics and shopping patterns. Fewer
submarkets and cities, however, have an obvious
need for new retail schemes. Strategies that rely
on delivering bigger and better product into already
saturated markets will succeed at stealing market
share only if the existing centers are deficient in a
meaningful way.
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 PERSPECTIVE JANUARY 2011 7

CONCLUSIONS
Creative investment structuring, including mechanisms
Although the economic recovery will likely be relatively
such as preferred returns and earn-outs, can be an
slow—as recoveries from financial crises tend to be9—
important tool in bridging buyer and seller expectations
the worst outcomes envisioned for CEE have not
and a way to cope with uncertainty. Structure adds value
materialized. But the region continues to face
in many types of possible transactions, although our
headwinds and hazards still lurk on the economic front.
experience has shown that lower levels of sophistication
Moreover, it is not yet clear that fundamentals have
among local counterparties limits the acceptance of
permanently stabilized; investors must not expect
such features.
immediate or rapid improvement.10 Meanwhile, those
assets that have traded in CEE have commanded full
Investors in CEE either need to adjust return
pricing but transaction volume is modest. Investors
expectations downward for stabilized assets in countries
continue to emphasize the top countries in the region
such as Poland, or must expand their risk parameters to
and focus on fully-leased prime assets with solid tenant
generate value-add or opportunistic returns. They can
rosters. Although signs of greater activity have
take additional real estate risk or additional country risk,
appeared, the investment environment remains
but they cannot expect the best core assets in the
challenging. Investors seeking higher returns are
safest countries to generate returns on par with those
gradually embracing incremental risk in order to achieve
targeted by the typical value-added investor.
incremental return. They face a trade-off—more country
risk or more real estate-related risk:

 More country risk – Hungary and Russia stand out

as countries currently out of favor but that have
long-term potential and deserve consideration as
investment targets. Smaller markets, such as
rapidly improving Estonia and EU-destined Croatia,
may also present opportunities. Romania’s near-
term prospects remain troubled, but a market of its
size deserves consideration, especially to the
extent that high-quality, stabilized assets become
available.

 More property-related risk – Secondary cities in

the strongest countries are attractive, particularly
in polycentric Poland. Selected development
strategies make sense, if undertaken with strong
partners. Finally, other strategies involving lease-up
risk can be more confidently underwritten in the
stronger countries.

9 According to Kenneth Rogoff and Carmen Reinhart (The Time is Different: Eight
Centuries of Financial Folly, 2009), recessions caused by financial crisis
historically have led to, on average, seven years of below-potential growth. By
this logic, the slow phase of the recovery has 4-5 years left to run.
10 Given that commercial real estate is typically leased on long-term basis,
space demand tends to lag the broader economy on both the upside and
downside. Although data from recent quarters show improvement in the form of
a leveling out of both vacancy rate increases and rent declines, sustained
improvement in these indicators is still several quarters away.

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 PERSPECTIVE JANUARY 2011 8

Appendix: Updating and Refining the CEE Risk Scoreboard

The basis of Heitman’s market-targeting strategy has been to identify and assess economic and political variation
among CEE countries. In March 2009, we wrote that

The financial crisis appears to have overshadowed any expectation of favorable outcomes, leaving
perceptions of the CEE region skewed by the headline-grabbing troubles of the least stable, most vulnerable
countries, such as Ukraine and Latvia. There is, however, wide variability among these countries in the health
of their national balance sheets.11

In the same paper, we introduced a “risk scoreboard” that divided countries into three categories based their exposure
to a number of risks, including currency, reliance on external financing, banking sector health, and political stability. We
now add a dimension to our risk scoreboard analysis to separate short- and long-term prospects. We take the bulk of
the attributes covered on the previous risk scoreboard and group them as components of a country’s “health score,”
which focuses on current fundamentals, while we evaluate mostly new measures of long-term potential as elements of
each country’s “sustainability score.” Adding this dimension to our analysis allows us to identify markets that may
experience short-term turbulence but that are expected to perform well in the longer view.12

The combination of both scores can be depicted in two-dimensional space, and classified according to a 3x3 grid. The
vertical axis of the grid ranks countries by their health scores; the horizontal axis ranks them on their sustainability
scores.

2009 Risk Scoreboard 2010 Risk Scoreboard

Methodology Methodology
One dimension Two dimensions

Less risk Stronger

Near-term
Near-term
“balance
conditions
sheet” risk

More risk Weaker

Long-term
Poorer Better
prospects

11 “Central & Eastern Europe and the Financial Crisis,” Heitman Perspective, March 2009.
12 We plan to use the Risk Scoreboard approach in the future for a broader, global market-targeting analysis, looking at countries throughout the world and their
attractiveness for commercial real estate investment. Previously, we focused exclusively on comparing and ranking within the set of CEE markets. We now strive to assign
ratings based on the basis of global benchmarks, rather than judging the field of CEE countries relative to each other. In other words, we are no longer “grading on a
curve.” It will therefore be theoretically possible that all or none of the CEE markets will be assigned a given rating.

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 PERSPECTIVE JANUARY 2011 9

The Health Score

The current economic situation is rated using a range of variables that reflect short-term performance factors such as
GDP growth, CPI, budget deficit, and CDS spreads. The composite of these factors makes up the health score. Each
variable is classified into one of three categories:

Countries in this category are recovering strongly from the economic crisis and have the least
susceptibility to a double-dip recession.

Near-term macroeconomic performance, financing risk, or shaky policy environments, present concerns
for these markets. But they also have mitigating factors that provide an offset to the risks.

These are countries that have shown macroeconomic vulnerability and have the most potential for further
downside.

We also introduce a fourth category on the negative end that is meant to provide additional precision within the grading
categories that make up the scale.13

On this particular dimension, the country is exceptionally worrying (e.g., deeply negative growth). We do
not place any of the CEE countries in this category on a composite basis, but we anticipate that some of
the world’s most troublesome countries (e.g., Congo, Somalia, North Korea) will merit this classification.

The following chart details the health score ratings for each of the CEE countries.
Czech Rep.

Autumn 2010 Health Score

Lithuania

Romania

Slovenia
Slovakia
Hungary
Bulgaria

Ukraine
Estonia
Croatia

Poland

Russia
Latvia

Previous year growth 1 1 1 0 1 0 0 3 1 1 1 1 0

Near-term growth 2 1 2 2 2 1 1 2 1 3 3 2 3
Secular exposures 0 1 3 2 3 2 2 3 2 2 3 1 2
Price stability 3 3 3 3 2 0 2 3 1 1 2 3 1
Government deficit 2 2 2 3 2 1 1 1 1 2 1 2 2
Political stability 2 2 2 1 3 2 1 3 1 3 3 3 1
Quality of government policy 2 3 3 3 0 3 3 2 1 2 2 3 1
10-year CDS spread 1 2 3 3 0 1 2 2 1 2 3 3 0
Banking system health 1 2 3 2 1 0 2 3 1 1 3 3 0
Overall health score 2.0 2.0 3.0 2.0 2.0 1.0 2.0 3.0 1.0 2.0 3.0 3.0 1.0

Latvia, Romania, and Ukraine fall into the Downside Exposure category, whereas the Czech Republic, Poland, Slovakia,
and Slovenia fall into the Stable Conditions category. Bulgaria, Croatia, Estonia, Hungary, Lithuania, and Russia come
in between, and are classified as Moderate Risk countries.

13 Reflecting on our previous paper, we felt that there was significant variation within the weakest category that was not being captured by the three-grade rating scheme.
As such, the classification of a country as “negative outlier” on a particular dimension does not necessarily reflect recent deterioration, but is the result of a more granular
classification.

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 PERSPECTIVE JANUARY 2011 10

The Sustainability Score

The sustainability dimension considers variables that contribute to the country’s long-term economic health. These
include population size, corruption, transparency and competitiveness. As with the health score, the elements of a
country’s sustainability score are classified according to one of four categories:

These countries have promising long-term prospects and relevance (due to their size, economic
significance, and good governance), and therefore figure prominently on investors’ radar screens today
and likely into the future.

Countries in the second category have either positive long-term economic and policy prospects but are
classified as second tier due to their smaller size and limited relevance, or they have significant scale and
importance but are held back by a clouded economic or policy outlook.

These countries face significant, long-term economic and political challenges. Further, they lack sufficient
depth and potential to merit investor interest. In other words, they may not be worth the “brain damage.”
Certain specific opportunities may have a broader investor appeal, but the liquidity of such investments
must not be relied upon.

The Negative Outlier score means that on a particular dimension, the country is an outlier at the less
attractive end of the spectrum (e.g., very small market).

The following chart details the Sustainability Scores for the CEE countries.

Autumn 2010 Sustainability Score

Czech Rep.

Lithuania

Romania

Slovenia
Slovakia
Hungary
Bulgaria

Ukraine
Estonia
Croatia

Poland

Russia
Latvia

Market size 1 0 1 0 1 0 0 2 2 3 1 0 2
Demographic prospects 0 1 1 1 1 0 0 2 1 1 1 1 0
Standard of living 1 2 3 2 2 1 2 2 1 1 3 3
1
Office advantage 0 0 3 0 2 0 0 3 2 3 2 0 1
2
Logistics advantage 0 0 3 0 2 0 0 3 1 2 2 0 2
Competitiveness 1 1 3 2 2 1 2 2 2 2 2 2 1
Corruption perceptions 2 2 2 3 2 2 2 2 2 0 2 3 0
Commercial property transparency 1 1 3 1 3 1 1 3 2 2 2 1 0
3
Infrastructure stock 1 3 3 1 3 1 1 1 1 2 3
Balance of payments 1 2 1 3 2 3 3 2 2 3 1 1 3
Fiscal sustainability & gov't debt 3 1 2 3 0 2 2 1 3 3 2 2 3
Long-term policy & reform outlook 3 3 3 3 2 3 3 3 1 1 2 3 1
Overall sustainability score 1.0 1.0 3.0 2.0 2.0 1.0 1.0 3.0 2.0 2.0 2.0 2.0 1.0

(1) Qua l i ta ti ve a na l ys i s of competi ti ve a dva nta ge i n offi ce-us i ng a cti vi ti es s uch a s regi ona l
hea dqua rters , bus i nes s proces s outs ourci ng, profes s i ona l s ervi ces , etc.
(2) Qua l i ta ti ve a na l ys i s of competi ti ve a dva nta ge i n l ogi s ti cs a nd di s tri buti on, ta ki ng i nto a ccount
l oca ti on a nd l ogi s ti cs -rel a ted i nfra s tructure.
(3) Qua l i ta ti ve a na l ys i s of the condi ti on a nd rea ch of a country's roa d network, a i rports , power gri d,
ra i l wa ys , publ i c tra ns port, etc.

As indicated in the table, the Czech Republic and Poland stand out as long-term Investor Target countries, whereas
Bulgaria, Croatia, Latvia, Lithuania, and Ukraine are classified as Niche Markets, suggesting limited scope to become
prime markets for foreign direct investment or real estate investments. Finally, Estonia, Hungary, Romania, Russia,
Slovakia, and Slovenia come out in the middle as Second Tier countries.

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