Could the sharp fall in property prices in Estonia, Latvia and Lithuania hit other markets? Dan McLaughlinreports.

A CHILL wind is buffeting the formerly booming Baltic economies. It is sending a shiver through the region's property market and fanning fears over real estate prices across parts of eastern Europe.

Rising wages and access to mortgages and other forms of credit have helped fuel surging growth in Latvia, Lithuania and Estonia in recent years, but they have also caused spiralling inflation that the three Baltic states are now trying to tame.

The measures they are using to dispel warnings of a sudden financial crash, however, have caused a sharp reduction in real estate deals and even a drop in property prices.

The value of property transactions in Estonia, where the economic growth rate has almost halved this year, fell the most in the third quarter of 2007 because of higher interest rates and lending restrictions aimed at reducing public spending.

In neighbouring Latvia, officials say the number of real estate deals has shrunk to the level of 2001, before the start of a boom that has driven property prices up by some 500 per cent in major Baltic cities.

In the Latvian capital Riga, the value of Soviet-era apartments has tumbled by 12 per cent in the past five months, according to local property firm Latio.

Tighter lending rules by Baltic banks, coupled with fallout from the recent home loans crisis in the United States, have cooled spending and sentiment, experts say.

"Activities in the market have slowed down considerably," Aigars Smits, head of the Arco real estate company, says of the Latvian market. "People are waiting, though nobody can really predict what will happen in the future. The situation is bleak."

In its latest Transition Report, the European Bank for Reconstruction and Development said the rapid increase in property prices across eastern Europe was probably unsustainable at a time when mortgage default was in the headlines and borrowing was getting more expensive.

"The speed of price increases in recent years looks unsustainable in many countries as continued growth would soon lead to overvaluation," the November report said.

"As housing supply improves and credit conditions become tighter in the coming years, some moderation in house price growth is likely." The EBRD noted, however, that: "On the basis of income levels in 2006, house prices appear on the high side only in a few capitals," a comment that chimes with the opinion of many real estate experts who insist there is still room for major growth across the old communist bloc, albeit at a slower pace than in previous years in some countries.

Prices for residential and commercial property and land in Romania and Bulgaria are widely expected to continue their rapid rise in the years to come, as the countries attract multinational firms and their employees to major cities, and wage rises and an expanding credit market fuel a desire to move out of small communist-era flats into newly built properties and suburban houses.

The two new Balkan entrants into the European Union are also much bigger than the Baltic states: Bulgaria's 7.3 million population is about the same as that of the three Baltic nations combined, and Romania is home to 22 million people - creating greater demand for new property and intensifying the movement of people from the countryside to big cities.

In its recent report on prospects for east European real estate, the British firm Property Secrets tipped Romania and the Czech Republic to be the biggest gainers in 2008, with real estate prices predicted to rise by 25 per cent. Bulgaria, Slovakia and Slovenia ranked next with expected 15 per cent growth, followed by Montenegro and Croatia with 12 per cent.

After several table-topping years, the Baltic states lagged: Estonia and Lithuania were forecast to experience 5 per cent gains, while Latvian prices were not expected to rise at all.

The key factor for the Baltic states will be whether they defy predictions from some economists that they are heading for a hard landing after the giddying rise of recent years.

Having been praised for fostering the fastest growing economies in the EU since they joined it in 2004, the Baltic states are now being criticised for allowing wage increases, easy credit and booming consumption to spark rapid price rises and huge current account deficits that show they are importing far more goods and services than they export.

Failure to tame inflation forced the Baltic states to postpone plans to adopt the euro currency this year, and it is one of the main reasons why countries like Hungary, Poland and the Czech Republic have reconciled themselves to not using the currency until after 2010. The International Monetary Fund and other experts have cautiously welcomed moves by the Baltic governments to gradually slow growth and rein in spending and inflation, so reducing the risk of an economic crash and any US-style mortgage crisis.

"I don't predict a massive bankruptcy of households. The level of bad loans are very low - about 0.4 per cent in our bank and no more than 1 per cent on average in all Latvian banks. Maybe this figure will increase, but not in huge amounts," says Andris Vilks, chief economist at SEB Unibanka, Latvia's second largest lender.

Raita Karnite, director of economics at the Latvian Academy of Sciences, insists that falling property prices were predicted and are not a sign of imminent financial disaster.

"Latvia reached maximal real estate prices at the end of the last year. Everybody in the banks and in the market understood that," she says.

"The anti-inflation plan came later and coincided with a natural slowdown and falling prices. The only merit of the anti-inflation plan was that a small group of middle income people now have more restrictions to get loans. But they were not the ones boiling the market. Many profiteers had already withdrawn their investments." This measured optimism tallies with a feeling among most property investors in eastern Europe that while opportunities for spectacular overnight gains are dwindling, the region remains a very solid mid- and long-term bet for healthy capital growth. "In commercial property, we are still slightly to substantially below western European levels," says Karl Petrikovics, chief executive of the Immoeast property firm.

"In residential property, there may be some overheating in certain specific areas. But in general, based on economic forecasts, I'm very optimistic for real estate," he says.

Rapidly developing cities like Bucharest and Sofia still look like good bets, many experts say, while urging caution over cheaper holiday homes in ski or beach resorts that could suffer due to oversupply of similar properties or an economic slowdown.

"Maybe Bulgarian holiday homes . . . are a bit on the speculative side. They may end up being worthless if the market collapses," says Willi Hemetsberger, head of global markets at Unicredit bank. "But around big cities, urban areas, residential should grow."