Angry at the prime minister following revelations that he had lied about the shaky state of Hungary's finances, 10,000 citizens took to the streets in September in protests that left 150 injured. Not surprisingly, a number of real estate investors “pulled out or postponed their decisions as a result of the perceived instability,” say researchers at CB Richard Ellis in Budapest.

Overall, property prices in Hungary seem vulnerable. One metric noted by Paul Kennedy, director of research for Invesco, a global institutional investor: Commercial real estate pays a yield of 6%, while Hungarian government bonds pay 7%. “That's just overpriced,” he says.

Sometimes, such a wide gap between yields and the bond rate can make sense, if rent growth is expected, Kennedy says, but that's not the case in Hungary right now. “The gap is just so great and the economy is worryingly weak,” he explains.

Yet despite a budget deficit that is expected to reach 10% of the country's entire GDP of more than $106 billion this year — a serious drag on an economy where growth in recent years has averaged about 4% — Hungary still has its fans.

A number of experts who follow this country of 10 million see the current budget crisis as a temporary setback. Even in the 1960s, back in the days when it was behind the Iron Curtain, Hungary was known as “the best barracks in the Soviet camp” because of its early efforts at economic liberalization, and these boosters believe the Hungarians won't stop now.

Martin Sabelko, managing director of central Europe for ING Real Estate Investment Management Central Europe in Prague, is one of those who believes the current crisis will blow over in six months to a year. Sabelko sees a rapidly modernizing country due east of Austria, whose capital, Budapest, is just two hours from Vienna.

Western investors have the wrong idea about Hungary in his view, as they do about the other eastern European countries. “We always forget, it's Europe,” says Sabelko, who manages more than $600 million in eastern European property. “It has not this communistic smell anymore at all.”

Short-run prospects

Even if the government cleans up its balance sheet in the next few years, 2007 may not be the year for investors to brush up on their Hungarian. In Budapest, where CB Richard Ellis estimates that 80% of the foreign property investment is concentrated, most sectors aren't improving.

The most serious obstacle: Over this year and next, total Budapest office stock is expected to grow by 25%. “I'm a little pessimistic about absorption next year,” says Michael Smithing, managing partner at Colliers International. At the beginning of the year, total modern office stock in Budapest totaled about 16 million sq. ft., according to CB Richard Ellis. By the end of 2006, it will have added nearly 2.7 million sq. ft., and Smithing predicts that it will grow by the same amount next year.

Over the next year, Smithing predicts that office vacancies are likely to grow from 13% to 20% as the new space becomes available. Already, the added supply seems to have hit rents. According to CB Richard Ellis, average office rents declined from the equivalent of $5 per sq. ft. in the first quarter to $4.55 per sq. ft.

Sluggish rents and high vacancy rates are nothing new for the market, according to Smithing. He says vacancy rates haven't dipped below 10% since 1993, and rental prices haven't moved at all. At the same time, a variety of new taxes that the government is scheduled to impose are also likely to dampen economic growth, shaving 1.5% to 2% off the GDP.

One local think tank shares Smithing's pessimism: Ecostat forecasts that GDP growth will dip from 3.9% in 2006 to a range of 2.5% to 2.8% next year, with consumer prices rising about 6.5%.

Others see more opportunity in industrial space. In most major European markets, says Valter Kalaus, a vice president for Equis Corp. in Hungary, the rule of thumb is that there is typically twice as much industrial space as office space. In Budapest, the situation is reversed.

In all, there's 8.6 million sq. ft. of industrial space in the greater city, according to CB Richard Ellis. The vacancy rate hovered around 11% in 2006. Average rents have been stable, with rents ranging between $1.91 and $2.22 per sq. ft.

Another 979,000 sq. ft. of space is projected to come on line by the end of 2006, according to CBRE. This appears to be running roughly in sync with demand, which reached 419,000 sq. ft. in the first six months of the year.

The industrial sector in Budapest is divided between new buildings and outdated facilities from the Soviet era. While some of the older spaces have been renovated — the film and television industry often occupies such spaces — most are not, and are rented out very cheaply to small and medium-sized businesses, according to Kalaus.

Most large businesses looking for new space are settling in suburban office parks where there is better infrastructure and easier access to Hungary's newly built highway system. To make it more attractive, the government is offering some tax abatements for companies looking to settle in Hungary. Overall, CBRE finds that vacancy rates for industrial space seem to be rising only slightly within the city even as they decline slightly on the outskirts.

In the apartment market, meanwhile, small speculators represent a large share of the sales interest. Small British and Irish investors looking for higher yields are active in the market, many buying property sight-unseen, according to Kalaus.

In Budapest, however, retail's fortunes may not be following rooftops. Growth is occurring principally on Andrassy Road, Budapest's traditional high street, according to Kalaus. Ten years ago, many shops moved out of the CBD and into suburban malls, but today the process is reversing. High-end shops such as Oakley and Louis Vuitton have all opened shops in this historic district, a unique location in a city that was otherwise almost entirely rebuilt after World War II.

High-end brand name shops might not seem like a great bet in a market where per capita GDP in 2005 stood at just under $17,000 a year, but Sabelko of ING, a veteran investor in shopping centers in Austria and Eastern Europe, argues that eastern Europeans are extremely brand conscious. “Hungarians are really willing to spend more on an item if it's a brand name,” he says, because they had so little access to quality products in the past.

EU membership

But will that money be any good? It's an important question, not just for Hungarians looking to buy more Louis Vuitton luggage, but for real estate investors in any sector. Kennedy says that investors who borrow in euros could face a risk if the Hungarian forint loses value, currently worth about a half cent.

The risk of a currency crisis shouldn't be underestimated. In a report released in August, before the latest political crisis, Fitch Ratings analysts predicted that Hungary will be the last of the 10 states most recently admitted to the European Union to be allowed to join the Eurozone, in part because it has the largest deficit in the European Union.

Fitch analysts guess that Hungarian shopkeepers won't be taking Euros before 2014, just two years after Poland (2012), and three years after the Czech Republic (2011). Yet Sabelko argues that the forint is irrelevant for investors. “Our contracts are 98% Euro-denominated,” he says.

Why buy Budapest?

One lingering challenge for Hungary in general, and Budapest in particular, is how it can differentiate itself from the region's other economies. Well-positioned between eastern and western Europe as well as the Balkans and Scandinavia, some investors see a bright future ahead for the city of roughly 2 million as a kind of European Memphis, Tenn.

Within Budapest, there are about 2.7 million sq. ft. of modern logistics and warehouse space. Most of the space is located within the Budapest Intermodal Logistics Center and Harbor Park, a logistics center owned by ProLogis.

Yet activity is sluggish: Vacancies stood at about 12% at the end of the second quarter, according to CBRE, about 75 basis points higher than the first quarter. Outside the city limits, another 6.3 million sq. ft. of logistics and business parks stand almost 11% vacant.

ProLogis is generally not a good company to bet against, but Smithing isn't sure that Budapest has a big future in logistics. “We keep expecting, ‘Oh, it's going to boom.’ It seems to be getting a bit stronger now, but if we look at the size and number of the transactions, we've always been lagging behind Prague,” he says.

If logistics doesn't pan out, some observers believe the well-educated population may be a greater source of strength for the city because of the high global demand for research and business process outsourcing. Chris Naylor, the Budapest-based regional director of Mosaic Property LLP, which is launching a $50 million eastern European private equity fund this year, believes that Hungarians have strong math and language skills, which will continue to prove attractive to major foreign companies.

Nokia, the Finnish cell phone giant, and Ericcson, the Swedish electronics concern, have located major R&D facilities in the Budapest area. Other large companies have opened call and business processing centers in Budapest including CEMEX, Diageo, and Avis.

Right now, the government is trying to provide more incentives for companies to bring more of that kind of business to the country, says Smithing of Colliers International. “We'll see if it works.”

Bennett Voyles is a Paris-based writer.