The Estonian construction and real estate sector, like in other European Union member states, has gone through significant bumps and jolts in recent years. The trends most evident in the start-up and fintech sectors have also left their mark on the real estate and construction sectors. It’s been a journey from a Covid-period induced ‘full stop’ to the brink of overheating economy in 2022, followed by period of cool down introduced by the energy crises in the end of 2022, where the cheap inputs of the past were turned upside down by both record high electricity prices (up to €4,800/MWh) and the rise in EURIBOR. According to Statistics Estonia, the volume of domestic construction in the third quarter of 2023 was 7% lower than in 2022, and this trend continued in the fourth quarter. The real estate macro figures, which were moving in a vertical line between 2020 and 2022, also stagnated in 2023. The total value of real estate transactions fell by around 17% year-on-year in Q3 2023. Many developers and builders expect the same trend to continue in 2024.
Market players’ conclusion: need to increase efficiency
For construction companies and property managers alike, the stagnating market brought the need for increased efficiency, and property managers turned their attention to how to make the properties they manage work more cost-effectively and in a more tenant-friendly way. Thus, we’ve seen a sharp increase in the number of energy-related matters in real estate projects during 2023. These related to the installation of solar parks and electric car chargers on existing buildings, as well as the application of energy efficiency measures (eg the introduction of AI in the management of heating and cooling systems in buildings, the installation of reflective films on windows, the upgrading of heating and cooling systems and the installation of metering sensors). These issues arose both in ongoing portfolio management (eg charging investment costs to tenants, selling energy generated by solar panels to tenants under an existing lease), but also in real estate transactions, where technical due diligence was more focused on the energy-saving and smart capabilities of buildings. It is no exaggeration to say that 2023 was a year of energy efficiency in commercial property development and management, driven by the energy crisis that started in 2022, but also by the need for an ageing building stock to compete with new, energy-efficient space.
Challenges and opportunities in 2024
The trend towards efficiency in real estate management is irreversible and may offer interesting projects in the field of real estate transactions this year. In the coming years, properties whose management overheads are not competitive with new buildings, will be squeezed out of the market. This, in turn, puts pressure on the owners of such properties to make significant CAPEX investments that the landlord would otherwise rather hope to postpone, due to both the current cooling rental market and the high cost of finance. The latter, in turn, may lead to the property being put up for sale. In addition, the war in Ukraine and the ongoing tightening of AML/KYC rules have brought to the market transactions where the investors are forced to sell assets because they no longer meet the risk ‘appetite’ of the domestic banks.
Based on our 2023 transaction advisory practice, we highlight some key factors for both buyers and sellers to be more successful in such transactions.
Two recommendations for the seller:
- Vendor audits. Compile your own comprehensive technical and legal due diligence of the object to be sold. Its primary value is the elimination of those deficiencies which, if ‘found’ by the buyer in a pressurised sales process, would acquire amplified significance in negotiating better sales terms. In addition, it allows to map and price in detail the investments that should be made in the property to bring it to the next level of quality, but which the seller is not willing to make themself. This will significantly reduce the ‘mystique’ and opacity in price negotiation, removing fears and risks from the buyer that may be amplified during negotiations.
- Transparent and easy data management. In addition to the need to have a clear overview of the object of interest, it is also beneficial to have easily accessible and structured data. For this purpose, there are a number of property management systems on the market (eg Moderan, Bidrento, ELKIS) which make this much easier. Based on our experience with due diligence and transaction negotiations, we can safely say that the seller’s efforts and money spent into using these systems are significantly compensated by the ease with which the information can be presented and reviewed.
Two recommendations for buyers:
- Mitigating the risk of seller bankruptcy. In a distressed or semi-distressed transaction, there is always a risk that the seller will be indebted to its creditors and that the seller will go bankrupt after the transaction. For the buyer, this means the risk that bankruptcy proceedings may be brought for clawback of the sold assets. In other words, it may happen that, after the sale, the new owner discovers that their newly acquired property has been seized to cover seller’s debts. In order to mitigate this risk, it is worthwhile to carry out legal due diligence that in addition to the target also reviews the risks related to the seller. Should the seller solvency issue arise, it is wise to require that the sales price in whole or in part shall be used to cover the debts of the seller. Consideration should also be given to deferring payment of the purchase price.
- Immediate due diligence with real construction cost estimates. The construction budget is the easiest way to convince the seller of the additional investment needed and the fair purchase price. As some energy efficiency investments may involve a complete rebuild of the building’s load-bearing structures or technical systems, the numbers presented can be very convincing when negotiating the purchase price. In addition, we have also seen situations where the final calculation of construction costs has led to the buyer walking out of the deal. The scale of energy efficiency investment should not be underestimated, especially in a situation where more and more credit institutions are considering it when granting new loans.
All in all, as they say about the Estonian climate (with good reason), there is no bad weather, there is only inappropriate clothing. The same applies to the real estate market of 2024 – there will be no bad year, only missed opportunities. A stagnant market has historically always presented challenges and opportunities, and we believe the same is in store for 2024.