Russia Rising

A growing economy and international investor interest point to a strong future.

By Georgii Ivanov, CCIM

Russia’s commercial real estate market is in an exciting phase of development, reflecting the Russian economy’s dynamic growth. One of the highlights is Moscow’s office sector, which has surpassed London in total annual lease-up for the first time this year and now is second in Europe only to Paris, reflecting massive pre-construction leasing. Local and international retail chains continue to expand deeper into untapped regional markets. The warehouse market slowly is evolving although quality space continues to be scarce. Investment markets across the board are growing quickly helped by the emergence of an investment-grade property sector.

However, some hazards are associated with this market. Political risks remain high in Russia and there is a shortage of investment-grade buildings. The quality of asset and property management needs to meet international standards, title issues often are not watertight during the development phase, and the lease quality needs to be improved.

In a vast and heterogeneous country such as Russia where a property is located is significant. Huge income disparities exist between the Russian regions depending on whether the region is rapidly expanding or stagnant. In Moscow, for example, average net domestic product per person is 150 percent above the national average, while Kazan in northeast Russia is home to 5 million people, but has an NDP of 41 percent of the Russian mean, according to Jones Lang LaSalle. Major regional differences also exist in terms of economic momentum. The following outlines the status of each property sector in Russia’s expanding economy and real estate market.

Office Speculation
Russian companies’ preference to own and developers’ reluctance to sell are defining factors of the Russian office market, according to Cushman & Wakefield’s Stiles Riabokobylko. The demand for office space is driven mainly by growth in the following industries: banking, science and research, telecommunications, commodity markets, and entertainment.

Currently, capitalization rates of fully tenanted class A standard office space in Moscow and St. Petersburg is 11 percent to 13 percent (before taxes and depreciation), although this is subject to variables such as location, quality, and tenancy. Capitalization rates on prime office space are expected to compress over the next three to four years, due principally to an expected supply increase.

In most cases, quality office buildings in cities are built by large private companies (particularly banks and oil companies) for their own use, and only rarely do they come on the open market. Most speculative business centers are erected in the cities by local construction companies at the expense of future owners. Moscow developers only now are starting to enter the regional markets with their projects.

Class A office centers are present in some cities with populations of more than 1 million including: Chelyabinsk, Ekaterinburg, and Novosibirsk. The first business centers of class A standard began development in Samara and Rostov-on-Don in 2006.

At the end of 1Q06, St. Petersburg was leading regional cities with a population of more than 1 million by quality office stock per 1,000 inhabitants, according to Jones Lang LaSalle. This indicator was about 82 square meters per 1,000 inhabitants (5.5 times less than in Moscow).

Industrial Demand
Despite continued unfulfilled demand, the modern-quality warehouse market remains hugely underdeveloped due to a combination of factors, the chief one being the complicated and bureaucratized land acquisition and rezoning process. Existing stock is insufficient and vacancies are virtually nonexistent. The market continues to be characterized by high rents when compared to developed European markets.

Warehouse space is mostly made up of old industrial premises, class B properties, trading depots, and hangars. Large logistics operators are almost completely absent from regional markets. The range of quality logistics and speculative warehouses in cities with a population of about 1 million is actively developing, for instance in Novosibirsk. New warehouses are being constructed or planned on new land plots at city exits, which are close to federal highways.

Existing supply of warehouse stocks cannot satisfy current and near-future demand. Class B warehouses will dominate the supply structure for years to come. Average rental rates for class A warehouses range between $140 and $120 per square meter and $130 to $100 per square meter for class B, according to JLL. With the emergence of large scale projects in the market in 2005 and 2006, landlords aiming to secure big tenants have started proposing new pricing structures in relation to the space rented and lease terms.

Retail Matures
The retail sector is the most developed of Russia’s commercial real estate. Steadily growing personal incomes in Moscow and the regions contribute to retail being the most dynamic and quickly evolving sector of the country’s economy. The modern, international-standard shopping centers appearing in Moscow are evidence of this trend, as is increasing development in other large regional cities. Most retail development continues to be done by local companies, but Sweden-based IKEA is one of the few examples of an international company developing retail in Russia. The majority of international retail brands are represented through franchisees.

Most foreign investors still are investigating the market and looking for properties with minimum risks and maximum yields. Yields here for prime shopping centers are 10 percent to 12 percent, and for high-street retail sites are 12.5 percent to 15 percent, reports Cushman & Wakefield.

Both Russian and international retailers continue to look toward the regions as attractive expansion opportunities. Two years ago developers’ ambitions lay in cities with populations of more than 1 million; they now are actively building across the country. Retail development is stimulated by increased purchasing power in Russia’s regions and a still tiny –- or nonexistent –- modern shopping center stock even in some of the country’s largest cities. Regional centers such as Kazan, Yekaterinburg, Samara, Nizhny Novgorod, Perm, Voronezh, Chelyabinsk, and Novosibirsk are seeing very active development. Important regional projects include IKEA’s 90,000 square-meter Mega Mall in Kazan, which opened in late 2005. It was the company’s first Russian project outside Moscow and St. Petersburg.

Samara-based Vremya Group, which is developing the Park House shopping center brand in the regions, actively is developing their own chains of shopping centers across the country. IKEA opened its shopping center in Kazan, and it continues planning expansion to all other 1 million plus Russian cities in the next few years, making it the most significant player in the regional retail market.

Another indication of increased attraction to Russian regions is the planned opening of the first Russian location of the British DIY chain Castorama in Samara.

Sources of Capital
The publicly traded vehicles still are at nascent stages. They represent less than 0.5 percent of the Russian real estate capital universe, according to the Russian Federal State Statistics Service. Similarly, the institutional property investment market in Russia also is in an early phase: Less than 5 percent of eligible stock is invested. What is more, the implied owner-occupation ratio, or the share of the invested stock in the total stock, is less than 2 percent, suggesting that more than 98 percent of all Russian commercial property still is owner-occupied. In comparison, in South Korea the implicit owner-occupation ratio stands at 80 percent, according to EIU. A lower owner-occupation ratio frequently is used to justify a real estate engagement in a specific market. In China the respective ratio is 80 percent and in Japan it is 60 percent.

Private debt is the most important source of financing real estate in Russia. It accounts for more than 60 percent of all institutional real estate investments. Strong demand for commercial real estate lending in the last year was boosted by falling interest rates, and a vibrant real estate investment market. In the past four years, bank loans for commercial real estate have increased by more than 500 percent to U.S. $1 billion, according to the Russian Federal State Statistics Service. This number is poised to grow further in the next few years, despite the government’s desire to slow credit growth. Also because real estate loans still play only a minor role on the banks’ balance sheets, commercial real estate financing via bank loans is very likely to continue its growth trend.

Private investors also play an important role in the Russian investment market. At the end of 2005, the total Russian private equity volume was roughly U.S. $1.6 billion, accounting for 40 percent of the Russian real estate capital market, according to IMS Group. In 2005, private property companies and individuals’ holdings of real estate grew by 40 percent year over year.

The Russian pension fund system is poorly developed. Its investment strategy can be characterized by a high degree of risk-aversion. Regulation mandates that at least 90 percent of asset allocation is in government securities or other approved securities. Its exposure to real estate sector is zero. Changes in the pension funds’ asset allocation strategy largely will be driven by congruent changes in regulation. In its absence, pension funds likely will keep their large positions in government bonds and other approved securities.

This holds true for insurance companies as well, given that Russian insurance authorities still regard real estate investment as risky. Regulation for insurance companies’ investment strategies remains restrictive. This will hardly change in the near future unless the regulatory bodies ease regulations.

Neither real estate investment trusts nor real estate mutual funds exist in Russia, implying that the real estate public markets are limited. The only way to invest in real estate in the public market is through listed property companies, but currently there are only a handful of these.

Future Prospects
Although the Russian real estate capital market is small, its momentum is remarkable, especially in the private equity and debt markets. In 2005 nearly $500 million of additional capital was invested into Russian real estate, according to IMS Group. Strong growth in private equity was driven by unlisted property funds and companies, which added around $100 million to the market, as well as by private individuals. However, even more significant growth came from private debt with commercial banks lending $400 million in 2005. Owing to a lack of alternatives, commercial bank lending seems to be the most efficient way of raising capital in Russia. But both the private equity and private debt markets also are set to grow significantly over the coming years, profiting from further project developments and more foreign direct investment. In contrast, the public markets are set to remain relatively small over the next few years. These segments likely will remain relatively small until the private markets increase in scale and, more importantly, the broader capital markets undergo significant deepening and development.

Russia has enormous potential in each property sector. Strong population growth, a large pool of qualified workers, greater integration with the world economy, and increasing domestic and foreign investment are fueling demand for office, retail, and residential property. Although not discussed in depth in this paper, this demand also can be applied to the hospitality sector.

Going forward, it will be a matter of exploiting this potential. For the real estate industry, three aspects are most important. First, further opening to foreign investment is desirable. Not only do international investors have the means to finance new construction projects, they also possess the expertise in market analysis, facility management, and building construction. In the short term, these will act as catalysts to bringing greater transparency to the market. Secondly, Russia needs a stronger capital market base for property financing. The debate on the potential introduction of REITs and real estate funds points in the right direction. The introduction of REITs will give international investors in particular a familiar investment vehicle. Private investors also could enter into indirect investment in real estate. Although interest in new products is most likely to come primarily from institutional investors, the rising middle class is likely to seek new instruments aside from direct property investments in the short term.

Contact Georgii Ivanov, CCIM, at (631) 692-4164 or Georgii_Ivanov@hotmail.com.

Russian Demographics
Home to roughly 175 million people, Russia is one of the most populous countries in the world. Russia’s economic transformation over the past decade has pushed up real gross domestic product growth to an average of 5 percent per year since 1999, according to the Interactive Research Group. Russia is emerging as an important business location, particularly in the energy, commodities, and science/research sectors.

Macroeconomic Environment
Russia currently is experiencing macroeconomic stability. Russia rose from eleventh to sixth on A.T. Kearney’s 2005 Foreign Direct Investment Confidence Index. Corporate investors see macroeconomic and political risks as less threatening than in previous years and also perceive greater opportunities in Russia. This naturally influences the Russian real estate investment market. Among the main investors already in the market are Fleming Family & Partners, Eastern Properties Holding Limited, Meinl Austria, GE Asset Management, the Raven Group, Quinn Properties LLC, and Hines Interests LP.

The ruble/USD exchange rate is 26 R/$ and has been hovering in the 25 R/$ to 27 R/$ range for the last month. The currency is backed by the fundamentally most asset-rich country in the world. Natural gas is much more important to the Russian economy than oil, since gas often is overlooked. Gas also has a large potential for price increase, double that of oil.

The credit and mortgage boom of the past couple of years is continuing to accelerate. Russia’s middle class has strong saving behavior, according to the Russian Federal State Statistics Service, and presently about $500 million of new money is deposited every month, and $150 million is lent out. But the savings rate probably will increase as recently adopted tax changes may raise employment rates and salaries. Credit should increase, as well. The long-term forecast is that Russia will become the eighth largest economy in the world by 2008, according to EIU.