By Theodore Murphy

As REIT-watchers around the world wondered out loud when Germany and the U.K. would adopt REIT-like investment structures, the two countries were quietly beat to market by an unlikely neighbor to the Southeast—Bulgaria. (Editor's note: For an update on the U.K.'s pending REIT legislation, click here.)

With a booming vacation-homes sector attracting international investment by the planeload, and an economy and financial-services industry quickly modernizing as the country prepares to join the European Union (EU) before 2008, Bulgaria's real estate market, though still small by international standards, is growing quickly and generating interest at home and abroad.

Property booms can be risky business, and the Bulgarian government is hoping that the REIT framework will help promote liquidity and transparency, diversify the property-market profile, attract and protect more of the growing investor base, and bring more real estate investments under professional management.

In exchange for these mitigative market changes, the reformist government that created the structure was willing to forgo corporate-level tax revenues. Bulgaria's REIT legislation, using U.S. and French laws as models, exempts REITs from corporate tax as long as most income is passed on as dividends to shareholders. The move came as part of a program of financial reforms designed to help entrench market principles and boost confidence in the economy of the former communist state.

With a combined market capitalization of some 78m Lev (U.S. $46 million), the 10 REITs listed on the Sofia Stock Exchange account for just less than 1 percent of the exchange's total market capitalization. The structure was put in place at the beginning of 2004, but most of the REITs did not list until 2005, and the sector is just beginning to expand. The IPO of an 11th REIT is under consideration, and a handful of other groups, encouraged by the early-adopters' success, are planning to list as well. According to data from the Sofia Stock Exchange, the average increase in equity capitalization among the 10 listed REITs so far is 48 percent.

In contrast to U.S. REITs, which tend to focus on one sector, and those in Western Europe, which generally do not include the housing sector, Bulgarian REITs typically invest in a mix of residential, office and retail assets.

Accordingly, Bulgarian REITs' initial success can in large part be explained by the strong performance of these sectors. The tourist-residential sector has boomed on the back of a huge increase from abroad in purchases of second-homes and investment properties—mostly by U.K. nationals seeking more affordable alternatives to Spain, but also by an increasing number of Bulgarian expatriates, according to the consultancy Colliers International. Despite interest rates still as high as 12 percent, Bulgaria's growing upper-middle class also is taking advantage of a vastly improved mortgage market to take ownership of suburban residences. Big-box retailers such as Carrefour and deep-discount retailers like Lidl are also taking up space in the suburbs, where Bulgarian companies are increasingly moving into new offices as well. The government has chipped in with new subway lines to make these markets more accessible. The combined effect is a mutually reinforcing interplay across the sectors—especially in suburban markets—plus a series of independent pockets of high performance in the tourist areas along the Black Sea and ski areas.

A report from Colliers attributes much of the bustle to Bulgaria's buoyant macroeconomy. The GDP has grown between 4.5 percent and 5.5 percent every year since 1998, and the International Monetary Fund projects 5.5 percent growth for 2005 and 2006 on expectations of continued structural reforms to promote private investment. Much of the private investment is likely to come from abroad, attracted by the improvements in economic policy and financial structures attendant to the EU accession process and the adoption of the Euro currency that should follow in 2009 or 2010.

Enjoying this supportive context, the country's REITs have been bolstered by inflows of capital from Bulgarian mutual funds, pension funds and retail investors. And although the nascent market generally has not attracted much attention from international investors, the two largest REITs, Bulgaria REIT and Prime Property, have secured meaningful investment from abroad.

Immoeast, a subsidiary of Austria's Immofinanz, picked up 20 percent of Prime Property for ?4.7 million (U.S. $5.5 million) earlier this year and has secured the option to take over a majority interest in all of the developer's major projects. Denmark's Danske Bank paid ?15 million (U.S. $17.7 million) for an 8 percent stake in Bulgaria REIT, which mainly develops middle-market residential and office properties for sale.

"It's a macroeconomic approach," says Ole Gotthardt, chief portfolio manager at the capital unit of Danske Bank. "We are looking for opportunities to benefit from convergence, and Bulgaria is doing very well. Residential prices have gone up 150 percent over the last three years and commercial real estate offers high yields, too. This is especially true outside of the city center where office properties yield 15 percent to 25 percent."

However, Gotthardt says investment success in the Bulgarian market requires a very cautious approach. "You have to find the right places, a lot of areas have been poorly organized by the government," he says.