Q: Perception of Reality? Knowing when growth is sustainable

Within any property market, there are three general types of buyer; end users (people that want to live in their property all or some of the time), investors (people that want to let their property out for profit) and speculators (people that buy in the anticipation that prices will rise). Thinking about market participants in this way allows us to make better judgements as to whether the market we are analysing is experiencing growth based on economic fundamentals or whether it is a bubble.

The underlying concept is that sometimes price growth is based on fundamentals (supply is exceeded by genuine and sustainable demand) and sometimes growth is self-perpetuating, i.e. Price growth attracts buyers, which makes prices rise further. In such a scenario speculators believe prices will grow and therefore buy property. If enough speculators buy property, demand increases and prices go up. Such a market is based entirely on fragile human confidence and when the speculators lose their confidence and stop buying or start selling prices plummet as there are no genuine end users in the market.

Speculation is essentially second guessing how other market participants will respond to certain stimuli and then gambling on it. Speculation is a valid investment strategy used by many different types of investors and is not harmful to a market per se. The problems arise when rampant speculation takes over market and price rises become more dependent on speculative investment than they do on fundamentally driven demand. An excellent example of speculation leading to a bubble followed by a crash is the Asian Economic Crisis of 1997. This particular economic phenomenon was only partly related to real estate investment buy it did play a part. Once speculators lost faith in the markets of South East Asia they pulled their money out. As a result stock markets in the region crashed, currencies plummeted in value and the real estate market went into free fall.

What does this mean for international property investors? It means that when deciding whether or not to invest in a market, you must decipher whether any price rise or fall is the result of underlying fundamentals or whether it is down to the second guessing of speculators.

Sunny Beach in Bulgaria ....

It is our opinion that an excellent example of a speculative market is Sunny Beach in Bulgaria. Due to Bulgaria's accession into the EU and the Bulgarian government's attempt to bring tourism to its Black Sea Coast, investors made the decision that Sunny Beach would be a good place to invest. Those who got in early were right. Prices in the town have risen dramatically. However, at the time of writing holiday apartments in Sunny Beach and on the Black sea coast are being sold off-plan to investors at over €1,500 per square metre and in some cases over €2,000 per square metre. The question is; do fundamentals support this price? Our opinion would be no, for the following reasons.

As a tourist destination, Sunny Beach could have two kinds of end-users for the types of apartments and villas that are being built there; holiday home owners and holiday let landlords. With the massive development that is happening in the town and competing resorts along the Black Sea Cost, we would need to see a reasonable number of holiday home buyers and more importantly a massively expanding tourist base to create demand for holiday lets. If there isn't enough demand for the number of hotel rooms and holiday apartments owned by investors then yields (net annual rental income as a percentage of the total purchase price) will be below the level which is attractive to investors. If this is the case then investors will not want to buy.

Our view for Sunny Beach is that due to the local climate, it will not be able to compete with the resorts of the Mediterranean in attracting tourists. The summer season in Sunny Beach is only 4 months long and the climate is too cold to attract even low paying guests for the rest of the year. Because investors' apartments will be empty for much of the year, they would have to achieve extremely high rents during the summer season in order to achieve an attractive yield. However, as the supply of holiday accommodation is likely to exceed the demand for it, rents are likely to be low even in the summer months.

In our opinion the driver behind the spectacular growth in Sunny Beach property prices has been speculation. People are buying because prices are rising. It is likely that many buyers in Sunny Beach have purchased with the intention of letting their property and would therefore consider themselves investors rather than speculators. However, the reality is that the demand fundamentals may be not there and whether buyers are aware of it or not, their purchases have been speculative. This may ultimately lead to a significant correction as off-plan properties are completed and investors struggle to generate respectable rental incomes. As people realise that the price of property is not justified by the available rental income there will be a slowdown in demand. Equally, as those who have already purchased fail to see a return they may begin to sell leading to an increase in supply. Supply will outstrip demand. If this happens the correction could be significant, although prices are unlikely to drop below a point that bears a sensible correlation to the rental income.