Russian bear with a rumbling stomach

There are two facts  about the Russian real estate market that everyone seems to agree on: that it is concentrated in Moscow and that it has huge potential

Emil Górecki

Until recently, the general opinion about Russia was harsh: that it was a poor, corrupt country not worth investing in. But today Russia is shaking off this image and building its economy through exports of crude oil, gas and other raw materials, and many global corporations are taking note of the possibilities forgrowth in the country. Such companies arrive in Moscow and  immediately cause property prices to increase, which is one reason why the capital is among the world’s most expensive cities. ‘Only’ 15 to 20 regions (mainly in the west and south of the country) have anything to add to the Russian real estate market, from among the 70 territorial units - states, regions and autonomies. ‘Only’, because more than 40 mln people live in their largest cities. In 2007, these regions attracted more than 60 pct of all investments, one reason being the special economic zones and technological parks that have been set up there (for example those in Kaluga and Novosibirsk), as well as the infrastructural investments financed by the national budget and local government.

Foreigners have their work cut out

Knight Frank, the property consultancy company, claims that native development companies dominate Russia’s regional markets, (i.e. outside the Moscow and St Petersburg districts), where they perform almost all the contracts. There are not many of them, which is why competition is not so fierce. Their small size is another characteristic feature, the outcome being that construction is financed by the sales of projects. However, an increasing number of companies are setting their sights on long-term profits and foregoing sales to lease out space instead. And the origin of investors is also changing rapidly. In 2006, Russians financed 44 pct of investments, whereas one year later that figure had fallen to 30 pct. Canadian and British investors have taken their place, together with others from such far off places as Singapore. Vladimir Pantushin, head of research at the Moscow branch of Jones Lang LaSalle real estate agents, remarks: “As long as foreign investors could peacefully expand in their own countries they had no need to move to the Russian market, which was seen as high-risk. Many operators pursuing long-term policies, such as Strabag of Austria and Enka of Turkey, had decided to enter the market quite a long time ago. Others moved in when profits were getting hard to come by in their native countries and when Russian development standards started to approach those of Europe.”

Market potential and take up rates are a stronger influence for foreign investors than the hindrances of bureaucracy and the mistrust of Russian officials.

Last year, Aberdeen Property Investors from the UK entered Russia intending to spend EUR 1.5 bln on office, retail and logistic projects. CA Immo New Europe is to spend EUR 1 bln on similar investments. Western European investors are joining the long list of Russian companies that have large capital sums to invest. For instance, Accent Russia Opportunity Fund has USD 1.2 bln, while Rutley Russia Property Fund has a further USD 1 bln in its pockets. Charles L. Voss, international expansion director in the St Petersburg subsidiary of Aberdeen Property Investors, comments that: “We decided to invest in the Russian property market as we see great possibilities compared with the risk. The high return in each investment and in every location is also encouraging. And that is why our plans concern both shopping and office projects, as well as logistics centres in cities with populations exceeding 300,000, of which there are more than 40 in Russia.”

Western investors are convinced that the flow of foreign capital cannot be halted, since the authorities are getting friendlier, foreign companies feeling more confident and an increasingly stronger occupational market has emerged. Adrian Baker, managing director of Raven Russian Property Management, a developer and investor with British roots, explains that: “Starting up activities in Russia is not as difficult as it was 3 to 5 years ago. We spent a lot of time finding a good partner who has western leanings, as well as experience in local business management. The most difficult aspect was to acquire professionals and also to comprehend the permitting processes, as well as the time which has to be devoted to concluding a transaction.”

Moscow takes pride of place

Russian-based consultancy company Cushman & Wakefield/Stiles/Riabokobylko estimates that the total value of transactions so far in 2008 on the Russian commercial properties market is USD 6 bln, the majority being invested in the retail sector. The total value in 2007 stood at USD 44 bln, 33 pct higher than the value of transactions finalized in 2006.

Jones Lang LaSalle sets it even slightly above USD 5 bln, with around 73 pct of that amount being invested in the Moscow region. As much as USD 2.1 bln went into retail projects across the country, i.e. around a half of the total. An interesting feature is that more important transactions are now starting to take place outside Moscow and St Petersburg – the cities with the most developed property sectors. Last year large investors turned their attention to such cities as Volgograd, Novosibirsk, Kaliningrad, Sochi and Kazan.

Valdimir Pantushin remarks that: “Cities with populations between 500,000 and 1 mln, where the market is just awakening, are growing with increasing speed. As is always the case at the beginning of the road, the greatest demand is for residential and retail properties. But the Moscow market is nevertheless continuing to expand with a growing intensity and will do so for the foreseeable future.”

Insatiable Moscow

Moscow and St Petersburg, the present and former capitals of Russia, are gradually becoming saturated with retail schemes, the number of which in Moscow increased by 14 pct in 2007. Although impressive, it is only a half the figure for 2006. Developers are gradually moving projects to the vast outskirts, although the accessible space index for the whole country is less than 1 pct and in Moscow there are 1,000 citizens per 190 sqm of shopping centre space. Developers are promising to bring online an additional 1 mln sqm of modern retail space in 2008, but even if only half of these projects open, then the shopping space per 1,000 Moscow citizens will rise to 250 sqm. For the sake of comparison, the index for Frankfurt is 419 sqm and Milan 575 sqm, Cushman & Wakefield’s specialists estimate that Moscow should achieve the European level in 2 to 3 years. Rents in the city rose by 11 to 16 pct last year, and a 10 pct price hike is expected in 2008. Today, rents average at USD 290 per sqm for mobile telephone shops to between USD 8 and 10 for hypermarkets.

Maria Voronova, marketing director of RosEvroDevelopment, an investment and property development company operating on the Russian regional markets, comments that: “Like any other capital city, Moscow will still be unsaturated with shopping projects for a long time to come. St Petersburg is a non-standard centre, for although it is second only to Moscow in terms of population, it lags far behind the capital in the size of its retail supply. Having said that, many retail projects are in the pipeline, especially those of a substantial size, and should they all come to fruition the city might even achieve a state of saturation. But a lot of room remains for smaller concepts”.

Shifting from old to new offices

The total space occupied by modern office premises in Russia will reach 100 mln sqm in 2008. Today, when one speaks about the growth of the office market, this is in relation to cities with populations above 1 mln. In this category the leaders are Yekaterinburg and Novosibirsk - in terms of completed office space and projects under construction. These are followed by the industrial and mining cities of Rostov on Don, Chelyabinsk and Omsk. For the moment, the demand for offices is satisfied by unclassified, old administration premises. High class (‘A’ or ‘B’) space does not exceed a total of 250,000 sqm in any of these million-strong cities, which amounts to 20 pct at most of all office space (in some cities the figure is as low as 5 pct). Quality office buildings are few and far between and stock is increasing very slowly. The 34,000 sqm  ‘A’ class ‘Grinvich’ office building was opened in Novosibirsk last year, as well as the ‘A’ class Kobra project of more than 15,000 sqm. The 21,000 sqm  ‘B’ class KPD building was completed in Ufa – and these are the largest new buildings constructed in regional cities.

Such is the lack of supply, Moscow’s quality office buildings are generally let to the biggest global corporations. The total space of all Moscow offices was 32 mln sqm in late 2007, of which only slightly more than 7 mln is modern office space meeting today’s standards. In 2007 alone the market supply increased by around 1.5 mln sqm with 62 office developments opening, twice the number achieved in 2006. Not all of these schemes meet the accepted classification standards, with a mere 20 pct satisfying ‘A’ class requirements. Even so, rents spiralled by as much as 20-30 pct in central locations. An increasing number of buildings are being upgraded - especially in densely populated cities where no space is left to build new ones. Last year, around 520,000 sqm of space was refurbished. Despite this, demand still easily outstrips supply - as shown by vacancy rates of between 1.9 and 3.6 pct and average monthly rents in the best locations amounting to USD 170 - 208, an increase of 50 pct since 2006. Office projects under development currently amount to 3.9 mln sqm, although inexperience on the part of the developers often leads to chronic delays.

“Only 14 of the 350 office developers had more than 3 projects underway,”  remarks John Delargy, consultant at the Moscow branch of Cushman & Wakefield/Stiles & Riabokobylko. “Many attempt to sell their office projects too early, sometimes even before the legal status of the plot is known. Financing is yet another headache. Many companies try to finance their projects after construction has started, a fact which makes the whole process highly complex.”

Warehouses around Moscow

A study undertaken by Jones Lang LaSalle confirms that the total supply of high-class warehouse space in the Moscow region is 4.3 mln sqm, 1.3 mln of which were completed in 2007, 80 pct more than in the previous year. Almost 6 mln sqm of warehouse space is to be developed by late 2010. Around 80 pct of all new supply will be developed by three companies: Eurasia Logistic, MLP and RosEvroDevelopment. Almost half of the warehouses planned for completion in 2007 was delayed by more than a year, resulting in vacancy rates falling to 3.3 pct, much lower than in Paris, London, Warsaw and Budapest. And the rents are high, with only London among the mentioned cities being more expensive. Rents remained steady until the third quarter of 2007. According to C&W/S&R, the monthly rent for 1 sqm class ‘A’ warehouse space was USD 10-11, and slightly less (USD 9-10) for ‘B’ class space. An increase in rents of around 10 pct was seen only in the last three months of 2007.

Live in luxury or not at all

One of Russia’s most urgent issues is to improve living standards. The inhabitants of smaller and regional cities live in old, Soviet blocks of flats which leave much to be desired. Potentially, the citizens of Moscow and St Petersburg are in a better situation, with the authorities of these cities working on programmes to create “a flood of accessible homes”, although there is little evidence of this to date. However, the development of the luxury end of the market is growing apace. Most apartments have already been rented, with the monthly rent being on average USD 6,800 for a 100 sqm apartment. In late 2007, apartments could be purchased in 57 buildings at various stages of construction, almost 50 pct more than the previous year, while the situation is the same with planned projects. In 2006, information was released about seven new projects, while the number increased to more than 20 in 2007. Prices are increasing at the same time, by an average of 23 pct last year, according to a report by King Sturge, and as much as 40 pct in the best locations, such as Yakimanka district.

When will the bubble burst?

The steady, high growth of Moscow’s property market is making investors wonder if the situation is perhaps getting out of control. Rents and purchase prices are among Europe’s highest and are growing much quicker than in the West. Furthermore, this market has hardly felt the crisis of the American sub prime mortgage market. In the opinion of the Jones Lang LaSalle analyst: “I do not expect a crisis within the next 2 or 3 years. The market is still strong and the continuing high price of crude oil is also important as a stabilising factor for our economy. But should the situation deteriorate, which is most improbable, the state and central bank will actively support the Russian economy to keep the negative effects at a minimum.” n