Endurance in the East

In the wake of the shooting down of the Malaysia Airlines Flight MH17 over Ukraine, allegedly by pro-Russian rebels,the world has seen another escalation of what has now turned into a global political crisis. One of the main results of the July incident has been the formation of united front by the West in imposing the stiffest anti-Russian sanctions in the post-Cold War era. These include denying Russian state-owned banks access to western capital markets, an embargo on Russia’s arms trade and some limitations on the export of equipment and technology to Russia used in fossil fuel extraction. In response, in the first week of August Putin imposed a one-year embargo on agricultural and food product imports from Australia, Canada, the EU, the US and Norway. The list of banned products includes fruit, vegetables, meat, fish and dairy products.

Deterioration of business

The sanctions war has posed further challenges to a Russian economy that has already slowed considerably after the annexation of the Crimea earlier this year. As a result the GDP growth outlook for 2014 has now been downgraded several times to a mere 0.5 pct by the World Bank. On the real estate market the political turmoil has translated into a drop in investment volumes and weaker tenant activity across all sectors. In the first half of the year the real estate transaction volume was only one third of what it was in the same period a year earlier (USD 1.2 bln compared to USD 3.4 bln in H1 2013). According to JLL’s forecasts the entire year will close at USD 3.4 bln – the lowest level since 2009 when investment volumes slumped to USD 3.2 bln due to the global economic crisis and a very modest figure after the USD 8.2 bln transacted last year, the USD 8.8 bln a year previously and the USD 8.5 bln in 2011. The downturn is also reflected in the lower share of foreign capital in the investment figures. Since the same period last year this has slumped from 59 pct to 18 pct. There is no question that the economic sanctions are adding to the business risks, such as higher costs. As a result foreign investors are taking the safe option of focusing on Moscow, while being increasingly reluctant to venture into the regions. In H1 investment in the capital city rose to 85 pct of the national volume, with only 15 pct taking place outside Moscow. “Investors are looking for targets with a strong pool of international tenants or reputable Russian firms, long lease agreements denominated in foreign currency, and excellent locations in areas of high business activity. These kinds of target have the best resilience against downward pressure on their value during any economic crisis,” says Vladimir Pinaev, CBRE’s general director in Russia. Another visible sign is the reduced activity of tenants, especially the foreign variety. “We have already witnessed a reduction in demand from international companies – in the office segment their share in transaction volumes have decreased to 10–15 pct compared to 25–30 pct in normal circumstances. In Q2 we also observed a substantial slowdown in overall transaction activity,” comments Vladimir Pinaev. In Q2 take-up on the Moscow office market was the lowest in 13 years, amounting to 84,000 sqm of leased space, while the vacancy rate on the Russian retail market for the first time in four years exceeded 3 pct (in Q2 last year it was only 0.5 pct). In H1 take-up volumes for warehouse space came to 292,000 sqm in total, which represented a 47 pct y-o-y drop. Even the Moscow hotel market saw a 4 pct decrease in occupancy rates (down to 59 pct) and a 1 pct fall in the ADR (now at the level of RUB 6,000) – an effect largely attributed to the Ukrainian situation. The downward trend in the activity of tenants and hotel occupiers has been accompanied by record breaking levels of new supply due to a peak in the development cycle – and one that is apparently out of phase with the macro trend. On the office market over the first six months of the year, 27 new class ‘A’ and ‘B’ business centres with a total of 532,000 sqm were delivered – the highest level since 2010. At the same time the Moscow warehouse market expanded by 700,000 sqm – the best result for this period over the past five years. An impressive Moscow hotel pipeline of between 10,000 and 15,000 new rooms is anticipated in the next five years (currently there are almost 40,000 rooms in the city). In addition to this there is the stunning shopping centre pipeline of 5 mln sqm – considerably more than that of all the other European countries combined. The obvious question is how the enormous scale of the new projects can be sustained in the face of the deepening deterioration of the Russian economy.

The impact of sanctions

Russia’s ban on food imports from countries imposing sanctions on Moscow has immediately added to worries about an eventual rise in inflation in the country. Russia is one of the five largest global food importers and will certainly have to look for other markets. In the meantime it will find it hard to satisfy the demand. Against this background some analysts have revised upwards their inflation predictions for 2014. Alfa Bank has worsened its forecast for Russia from 7 to 8 pct, but Russia’s Economic Development Ministry has decided not to review its prognosis, which remains at 6 pct. “Higher single-digit inflation on its own is not a big issue for the real estate market. It will have the direct effect of higher indexation rates for leasing agreements denominated in Russian rubles. This kind of agreement is typical for lower quality commercial space, whereas in the majority of class ‘A’ and ‘B’ facilities rents are denominated in US dollars,” explains Vladimir Pinaev. The downside of the expected inflation, however, is that it will also result in a reduction of the purchasing power of the Russian population. The effect could be exacerbated by the gravest of the sanctions imposed on Russia so far, namely the limitation of access to the US and EU debt markets for state banks as well as the effective closure of the EU as an IPO and SPO destination for Russian companies. This is expected to put greater pressure on the domestic debt market, making refinancing costlier and harder to source. It is also likely to have an impact on the cost of consumer credit, which can easily affect sales. Over the longer term it could have major implications for rents and vacancy rates. “Developers will have to factor in this new tougher demand environment when calculating their future cash flows. In this environment, it is clear that only the most commercially viable projects will be able to afford the increased cost of risk, and those projects with debt already in place will trade at a premium,” predicts Tom Mundy, JLL’s head of research in Russia & the CIS. When the Crimean crisis hit the headlines the immediate result was a depreciation of the ruble. “Over this period many tenants pushed to renegotiate their lease terms, seeking either a fixed currency corridor or switching to ruble denominated contracts. This trend subsided through the second quarter as the ruble stabilised; however, we wouldn’t be surprised to see this type of activity pick up again in the second half of the year,” comments Tom Mundy. Further depreciation of the ruble could be prevented, though, through the intervention of the Bank of Russia, which is well supported by the state thanks to the substantial Russian oil export revenues. “With the current high oil prices – now exceeding USD 100 per barrel – and healthy international reserves, the Bank of Russia is in position to manage the ruble exchange rate quite effectively,” explains Vladimir Pinaev.

What next?

So all in all how bad is it going to be H2? According to the international consultancies operating in Russia, the negative trends seen in H1 will intensify across all sectors. Vacancy for warehouses and in the retail sector is expected to rise from 4 to 6–7 pct and from 3 to 6 pct respectively. In the office leasing segment transaction volumes could be 15–30 pct below the usual figure. However, the effect should be mitigated by tenants taking advantage of relocation opportunities, as landlords become more flexible in commercial terms. This process is likely to be reflected in the higher leasing transaction volumes in Q4. For the hotel market 2014 is expected to be a very difficult year. Most market analysts, however, are taking an optimistic view, looking forward to the market bouncing back as soon as the conflict in Ukraine ends. “Russia is fortunate to benefit from what is a huge retail market in terms of turnover, which is still expected to grow by 1.9 pct this year. Consumer spending has been resilient despite the economic slowdown and the market is exhibiting a significant under-penetration of stock relative to European levels,” explains Tom Mundy. This is why investors still seem to be in the game for new opportunities. It is only the gap in sellers’ and buyers’ expectations given the current sentiment that is keeping the transaction volumes low. As Tom Mundy summarises the situation: “Despite this healthy backdrop, as long as the sanctions are in place, developers will have to adapt to a new environment of weaker growth, lower investment and a weakening of consumer demand.” ν