Putin and predictability

Russia’s recent aggression and the startling speed of its success have led observers to take a rather more cautious approach to their forecasts. And among those who have been taken by surprise by events are real estate market players and analysts. “It is hard to talk about the possible scenarios for the real estate market in Ukraine at the moment, when the entire country is in danger of descending into a military conflict. We are worried about the safety of our families and our future. In these circumstances business is not our greatest concern” – is how one representative of a Kyiv-based real estate consultancy summarised the situation just one day after Putin’s annexation of Crimea. Amid the general commotion, the noises that economists were making were not much different: “The prospect of Ukraine being divided, which has become more likely after the annexation of Crimea, also shows us that we are not only dealing with a high-risk market, but unfortunately one that can be torn apart by military conflict. And where there is war, you find little room for rational business calculations,” noted Andrzej Sadowski, the vice-president of Polish think-tank Centrum im. Adama Smitha.

Market in anabiosis?
As usual in a political crisis, the first to react were the financial markets. The hryvnia, which had been pegged to the dollar at 8:1, has since, to the dismay of the Ukrainian government, fallen sharply in the wake of recent events. In mid-January costly attempts at propping up the currency had to be abandoned. Now the hryvnia is floating at around ten to the dollar, which has obviously put tenants onto a state of alert, since rents have increased by a fifth due to the fact they are usually paid in dollars (or euros), whereas tenants generate revenue in the local currency. However, the devaluation of the hryvnia is likely to have more impact on the office sector than on retail, since shopping centre leasing is often dependent on turnover volumes, which depend on retail sales. “Retail leasing to date has remained relatively unscathed; however, there has been downward pressure on rents. A number of landlords have accommodated this through short-term rent adjustments,” explains Nick Cotton, the managing director of DTZ Ukraine. According to Colliers, in mid-March very few tenants were looking for new space, with 90 pct of all negotiations taking place being renegotiations. The local press has described the real estate market as being in a state of “anabiosis” (in biology, an energy-saving state). One of the major investors, Dragon-Ukrainian Properties & Development, has even officially announced that it no longer has plans to invest in new projects. However, the number of such declarations has yet to turn into a torrent – in particular, they are not being issued by developers with ongoing projects. The largest shopping centre project in Ukraine – Respublika in Kyiv (300,000 sqm gba, 450 stores – is opening in October and the first tenants are already moving in. A similar stance is being taken by many others. “We have not been affected on a large scale. Our project under construction is in Lviv, which is a region of the country that politically seems to be united in pursuing the goal of further European integration. Therefore our construction is still proceeding at a decent pace,” claims Gawein Minks, the managing director of Multi Development Ukraine, which has three retail projects across the country. The same attitude is evident at Immochan Ukraine, which is to open the Rose Park shopping centre in Makeevka in Donetsk oblast (eastern Ukraine, app. 100 km from the Russian border) this year and is commercialising another in Odessa, on which preparatory work started in January. Arricano, one of the leaders of the Ukrainian retail market (five malls completed with 162,000 sqm gla in total), is yet another example of the survival of positivity: “Arricano has not changed its strategy due to the situation in the country. Within two years we are planning to build two shopping centres in Kyiv: Prospect mall and another in Lukianovka,” the company told us.
The shopping centre pipeline is a particularly long one for Kyiv. JLL reports that if all the announced projects are developed according to plan there will be over 400,000 sqm of modern shopping space completed, which is three-and-a-half times more than last year. Currently around 20 shopping centres are under development in the Ukrainian capital alone. Of course, Kyiv still has a very low level of saturation for retail space, at app. 250 sqm per 1,000 inhabitants (compared, for example, to Madrid, with almost 800 sqm), but the energising of these developers might have not come at exactly the best moment.

Hopes for a better future
Although real estate represents a long term investment that can be spread out over market fluctuations, one can hardly make reliable predictions for investors under the present circumstances. Everything depends largely upon how effective Putin is in destabilising Ukraine, discrediting its present government among Ukrainians, and steering the country away from the necessary economic reforms and European integration. At present the momentum generated by the Maidan revolution still seems high. “The confidence in Ukraine has actually risen, as a number of investors are anticipating a reduction in both bureaucracy and corruption coupled with a move towards further integration with Europe. This will offer opportunities for direct investment by mid to late 2015,” says Nick Cotton of DTZ. According to Yarema Kovaliv, the acting CEO of Arricano Real Estate: “We expect that the situation in the country will stabilise and in two or three months Ukraine will receive external financing, which will have a positive impact on bank lending activity in the country. In turn, this will help Arricano to more effectively – and at more favourable terms – secure new credit for the company’s project development.” Indeed, the weak Ukrainian economy is now counting on foreign aid. Without such an injection of funds the Ukrainian financial sector could experience serious liquidity problems leading to the cancellation of new projects due to the lack of financing. Ukraine’s economic situation is far from ideal: the state budget has a huge hole in it, the economy is energy-intensive and therefore costly, and a huge grey economy exists of around 50 pct of GDP. The situation has been worsened by the excesses of Yanukovych’s regime, during which USD 37 bln went missing, according to the new prime minister Arseniy Yatsenyuk.

Much needed reforms
This is not merely a question of a nice opportunity to reform the country. For Ukraine, seizing it could actually be the difference between sinking or swimming. “In the present geopolitical situation and after all that has happened, democratic and economic reforms and further integration with European structures are the conditions for creating a business friendly environment for foreign investors. If that doesn’t happen the economic interaction with Western Europe could slow to a standstill,” warns Katarzyna Vannucci, an architect and associate in the Wrocław-based Arch-Group, which closed its Kyiv office in 2010 after three years of activity in Ukraine. The continuing financial crises, along with a number of contracts for which payments were never made and the general lack of financial security for doing business in the country, were chief among the reasons for their withdrawal. The same view is supported by another Polish firm, construction company Unibep, which has also scrapped its plans for Ukrainian expansion. “We have not found a way of operating in that country in a way that would be financially safe for us,” admits Jan Mikołuszko, the CEO of Unibep. But as he also adds: “When the new authorities have dealt with the omnipresent corruption, we will return to this market.”
However, the economic reforms needed will come at a price, further straining the patience of a Ukrainian society already disillusioned with the country’s inability to take advantage of the Orange revolution in 2004. “There will have to be years of serious economic pain and deep reforms before the country can really start looking forward,” forecasts Gawein Minks, the managing director of Multi Development Ukraine. Combined with the macroeconomic problems, the necessity of introducing harsh economic reforms is likely to bring about a slowdown of the Ukrainian commercial real estate market regardless of the future course of the political crisis.

Russia to also pay a price
A slowdown is also expected in Russia, where economic problems had already started to become evident from around the outset of the Ukrainian crisis. “It is clear that the events in Ukraine will create a significant headwind for Russia’s investment market in 2014,” explains Tom Mundy, JLL’s head of research in Russia and the CIS. The resilience of the Russian market has hardly been tested since the collapse of Lehman Brothers in 2008, but now the ruble is trading at a five year low against the dollar. In the first quarter of this year the central bank was forced to stump up around USD 30 bln to prop up the national currency. Although the oil-fuelled Russian economy, with its app. USD 500 bln in foreign currency reserves, so far seems set up to be able to afford this fight, the final effect of the proposed economic sanctions remains unknown.
The first factor is that the Russian economy is heavily in debt. In recent years the country’s foreign debt has been increasing by app. USD 100 bln per annum and now amounts to app. USD 750 bln. Creditors include European (particularly German), American, Chinese and Japanese banks. Secondly, the Russian economy is weak because of its structure. It is largely dependent on its energy and mineral production, with oil and gas amounting to 70 pct of exports. This, together with the increasing production of shale gas in the United States, poses a significant threat to the Russian economy, especially if Europe were to seriously start importing gas from the USA. Thirdly, the outcome of the economic war will largely depend on the scale of the flight of foreign investors. International think tank Capital Economics predicts that if the trend continues at the present rate for half a year or more, it will plunge the country’s economy into recession by the end of the year. “As far as the real estate market is specifically concerned, the main transmission points will be: the ruble, which will put pressure on importers’ costs and impact retail margins; inflation, which will erode the spending power of the Russian consumer and dampen retail sales; and a slowdown in GDP, which will undermine the Russian investment case relative to other emerging markets,” states Tom Mundy of JLL.
Tenants and investors are already displaying more hesitancy in their decision making as they wait for things to become more certain in terms of future economic trends. Landlords, on the other hand, are tending to be more flexible; while investors are becoming more conservative, asking for higher yields and lower asset prices.
“As a result, in H1 2014 at least we expect to see lower than forecasted leasing and investment activity. It is still possible that we might see a decline in take-up just within the 10 pct range compared to H1 2012. In the mid-term the adverse situation could depress economic activity and lead to an imbalance between supply and demand. As a result, in early 2015 we might see growing vacancy levels and a stronger downward pressure on rental rates, followed by a reduction in new project announcements. In the worst case scenario, transaction activity might shrink by 15–20 pct,” suggests Valentin Gavrilov, CBRE’s director of research in Russia.

Many possible CEE scenarios
Although the impact of the Ukrainian crisis is likely to be felt beyond Ukraine and Russia, sudden changes in other CEE countries have so far yet to be registered. Does this mean we are insulated from these events? “To some extent, yes. Even the potential weakening of the economic ties between Russia and its neighbours should not hit the real estate market much, since it is not largely dependent on exports,” believes Joanna Mroczek, CBRE’s head of research and consultancy in Poland. If the problems intensify, however, the weakening of exports could substantially impact the economy. According to PKO BP’s analysts, a recession in Ukraine, resulting in a 40–50 pct slump in foreign trade, would decrease the annual growth of Polish GDP by 0.5 percentage points.
Broken economic ties is more of a concern for Russia’s and Ukraine’s immediate neighbours, including Romania, Bulgaria, Hungary and the Baltic states. “The economic outcome would depend largely on the ability of those countries to find new markets for their products. I believe that many producers in Poland were preparing for such a situation long before the conflict erupted. Polish exporters proved to be flexible after 2008, when European markets shrunk, leading them to look for buyers in South America, Asia and even Africa,” points out Andrzej Sadowski.
Poland is perceived as a stable market that has successfully completed its economic and political transformation. In the light of recent events in Ukraine and North Africa, its regard could even be enhanced in the eyes of investors disappointed with countries with lower labour costs but less political and economic stability. On the other hand, however, the deepening of the political crisis in Ukraine could negatively affect the perception of the whole region, discouraging companies from investing in neighbouring countries and hitting the exchange rates of national currencies. “Usually economic instability serves as a trigger for the ‘bottom fisher’ companies who are looking to acquire real estate assets at below market prices. However, the Ukrainian crisis has not yet offered them any clear-cut opportunities. Institutional investors in Russia are currently waiting for the political situation to stabilise before proceeding any further with new investment activities. It is important to get a sense of whether the Ukrainian political crisis will have a short- or long-term economic impact. This may shape the Russian real estate market for the rest of the year,” says Stanislav Bibik, an executive director and head of the capital markets department at Colliers International Russia.
For investors the main problem remains the very wide spectrum of possibilities that they now have to factor into running their businesses. These range on the one hand from Ukraine joining European structures and setting the country on a course towards prosperity to, at the other extreme, Putin’s imperialistic reconquista including not just the territory of Ukraine but that of other countries in the region. It also cannot be completely ruled out that new opportunities will open up for the “buy when there is blood in the streets” type of investor, who sees military conflict as a chance to do some business. It is hard to assess how capable the Russian leader actually is of destabilising Ukraine without physically invading the country yet bloodlessly forcing it to swerve from the road of economic reform. In terms of real estate, as a general rule the more intense the conflict, the more probable it is that consolidation will take place, since the stronger developers, who can accept greater risks, are likely to take advantage of discounted offers. It is more likely that this will come to pass in Ukraine rather than elsewhere, but the situation remains as unpredictable as Putin himself.