Leading Hungarian law firm advises on post-COVID investment opportunities

04 Nov Leading Hungarian law firm advises on post-COVID investment opportunities

Dr. Eszter Kamocsay-Berta, Managing Partner, KCG Partners, provides a legal perspective to the current and future environment for doing business in Hungary

Known for combining the efficiency and economy of an elite local law firm with the in-depth knowledge of a global practice, KCG Partners is one of the leading business law firms in Hungary, with a strong reputation in litigation and tax advisory. I’m sure our readers would, therefore, welcome your insights into the ease of doing business in Hungary? For instance, what kind of protection mechanisms, litigation systems and dispute arbitration schemes exist to protect investors? In addition, what are the main advantages, challenges or backlogs that exist for creating a business in Hungary today?

As a result of its strategically excellent location at the heart of the Central and Eastern European region, having one of the most open economies in Europe and with an foreign direct investment (FDI) stock of around €80 billion, according to the Hungarian Investment Promotion Agency (HIPA), Hungary is an attractive choice for foreign investors and it is considered to be a gateway to East and Southern Europe.

During the last couple of years, the Hungarian Government had introduced measures and solutions that enhanced and improved the Hungarian business environment, such as the EU’s most competitive corporate income tax (CIT) with a 9 percent flat rate, establishment of HIPA with the aim of providing professional help to foreign companies intending to invest in Hungary and incentives that are available to all companies registered in Hungary regardless of their nationality.

Hungary’s well-established infrastructure and clear regulatory framework also ensures a favorable environment for investments. Furthermore, investments are protected by the country’s political and economic stability, which is reinsured by the fact that Hungary is a member of the EU and other international organizations such as the Organisation for Economic Co-operation and Development, the World Trade Organization, NATO and the International Monetary Fund.

In addition to the main advantages listed above, new sources of financing are available for investors due to the active intervention of the Central Bank of Hungary (MNB)—also referred to as the Hungarian National Bank—on the finance market. According to the MNB, the Hungarian banking sector is considered stable. This should be highlighted, as bank loans are still a major form of financing in Hungary. Nevertheless, the MNB has launched some new financing forms, within the framework of the so-called Funding for Growth Scheme that, since 1 July 2019, also includes bond funding in order to provide alternative financing schemes to companies.

As to the backlogs, we may refer to a relatively new legislation, according to which foreign investors can only carry out certain activities, have dominant influence or acquire shares in companies carrying out certain activities that are mentioned in the Act if they acquire the competent minister’s approval. Among other activities, these include financial services, operation of payment systems, and services that fall under the scope of the acts on electric energy, natural gas, public water services or electronic communication. This relates to Act LVII of 2018 on the control of foreign investments conflicting with Hungary’s security interests.

Finally, we would like to cover the questions concerning the Hungarian legislative and legal system. Due to the fact that Hungary has a continental legal system, civil procedure is characterized by formalities and cost intensity. Even though the civil procedure system has been reformed by a newly adopted Civil Procedure Code in 2016, where the main goal was to accelerate the procedures and to prevent excessive delays in the proceedings, there is still a long way to go in order to ensure quick solutions for litigating parties. However, alternative dispute resolution methods, including arbitration, mediation and specialist courts—tribunals—are available in Hungary. According to our experiences, arbitration can be a quick, professional and more cost-effective solution for commercial matters. Investors can apply arbitration clauses in their contracts by appointing, for example, the Permanent Arbitration Court attached to the Hungarian Chamber of Commerce and Industry in the case of a legal dispute or by choosing another permanent or ad-hoc arbitration court.

The country attracted a record number of FDIs last year, with 101 investments in 21 different sectors coming from 20 different source countries. Can you provide an insight into Hungary’s tax and fiscal attractiveness in comparison to its European peers, and what main mechanisms are in place to stimulate investments and research and development (R&D)?

Hungary has a favorable tax and financial environment as well as a suitable workforce. In terms of tax and incentives, in order to improve the business climate the Hungarian government has created by far the most competitive CIT in the EU with a 9 percent flat rate and has gradually reduced taxes on employment: the social contribution rate has fallen from 27 percent in 2017 to 15.5 percent in 2020. In addition, there is no withholding tax on dividends, interest and royalty paid by a Hungarian company to a foreign company, while Hungary also has a wide international treaty network with more than 80 double tax treaties.

The government’s incentive scheme supporting technology-intensive investments, job creation, asset investment and R&D projects via non-refundable cash subsidies, tax allowances and available EU funds also facilitates R&D activities and fosters the development of digital environments. The Hungarian labor force is well qualified and cost effective as well, which increases the country’s international competitiveness. In addition, a dual vocational training system is in place built on industry needs.

In order to facilitate investment in Hungary, HIPA, the national investment promotion organization of Hungary, provides management consultancy services in the fields of location selection, supplier development, and mergers and acquisitions (M&As) in a one-stop-shop service model on a free of charge basis. Hungary also ensures the swiftest process to start a business in the region at within only seven days, according to the World Bank.

In light of the above, it is safe to say that Hungary is a favorable option for investment in the region, and there is also a strong commitment from the Hungarian government to attract and support FDI, be it in automotive manufacturing or innovation, service centers or startups.

How has Hungary been affected by the COVID-19 pandemic and how has it tackled the subsequent economic crisis?

The first wave of the COVID-19 hit Hungary in the middle of March 2020 and lasted until July, with the highest number of active cases standing at around 2000. The mortality rate, 13 percent, was greater than the EU average, which is a result of the lack of large-scale testing, but Hungary was among the best in the EU in terms of disease handling. The second wave started in August and is still ongoing, with a higher number of active cases as the virus spreads mostly among the younger.

Hungary responded to the first wave of the virus with the introduction of its State of Emergency and complete shutdown, as the danger posed by the virus was yet to be discovered. The shutdown included the closure of borders, shops and schools, the introduction of a curfew and the obligatory use of masks in public places. These short-term measures were effective, however the shutdown came at a cost, as gross domestic product (GDP) shrank by -13.7 percent in the second quarter of 2020, which was almost identical to the EU average in comparison to the first quarter.

Given the experience gained during the first wave, restrictions are milder in the second, as the government counts even more on the individual liability of the population. The State of Emergency was introduced again on 4 November; however, the main focus of the defense is put on wearing facemasks and social distancing. During the second wave, the government intends to balance between taking only the necessary steps to handle the disease while maintaining the functionality of the state, thus supporting growth and the creation of new jobs.

Hungary, an open economy, was greatly affected by the pandemic as the high degree of trade openness makes the country vulnerable to global demand shocks. Furthermore, the closure of businesses resulted in dismissals and a slowing economy. On the other hand, it caused a serious loss in tax revenues, thus increasing the governmental deficit. The economic policy became more focused on keeping a low unemployment rate, removing the existing administrative burden and giving specific tax reliefs to companies, especially in strategic sectors. In general, the measures taken are specifically targeted at the vulnerable or hardest-hit sectors. While the virus undermines confidence, one of the key factors in accelerating economic growth is to regain the trust of the population with responsible measures, as demand in the Hungarian services sector decreased.

Shortly after the emergence of the virus, the country reacted to the crisis with an anti-cyclical policy, with both expenditure and tax measures to accelerate economic recovery. The main goals of these were the stimulation of the economy and the preservation of workplaces. It is estimated that the measures taken since April saved more than 400,000 jobs—almost 10 percent of total employment. As a cornerstone of the economic recovery, on 4 April the government introduced the creation of two funds for a total of €5.5 billion or 4.3 percent of GDP: the Economic Recovery Fund at 2.9 percent of GDP to finance economic growth and loan programs, and the Epidemic Prevention Fund at 1.4 percent of GDP to cover the costs of prevention and to finance the necessary medical equipment and wage increase of health professionals.

As Hungarian economic policy in recent years was based on the encouragement of employment instead of giving unemployment benefits and aids, the expenditure measures were aimed at avoiding dismissals and preserving existing workplaces while providing financial support for the creation of new ones. All maternity leave benefits were prolonged and a wage subsidy scheme similar to Germany’s Kurzarbeit was introduced to encourage the continuance of employment. Companies could apply for a job-creating subsidy if they hired registered job seekers and the Hungarian Defence Forces also launched a six-months-long reservist program to mitigate temporary unemployment. Several retraining programs were launched especially in the IT sector to enable quick reintegration into the labor market. To further help disadvantaged groups, evictions and seizures as well as tax enforcement were suspended.

To facilitate growth in the private sector, measures taken to preserve the competitiveness of Hungarian companies were aimed at creating and retaining jobs. Preferential loans have been introduced and a state guarantee worth €1.4 billion was added. Furthermore, effectiveness- and competitiveness-increasing programs for small- and medium-sized enterprises (SMEs) were introduced by supporting high-tech and green developments if the company keeps 90 percent of its employees from April 2020. Companies also received state support for their job-preserving investments in competitiveness-enhancing programs.

Given the fact that some of the affected areas of the economy are strategic sectors, there were several measures aimed directly to help these. The tourism and catering industry, which accounts for almost 10 percent of GDP was one of the hardest hit by the virus. Consequently, €2.8 million was allocated to cover damages, and campaigns were launched to facilitate national tourism and domestic consumption. Besides this, to maintain the performance of the construction industry that accounts for up to 5 percent of GDP and to enable the sector to serve as an engine for the Hungarian economy in the following period, VAT on residential properties was reduced by 22 percent to 5 percent. Also, construction activity lasting less than 180 days will no longer be subject to business tax after temporary activity. To protect agriculture, another key sector of the Hungarian economy, subsidy programs were launched and preferential loans were made available for farmers.

Tax measures were primarily focused on removing administrative burdens and temporary tax cuts, thus helping sectors that were most affected by the pandemic, such as sports, transportation, tourism and catering, agriculture and entertainment. Tourism tax and tourism development contribution was abolished until the end of 2020 and social security contributions were permanently reduced by 2 percent. Several small businesses in the abovementioned sectors were exempted from paying the Fixed-Rate Tax of Low Tax-Bracket Enterprises from March until June, which affected more than 80,000 companies.

On the other hand, a temporary tax increase in the less affected sectors, such as banking and finance, was intended to outbalance the tax revenue losses. For the year 2020, the upper level of bank levy of credit institutions was increased and a special tax was introduced on retail companies with annual revenue of over €2.4 million.

Apart from tax and expenditure measures, many liquidity-supporting measures were taken. The annual percentage rate was fixed and a credit moratorium was prolonged automatically for certain social groups. The MNB introduced a program for SMEs that contains a preferential loan regime with the total funds of up to 1,500 billion Hungarian forints (€4.2 billion) with favorable and predictable interest rates capped at 2.5 percent to maintain jobs and production capacities, and to finance their investments. Rental fees were also frozen for the most affected sectors.

What is your outlook for the Hungarian economy for the rest of the year and next, and do you foresee new opportunities emerging as a result of the COVID-19 crisis?

The COVID-19 pandemic and the following economic downturn found Hungary in a much more stable financial and social state than it was when the last recession occurred in 2008. According to government officials, the second wave is expected to reach its peak around December, but the final solution to the pandemic situation is going to be the development of a vaccine. Until that, the most important task is to balance between measures to save human lives and the necessity of keeping economic growth, thus maintaining the ordinary operation of the state.

As the pandemic situation extends to 2021, one of the key issues is the restoration of trust. Health-related restrictions are primarily aimed at slowing down the spread of the virus, thus avoiding a complete shutdown and further reduction in demand. As countries turned inwards, several investments were made in Hungary to establish the production of goods that are crucial for security, thus becoming less reliant on importing those. Regaining the confidence and soothing fears of the population is crucial because the sooner life can get back to normal, the faster the emergence from the crisis can start.

Even though the length of the economic downturn is greatly influenced by the pace of development of the cure, it is expected that the Hungarian economy will reach its performance of 2019 in 2-3 years—a year later than the global economy—given that the world economy is favorable. Until that time, the competitiveness of the state shall be kept and the reshaping of the economy shall start. One of the key factors in future growth is the state of the German economy, as the Hungarian economy is greatly dependent on it since Germany is the largest trading partner of Hungary. Many German car manufacturing companies have placed their production over the past years in Hungary and the economy is sensitive to the cessation of this production, as the automotive industry accounts for almost 10 percent of GDP.

As countries turn inward, the role of domestic production becomes more important. Many businesses will require a new business model as the changes in the supply chain may remain permanent. Countries that are close to other states with high purchase power and have stable and predictable production will become more significant. The latter will be supported by the EU budgetary cycle from 2021, as Hungary intends to spend on the business development of Hungarian companies and creating more workplaces. This could result in even more focus on e-commerce and the optimization of several workflows. The economy will adapt to the new challenges and some sectors—like IT and health—are going to become more significant in upcoming years. These areas are greatly supported by the government with the introduction of tax cuts and training programs, as the health and IT sectors are showing an increasing demand for skilled workers. Given the experiences of recent years, it is expected that further help for families is going to be provided.

Hungary has the reputation of being a cheap or competitive labor market, and more than 800,000 jobs were created in the country over the past 10 years. What are some of the considerations to bear in mind for an investor coming to Hungary in terms of the available workforce and employment law?

We would like to express that, even today, one of the key attractions for foreign investors in Hungary is that the Hungarian labor force is highly educated and skilled with a particular emphasis on engineering, medicine and economics. Another key factor that draws investors’ interest to Hungary is that employment-related costs are relatively low. For this reason, Hungary can optimally integrate itself within the European production chain and be considered as an efficient production workshop.

However, Hungarian firms, especially Hungary-based multinational firms, have recently been focusing on robotization and the utilization of new workforce-saving machines and other technologies that have a negative impact on the employment rate in Hungary.

The Hungarian labor market has undergone significant improvement in recent years. In 2012, Hungarian employment law experienced radical changes, which resulted in a more employer-friendly framework that loosened the strict formalities of employment issues. Hungarian labor law is now broadly similar to employment laws applicable throughout the EU countries.

Last but not least, it should be noted that there is a minimum wage in Hungary that is 161,000 Hungarian forints per month, which is approximately €448, and the guaranteed minimum salary is 210,600 Hungarian forints, about €587, in 2020. According to the Hungarian Central Statistical Office’s latest statistics from July, the gross average monthly wage in Hungary is 372,600 Hungarian forints— €1,037.

What are some of the main trends you are seeing in Hungarian M&As and what can these teach us about Hungary’s business dynamism?

Hungarian M&A market deal sizes are on a different scale to deals in Western Europe or the U.S. The majority of cross-border deals fall within the €10-100 million range, with a few, major transactions above that. Still, the Hungarian M&A market showed significant growth both in number and value of deals between 2016 and 2018. 2019 has been, and 2020 is expected to be, a down year in this regard, the latter due to the global pandemic. In recent years, the Hungarian M&A market has been driven mainly by larger state-backed and several corporate transactions. Real estate, energy and communications continue to be the key sectors of M&As in Hungary.

By value, the largest merger and acquisition deals in Hungary in 2019 were: Telenor Real Estate Hungary, which was indirectly acquired by the state for €300 million; ÉMÁSZ North Electricity’s indirect acquisition by the state for €250 million; the sale of French real estate group Klépierre’s shopping mall portfolio to Indotek group for €220 million; Magyar Gaz Tranzit Zrt.’s acquisition by the FGSZ Földgázszállító Zrt. for €115 million; and Indotek group’s acquisition of the Sofitel Budapest Chain Bridge for €110 million

Another interesting trend in Hungary is the generational change of family businesses. 30 years after the regime change in Hungary, there are several thousand medium-sized companies with owners approaching retirement age and often there are no family members to continue their business. This trend is creating attractive opportunities to acquire functioning businesses and complete new investments typically in traditional industries such as metals, plastics or timber, construction, agriculture and machinery, but also in more innovative areas such as IT services, software development and telecommunications.

In line with all other indicators, real estate prices were on the rise in Hungary last year. According to Eurostat, prices rose by 4 percent between January and March, year-on-year, which represents the biggest increase in the EU. How would KCG Partners assess the Hungarian property market at the moment, and what trends, risks and opportunities exist in real estate, in your opinion?

The Hungarian construction industry was rapidly rising in recent years, but already showed signs of slowing down by the end of 2019. The growth of production from 2018 to 2019 was a whopping 30 percent, but the growth from 2019 to 2020 was only around 5 percent. Almost certainly, this year’s production growth would have fallen far short of last year’s level regardless of the pandemic. The arrival of the COVID-19 pandemic hit the construction sector in this stagnating state and, due to all the detrimental effects of the pandemic, the construction market was hit hard. According to analytics, 45 percent of the total project output is affected in some way by the pandemic—through delays, disruptions or supply shortages, for example—including 80 percent of residential buildings, hotels and other accommodation, commercial buildings, industrial buildings and storage facilities.

The real estate market is closely linked to the construction market; therefore, it has been rapidly declining as well, producing a staggering 67 percent decline by the end of spring. Since then, a slight increase in transactions has started. I’d like to provide an overview of the trends we are seeing in specific real estate sectors.

The commercial sector is currently at a stage where there is a great risk of supply and demand becoming disproportionate and the commercial real estate market becomes oversaturated.

As for hotels, with the social distancing rules, travel bans and decreased demand for traveling abroad or within the country—the booked hotel nights of Budapest hotels in July decreased by 84 percent when compared to last year—hotel projects came to a standstill and are likely to be far less in the focal point of investors until the end of the pandemic, when traveling has bounced back, and people are allowed to and want to go out into public areas. About 7,000 hotel rooms are planned to be handed over during the next three years, representing 12.4 percent of the total capacity in 2019. Of these, 4,000 rooms will be built in Budapest, the majority of the rest being in Lake Balaton and its surroundings. These developments have now all slowed down or were suspended. Experts expect that tourism will return to the 2019 level by 2023-2024. Nevertheless, it is likely that there will be large investors with more liquidity who can consider and trust tourism in the longer term, so they will have good opportunities to purchase assets.

When it comes to malls and shopping centers, with people staying home and spending more time at home, shopping habits and daily needs have clearly changed. For example, online traffic has doubled compared to last year’s numbers. The demand for visiting large shopping malls or outlet stores has been replaced by preferring smaller convenience stores located closer to the homes of people looking to spend as little time as possible in crowds. This caused the vacancy of shopping malls to double to around 4 percent in the country. However, they are expected to keep their function in the next year.

Even though working from home has become a new standard for many companies—40 percent of total employment in Budapest was transferred to work from home in May—the paradigm of needing office space hasn’t declined rapidly, especially for the IT and financial sectors that generate a high demand. Vacancy in modern offices increased to 8 percent in September 2020, mainly driven by declining demand and newly built office spaces. This year, a total of 200,000 square meters of new office space will be available on the market, and a 16 percent increase in supply is expected between 2021 and 2022.

The most resilient segment has been the industrial and logistics real estate market, which continues to have very low vacancy and a slowly responding new supply of available spaces. For this reason, the proportion of pre-leases is high even for new industrial properties that have not yet been handed over.

Due to the changed dynamics of the real estate sector, the Hungarian government decided to focus on the residential and housing sector. With the reclaiming of the 5-percent VAT on new homes from 2021, which is applicable to flats not exceeding 150 square meters and houses not exceeding 300 square meters, both the construction and the real estate market could receive a huge boost. As a result of the long-awaited measure, supply might finally expand substantially, with up to 3,000-4,000 additional new homes being built yearly, meaning about 12,000 new homes built in total on a yearly basis.

The government also introduced a program that is expected to solve the problem of neglected industrial zones located within city limits. The VAT for new homes built or refurbished in these areas will be reduced to 5 percent as well to speed up the urbanization process and to supply new homes for the high demand.

Further to lowering the VAT back to 5 percent and the support of rust zones, the government introduced other programs to aid housing projects. Couples willing to have children within a certain number of years can already receive non-repayable state aid to be used for purchasing both new and existing real property, they can have the VAT refunded and, also, they don’t have to pay any duties or fees when purchasing said property.

For house renovation projects, eligible families with children can receive up to 3 million Hungarian forints in aid if the renovation costs reach or exceed 6 million forints starting from 2021. This measure is said to increase the number of home remodeling projects by 50 percent.

The real estate market in Budapest is in definite need of refreshment as, over the last couple of years, real estate prices have tripled or quadrupled. This spectacular rise resulted in the market reaching price levels last year that substantially reduced demand, dramatically reducing transaction numbers. With all the above measures and the new supply of residential projects and houses, the trend of increasing prices might be alleviated with the result of 100,000-200,000 new homes being built in the next 5-10 years based on the announced regulations and the attitudes of market participants.

Even with the shifting of demand, there is a lot of potential in real estate in Hungary, with numerous opportunities especially in housing projects. The government is fully supporting families and the construction market to build new homes in large volumes over the upcoming years to normalize the overgrown prices that are present today. The demand for these homes is already visible and palpable, especially in Budapest.

Logistics and industrial real estate are always needed and this sector is still considered a proper investment, although with greater investments and a longer return period. As for offices, investments and projects in this sector might become profitable in an even longer time span, with the ever-present slight risk of people getting accustomed to or needing to work from home for a longer time period due to the pandemic situation and/or government orders.

As for the current pandemic situation, there are still unseen factors that could potentially change the demand and paradigm of the real estate and construction market situation. These include safety measures, travel bans, curfews or any government regulation having an indirect negative effect. As seen with the first wave of the pandemic, the biggest risk it contains for the real estate market is uncertainty and unpredictability.

Nevertheless, investor interest in the real estate market has not disappeared, but waiting and price seeking has become a characteristic behavior. The government announcements and initiated programs with the favorable VAT and aids will hopefully help many projects get the green light.