In-depth: Alpha and Omega

Namely today the market sees the arrival of major Western real estate investment funds and pension funds who consider returns and risks of investing in Russian commercial properties as quite acceptable. Certain property investors are even ready to assume development risks and buy into developments, completed by 60 to 80%. The majority of deals are structured as acquisition of a portfolio of property assets (18 acquisitions or 66.7%). 33.3% of deals involved acquisition of companies that held titles to commercial properties. For the time being buyers express interest in properties in Moscow and St Petersburg, but some operators have already announced plans to tap into the markets of cities with population over 1 million.

Last year our experts predicted that by 2007 commercial real estate market in Russia would reach the point of saturation and returns on capital investment in retail properties, offices and warehouses would not differ from the EU average of 5 to 6% per year. But those predictions were not to materialize and returns on commercial real estate still soar. Warehouses and retail properties are especially attractive for investors.

As individual income grows retail is booming. International and domestic manufacturers, as well as importers are stepping up deliveries, generating a shortage of quality storage properties. Russia’s stock of high-grade warehouse space matching international standards measured 2 million square meters, which is less than 20% of the overall supply. At this, the majority of those properties are owned or rented by logistics operators. In this context, acquisitions or long-term tenancies are becoming increasingly popular in the segment of class A properties. This is connected with the poor quality of properties available for rent in Russia and with arrival of more major logistics and retail operators.

Who Is Who

The number of acquisitions of properties by institutional investors, especially pension funds is growing as investments become less risky.

Today, there are several major international investment funds active in Russia. The leaders are British funds Fleming Family & Partners, The Raven Group and London & Regional Properties, Austrian Immoeast and Eastern Property Holdings. Britons, with an exception of London & Regional Properties, focus chiefly on warehouses, while Austrians are keen on shopping centers and offices. London & Regional Properties, led by David Geovanis, former managing director at Bazovy Element (Basic Element), is practically omnivorous, participating in all segments of the market and pursing housing construction projects.

Russia has also seen the arrival of major western developers, in particular Meinl Austria, whose Meinl European Land raises and takes over shopping malls in this country.

Thus, the structure of operations in commercial real estate market in Russia is growing similar to that of Europe. Developers build and promote their properties and then sell them to institutional investors and proceed to new construction. In developed markets the majority of end-users rent properties as real estate is not their core business, and tenancies free them from the need to withdraw capital from their core operations.

But in Russia many companies seek ownership in their properties, due to a number of reasons. The shortage of suitable units for rent forces companies to order built-to-suit offices and shops. The rapid increase in capitalization of such projects justifies such investments but as the market grows the situation is changing and many landlords are likely to sell their units and with a view to retain leaseholds (under lease-back schemes).

Land of Fools

We have also registered a number of alarming trends on the market today. A general euphoria over soaring returns on retail properties is hardly justified. While in previous years investors underestimated regional markets, today their prospects are clearly overestimated. The province is flooded with easy money of non-professionals. Those are oil revenues whose owners think that development is something similar to a fairy-tale tree with golden coins instead of leaves that grows in the Land of Fools. As a result, mall projects in the province are poorly thought-out.

Sometimes it happens so that when designing their projects non-real estate companies are not even aware of rival projects under construction or operating around the corner. As a result, what we see are clusters of shopping centers measuring 200,000sqm each on. Those are projects that are doomed from the start. Professionals are not happy either as owners of failed malls will fight for profits using all means available. This serves as an additional factor that has a negative impact on returns and appeal of commercial real estate market.

It is possible to predict that in some 3 to 5 years certain segments of the Russian market will reach the stage of stagnation. Only one-of-a-kind projects in superb locations and major companies will survive the crisis. As soon as in the next 2 to 3 years we expect minimal rates of return to drop from 9-10% to 7-9%. The lowest returns are to be seen in office market, being the most developed, the highest are returns on warehouse projects.

Ambitious Plans

Forecasts and future M&A plans are upbeat. Last year international finance companies announced plans to spend $5 billion on commercial real estate in Russia. The projected volume of transactions in 2007-2008 is expected to reach $4 to 4.5 billion, including $2 to 2.5 billion in 2007.

Over the next two years the stock of new properties is likely to grow 20 to 25% whereupon the balance between demand and supply will be achieved. Thus, Russia’s commercial real estate sector is on the rise and will retain leadership in M&A over the next 2 to 3 years. But the glut that is likely to happen in 3 to 5 years will result in stagnation.