When Hines opened its first Moscow office in 1992, the company behind many of the world's finest modern office buildings operated out of a construction trailer. “It was definitely roughing it,” recalls Lee Timmins, senior vice president at the Houston-based concern.

Not only were the accommodations threadbare, but the office was located on a work site in a desolate area of the city. “The biggest problems we encountered were getting reliable electricity and figuring out where to get lunch,” Timmins says.

These days, Timmins' office quarters at the Park Place Moscow tower are “palatial” by comparison. Hines' current office is located inside a 406,000 sq. ft. mixed-use development that features 133,000 sq. ft. of Class-A office space. In 1993, Hines was hired to oversee management and leasing at the building.

Since those early days, Hines has built a string of office properties in Moscow and won several management and leasing assignments. The firm now boasts nine separate Moscow-area projects — six of them office buildings — consisting of roughly 2.3 million sq. ft. The firm also has the 329,000 sq. ft. Ducat Place office project under construction, which is on target to be completed at the end of 2005.

Hines broke new ground by being the first American office developer to venture into Russia. It was a risky move then, and it's no less risky today. The trail the company blazed back then remains largely untested by other U.S. developers.

Warsaw is another market that has attracted little interest from U.S. developers, but Golub & Co. has been active there since the mid-1990s. Both the Warsaw and Moscow office markets illustrate the myriad risks and potential rewards of breaking into these prime Central and Eastern European markets.

“You can find favorable risk-adjusted returns in Central and Eastern Europe, but the biggest problems are transparency, liquidity and local partner risk in the markets,” says Christopher Merrill, managing director of international private equity at Heitman. Merrill should know — his firm has been active in Central Europe since 1996 and now manages close to $1 billion worth of commercial real estate in the region.

Before setting up shop in Russia, Hines recognized that Moscow had a reputation as a volatile market. Still, Moscow's lack of modern office space, the prospect of growing demand and the chance to become the first American developer there were too hard to resist.

With roughly 30 million sq. ft. of Class-A and -B office stock, Moscow has the equivalent existing supply of Austin, Texas. That makes it a relatively small office market, despite its international stature as a seat of power. Its office market has seen many peaks and valleys of demand since the early 1990s.

In fact, Timmins says that Class-A asking rates fell from almost $100 per sq. ft. down to $70 per sq. ft. between 1992 and 1998, the year of the Russian financial crisis. By 1999, rates were hovering around $50 per sq. ft.

“Class-A rates are now up to $65 per sq. ft., and we've seen a pretty healthy increase over last year,” he says. Hines did raise its effective rents in Moscow by 15% between 2002 and 2003, he adds.

Momentum for Moscow Is Building

More increases may be in the offing. Out of roughly 30 major European cities, Moscow is expected to absorb the biggest influx of new companies over the next five years. A Cushman & Wakefield Healey & Baker survey found that 46 companies plan to establish an office in Moscow before 2009. The next largest influx is expected to hit Warsaw, where 29 companies have similar plans.

Still, Timmins says that returns have consistently fallen about 10% short of projections due to cost overruns and other issues unique to the Moscow market, though he declined to discuss specific figures. That may explain why so few American office developers have cracked the Central and Eastern European markets over the past decade. Just four major American firms — Hines, Golub & Co., Tishman International and AIG/Lincoln — have developed substantial office projects in the region. All of them are closely held, private developers willing to take higher risks in exchange for higher returns.

Hines has learned some valuable lessons in Moscow, but none too painful to force the developer out of the market. Other Americans have simply given up. “We are definitely seeing some players underestimate the risks here in Moscow,” Timmins says. “I think some U.S. developers will return, but they need more patience due to the enormous hurdles of building an organization to execute in this market.”

So, given the risks, what lures a U.S. office developer to Eastern Europe? Michael Topham, executive vice president and partner of Hines' European region, believes that the reasoning is threefold: “They either have some historical link to that region, they have a client relationship there or they see fundamental growth in the economy of that market,” he explains. Also, the prospect of being a prominent U.S. player in an emerging market is tempting for any developer.

Don't Forget Poland

Western Europe has traditionally been a favorite of offshore developers, who are attracted to the stability and liquidity of the French, British and German real estate markets. Still, with nearly a dozen nations scheduled to join the European Union this year, it's predicted that U.S-led office development will increase in markets such as Russia and Poland.

Foreign capital has inundated European real estate in recent years: out of €67.5 billion (roughly $85.8 billion) that flowed into European real estate in 2002, around €22.3 billion originated from non-European investors, reports Starwood Capital. It's unclear how much of that capital originated in the U.S.

Only €1.1 billion of that non-European capital flowed into the Central and Eastern European real estate markets. A full 60% of this sum went into Poland's real estate market. That's not surprising, given that Central Europe's single largest office market is Warsaw. In 2003, Warsaw had 20 million sq. ft. of office space, much of it modern Class-A stock.

Despite Poland's economic slowdown that began in 2000, Warsaw's gross office absorption increased roughly 30% between 2001 and 2002. Poland also boasts a population of more than 40 million people, which investors see as a positive signal for both office and multifamily development.

Golub & Co., the Chicago developer, established a Central European operation during the mid-1990s when the firm developed an office project in Warsaw. Golub completed the 100,000 sq. ft. Warsaw Corporate Center in 1993. Michael Newman, president and CEO of the Golub Co., says the Warsaw market has dramatically changed in less than a decade.

“When we first arrived, there were no hotels or restaurants. Now markets like Warsaw are much more like Western European cities,” he says. One of the main reasons that Golub entered Warsaw and Prague, says Newman, is that both cities have large populations underserved by commercial real estate.

Newman is confident that the EU expansion will add further stability to this region, too. He adds that Golub is exploring development opportunities in Bucharest, Romania and Moscow.

Joining The Club

This year the EU welcomes Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. The cost of admission requires these nations to adopt certain legislative and budgetary policies, which many sources say should benefit the perceived liquidity of real estate assets in those countries.

This latest EU enlargement will create one market with 27 member nations and 480 million people. While the EU's population will increase by nearly 30%, these new member nations will only add 6% to its GDP.

The changes wrought by the fall of communism and the EU expansion bode well for office development, believes Topham. Cities such as Warsaw, Prague and Moscow are roundly viewed as good prospects for near-term office demand. Meanwhile, other newcomers such as Hungary and Romania may also harbor some growth potential, say sources, but hidden liquidity and political risks may also lurk there.

“There's no question that Eastern Europe will be the land of opportunity for years to come. But you don't want explosive growth that will take these markets from boom to bust very quickly,” says Steve Mallen, head of global research at London-based real estate brokerage Grubb & Ellis/Knight Frank.

A Glut in Moscow?

Office developers are wise to proceed with caution in Moscow and Warsaw, says Mallen. Both markets pose different risks to investors. Moscow, for example, posted 6% average office vacancy at the end of the third quarter of 2003, compared with 16% in the U.S at that time.

But Moscow's low vacancy rate has the potential to inflate over the next few years. A glut of speculative office development in the works now will be delivered in 2006. Timmins of Hines believes that a cumbersome approvals process may prevent this glut from taking shape, yet he is concerned about it materializing.

Meanwhile, Warsaw posted a vacancy rate of approximately 17% at the end of the third quarter of 2003, which is high by any measure. To put those numbers into context, Grubb & Ellis/Knight Frank recorded the average European office vacancy at 9.6% during the same time period. The firm expects that average to continue to climb in 2004.

“U.S. investors and developers have really opened up the Central and Eastern European market,” says Giles Wilcox, a partner at Cushman & Wakefield Healey & Baker's London office. “The reality is that you have a much better chance of getting a U.S. developer to successfully build a 50-story office tower in Eastern Europe than anyone else. The Americans are prepared to take that risk in Central and Eastern Europe.”

Wilcox sees plenty of other investors and developers waiting on the sidelines in Warsaw and Moscow. “These people have done their research, but they are waiting for the right moment to come in and establish their market position here.”