Eastern Eden

Last year Russia and Poland accounted for 74 pct of the investment deals in the CEE region. As the economy continues to recover, is Russia's share of the market going to increase further this year? If so, this will mainly be due to investors who are nowhere to be seen in most of the countries of the region

Mladen Petrov

The numbers might not be that impressive given the size of the market, but they are still a positive sign. At the beginning of the year, Barwa, the largest listed real estate company in Qatar in terms of real estate developments with a total asset capitalisation of over EUR 7 bln, and Gazprombank, Russia's largest non-state owned bank and part of the Gazprom group, the world's largest gas exporter, announced the first closing of the sharia-compliant Barwa Gazprombank Russia Real Estate Fund. This is the first such partnership between the two companies run according to Islamic principles, and into which each are to contribute USD 75 mln in equity. An additional USD 2 mln is being provided by The First Investor, a subsidiary of Barwa Bank.

An old acquaintance
Investors from the Middle East, along with a number from the Far East, have been a key component of the real estate recovery in Europe throughout 2010. During the crisis such investors were predominantly looking for trophy assets in the safe havens of London, Paris and a few German cities, with smaller transactions also taking place outside the core Western European markets. However, as the January announcement of Barwa and Gazprombank demonstrates, the Russian market is also on the table, as investors from the Middle East and Asia increase their activities in the country. Will more be following in their footsteps? Konstantin Lysenko, the director of capital markets for CB Richard Ellis Russia, believes this to be the case: "A couple of other Asian and Middle Eastern investment funds are actively searching for opportunities on the Russian market. One such player, the Singaporean sovereign wealth fund GIC, has been successfully active on the Russian market for some time," explains Mr Lysenko.
The Russian real estate investment market remains, along with the Czech market, dominated by local investors. The majority of CEE markets, except for these two countries, reported cross-border activity levels of over 80 pct. Last year saw a small increase in cross-border investment, but nevertheless 2010 marked an important shift in the geographical composition of international capital. According to a recent study by CB Richard Ellis, in H2 2010 non-European investors accounted for almost half of all cross-border investment.

In or out?
European institutional investors also admit to eyeing up Russia, but remain extremely cautious. Despite the increasing interest in the country and the improving economy, the time has not yet come for conservative investors to step up to the ante. In the midst of the crisis major funds were actually leaving the country. "KanAm Grund, with its open-ended KanAm grundinvest Fonds, invested in Moscow years ago. For several reasons - the credit crunch, reform of German investment law - we disinvested in 2009 and have since been focusing on Western European markets," recalls Michael Birnbaum, the press officer of KanAm Grund. The fund has already disposed of an office building and an office project in Moscow. Is the firm planning to make a comeback any time soon? "Not in the short term," says Mr Birnbaum.
And what about other Western European investors? As one representative of a big international bank operating in Russia told us: "There is a lot of cheap money available from local banks, particularly state-owned ones, but so far there are no long queues of foreign investors waiting for the banks to open. We are coming up to an election period and a large part of the Russian elite is already focused on what changes this might bring. The run-up to elections always creates a lot of uncertainty and that is something which traditionally worries investors." A number of foreign investors we spoke to expressed their concerns about the risks connected with buying properties in Russia, citing also rents - which have only now, due to the crisis, fallen to more sustainable levels - and, as usual, the unpredictable political environment in the country. "You never know, so you need to hedge appropriately," one investor told us.
Nevertheless, Invesco Real Estate, another important institutional player, admits that it is looking for opportunities in the country, but has a list of requirements. The firm, following the ongoing recovery of the real estate market, has  EUR 1.5-1.7 bln to spend in Europe this year. As Tomas Picha, Invesco's director of transactions for the CEE region reveals, the time has come for some direct acquisitions, but under certain conditions. "Up until now we have never invested in  Russia directly, but we are happy to look at the best two or three properties available on the market, something that would justify the risk undertaken," Mr Picha says. The fund was close to buying its first property in 2007/2008, but it eventually reconsidered. "It should be noted that we are not comfortable working with local developers. We are in the process of analysing a couple of buildings in Moscow, which have all been developed by international firms. When it comes to pricing, we feel that 9-9.5 pct sounds like what the actual yield is." This year Invesco will still be primarily focusing on Poland, the Czech Republic and Slovakia, with certain properties in Hungary also being on the company's radar. "We are looking at larger-sized properties there, but we don't have a specific target to achieve. Russia for us is just an opportunity to diversify our portfolio. At this point we are certainly not going to build a whole portfolio in the country," reveals Tomas Picha.

Local power
And then there are also the investors who have decided to go ahead and buy anyway. Last year properties worth EUR 2.169 bln were transacted in Russia. Eight out of ten of the largest investment deals took place in Moscow, with local buyers accounting for eight of these transactions. Lenmar Capital acquired developer Horus Capital, including five of its assets in Moscow, totalling 168,800 sqm of office space, for EUR 690 mln - the largest investment deal in the CEE region last year.
Overall, in 2010 deals worth around EUR 5 bln were signed in the CEE region, with Russia and Poland accounting for as much as 74 pct of these transactions, according to CB Richard Ellis' data. Across the region - and Russia is no exception - the majority of activity has been focused on the office sector, which recorded a five year record-high in terms of its share of the overall investment activity, up to 46 pct last year.
The interest in office properties in Moscow looks to be well-grounded. Jones Lang LaSalle observes in a recent report that the current trend is for investors and lenders worldwide to return to riskier assets such as financing and liquidity returns, as well as more stable macroeconomic and property fundamentals, putting Moscow firmly on the global office hotspots map. The growth of prime assets in the top tier of office markets has typically been between 20 pct and 50 pct over the past year, and well over 30 pct in markets such as Hong Kong, London, Paris and Moscow. Value growth is expected to continue in most markets in 2011, pushed by rental uplift as yield compression slows in the major markets. The Russian capital is no exception, where there is currently strong upwards pressure on rents, particularly in the capital's CBD. Moscow, along with London, Paris and Stockholm, is registering the strongest rental growth in Europe. In Q4 2010 prime rents in Moscow reached EUR 634 per sqm a year, representing an annual increase of 21.4 pct. In this period the vacancy rate for class ?A' properties declined from around 25 pct to 18 pct. In addition, only a moderate amount of completions are expected in 2011, with the continuing repercussions of the financial crisis. Preliminary indications are that the market could see about 800,000 sqm of new stock in 2011.

Office hunting
With current total office stock standing at 12 mln sqm, investors have a lot to look at in Moscow. "And yet snatching the right property might pose difficulties. The ideal size varies between 10,000 sqm and 15,000 sqm gla in Moscow's CBD, but there is a handful of much larger projects, often as big as 100,000 sqm of office space. Looking around Moscow you will see a lot of skyscrapers under construction, but my concern is that the volume of demand is not high enough to catch up with the pace of development and the size of such properties," worries Konstantin Lysenko of CBRE.
When it comes to the origin of investors, local buyers still account for 75 pct of the total. This is not exactly news - local players understand the market better and are faster when it comes to closing deals. But as Konstantin Lysenko points out, foreign investors are needed in Russia for many reasons. "Size is the key in Russia. Some projects - priced at USD 300-500 mln - could be just too big to swallow for local investors. This is where foreign investors could step in as only the super-big international funds have the capacity to handle such deals. It seems a bit early, though, for European investors to enter the scene, as throughout 2010 it was still mainly opportunistic buyers who were dominating the market. Core institutional investors are only just coming back, and we expect the first few deals to be closed this year."
In fact it was actually the size that Chinese investors liked most about Greenwood Business Park in the capital. The office complex on the outskirts of Moscow changed hands for EUR 284.6 mln in the second largest transaction in 2010, with the  Centre for the Development of Trade and Management of Investment into Europe being the purchaser. The 130,000 sqm mixed-used project is now starting to operate as the largest hub for Chinese companies doing business in Russia. According to the park's website, around 5,000 Chinese companies, ranging from the clothing to the automotive industry, have opened offices or showrooms in the 15-building complex. The highly-anticipated transaction is both proof that China is one of Russia's major trade partners and a sign that Chinese companies are looking to invest capital outside their home market as they switch their attention from domestic urban residential investment to strategic assets in advanced economies. Attracted by the potentially higher yields overseas, government-backed investors are limiting direct acquisitions in favour of fund investments, data by US research firm Real Capital Analytics shows. "Unlike direct property buyers, Chinese developers typically venture overseas with motives related to China's strategic trade interests," says the report. The Greenwood Business Park deal also falls under that category. The buyer, after all, is a Chinese state-owned institution.

Coming soon
The limited access to prime retail product is one of the reasons for the clear dominance of office market investment deals. "As the real estate market in the country recovers, with returns gradually coming back to pre-crisis levels, this year we will also be seeing more deals in other segments of the market. The retail sector, for example, was hit harder by the crisis. Also, a large number of completed projects, such as those by Auchan and Metro Cash & Carry, are not meant for sale. I expect retail deals to increase their share from below 30 pct to around 40 pct this year," predicts Konstantin Lysenko. Also this year, more industrial properties are expected to be put on the market as the funds that acquired such projects in the 2004-2008 period need to dispose of them and pay their investors. The general feeling is that the 2010 Russian investment volume will be close to the pre-crisis levels of around EUR 3 bln.

Alexander Plekhanov
principal economist specialising in the Russian market at the European Bank for Reconstruction and Development

On the growth path
The growth momentum in Russia picked up again after slowing in Q3 2010, when the economy was adversely affected by the heat wave, drought and forest fires. Economic growth reached 4 pct in 2010 and is expected to accelerate further to 4.6 pct in 2011 and 4.7 pct in 2012. The recovery - from what was the deepest recession among the G20 countries - has been supported by higher oil prices (the Urals brand averaged USD 60 per barrel in 2009, but was up to USD 78 per barrel in 2010 and USD 103 in Q1 2011), sustained fiscal stimulus was extended with further pension increases, and ample liquidity in the banking system. At the same time, investment activity remained somewhat subdued, perhaps reflecting the uncertain outlook for commodity prices. Net capital outflows (which peaked at USD 130 bln in Q4 2008) persisted in 2010 and Q1 2011, but were more than offset by the current account surplus, while the stock market has recovered to levels close to the June 2008 peak. In general, Russia's outlook for growth and exchange rate stability remains highly dependent on commodity prices, particularly oil and gas. Having accumulated substantial fiscal and international reserves during the boom years (over USD 115 bln and USD 500 bln respectively), Russia has ample room for policy manoeuvre in the short term, should commodity prices decline. Coping with a more prolonged decline in oil prices and diversifying the economy will, however, be a major challenge.