Money-Growing: The Commercial Real Estate Market: 2005 - Reserved Optimism

However, current legislation still fails to meet the needs of institutional investors, although, compared to other Russian regions, Moscow has already achieved substantial progress in that area. Market analysts do not rule out that next year will eventually see the adoption of an official classification of retail and warehouse facilities, which will constitute another step towards a more civilized commercial real estate market.

Offices – Rates and Location

The demand for high-quality office space in Moscow remains unsatisfied. Though supply is growing, potential tenants still have to choose from a narrow range of quality properties offered at high rental rates. In the long term the volume of vacant space is expected to grow as a result of a forecasted increase in construction, which, consequently, will bring prices down. Knight Frank analysts believe that by the end of 2005 rates will fall 4 per cent for class A office space and by 2-3 per cent for class B.

Analysts at the Colliers International real estate agency assume that rental rates in 2005 will remain unchanged. “Moscow’s office space market is entering the stage of saturation and is nearing a point of equilibrium where rental rates are stable,” says Oleg Myshkin, head of the office real estate department at Colliers International.

Rental rates both in the class A and class B sector stabilized this year. According to Knight Frank, the weighted average rental rate for class A property is $655 per square meter per year, while class B properties are leased at $460 per square meter, including operating costs and standard tenant improvement, but excluding VAT.

The gap between the prices and rates charged by class A and B property owners will continue to grow, Vyacheslav Aksyonov, head of the office real estate department at Paul’s Yard, is convinced.

2005 is expected to witness the rapid development of new land plots outside Moscow’s city center [between the Garden Ring and the Third Ring Road] and a further decentralization of the office space market. Yulia Nikulicheva, deputy director at Jones Lang LaSalle, says that more and more tenants are looking for offices outside the city center, and developers are heeding those demands.

Aleksei Averyanov, head of the Issledovanie.ru project, links the shift of office buildings from downtown Moscow to an acute shortage of plots within the Garden Ring and congestion problems. Over the next two years, Averyanov believes, developers of office space will focus on the city’s main thoroughfares, such as Leninsky Prospekt and Kutuzovsky Prospekt, and areas between the Garden Ring and the Third Ring Road. In his opinion, contrary to all expectations, areas near the Moscow Ring Road [the outer limits of the city] will not attract many tenants, because they are too remote.

At the same time Oleg Myshkin of Colliers International has called the development of the Krylatskiye Kholmy business park a landmark event, which gives grounds to say that submarkets can develop into a significant component of Moscow’s office real estate market. But then again, a business park and a business center are different formats.

“If tenants show real interest for the first business park to appear in 2005, it will be possible to speak of the emergence of a new type of office property which could become a strong rival to business centers and noticeably influence the market in future,” Averyanov is convinced.

The reconstruction of industrial estates and development of industrial parks will continue next year. Vyacheslav Aksyonov sees the reconstruction of plants and factories resulting in a growing market supply of class B office properties, with their occupancy depending primarily on their location.

Yulia Nikulicheva believes that 2005 is unlikely to witness many investment deals on the office market, as all the buildings that could be sold have already been sold. By the end of this year, according to Paul’s Yard, the supply of properties for sale will have grown at the expense of lower-quality properties offered at $2,000 to $3,000 per square meter, exorbitant rates for class B offices.

But Jones Lang LaSalle experts expect the arrival of new foreign investors and developers interested either in implementing their own office projects or in purchasing existing facilities. While by the end of this year one square meter of unfurnished space will cost $3,500, in 2005 its price could reach $3,800 and hit $4,000 as early as 2006.

Despite a certain decrease in the yields on office real estate, the annual yield for class A properties currently amounts to 12-14 per cent and 14-16 per cent for class B properties, according to Knight Frank. In the opinion of Aleksei Averyanov, in 2005 the yield for office buildings will be 13-15 per cent.

Development of the office real estate market in 2005 will be largely shaped by the growing market of project financing, a reduction in the cost of financing, simpler ways of securing it and the development of mortgaging procedures. Consequently, activity by developers on the market will bring about an increase in the development of significant projects on the basis of project financing.

Moskva City Unlikely to Hurt the Market

Some 200,000 to 220,000 square meters of class A and class B office space is to be commissioned in the fourth quarter of 2004, according to the analysis department of Knight Frank. In 2005 work on another 600,000 to 650,000sqm will be launched.

Colliers International forecasts that the volume of new class A and B office development in Moscow will reach 900,000sqm next year, which is 28 per cent higher than in 2004. “Construction of class A office properties will nearly double and amount to some 45 per cent of the total size of construction in 2005. As a result, by the end of 2005 the total class A and B office space in Moscow is expected to reach 4.5 million square meters,” says Myshkin.

Among the most significant projects to be commissioned in 2005 Myshkin names the second phase of the Aurora Business Park at 82, Sadovnicheskaya Street (38,000sqm for lease), Kapital Plaza at 18, Pervy Lesnoi Pereulok (37,000sqm), Stanislavsky Tsentr at 21, Malaya Kommunisticheskaya (35,000sqm), Dukat III at 6, Gasheka Street (28,000sqm), Bashnya Na Naberezhnoi – a part of the Moscow International Business Center Moskva-City at Krasnopresnenskaya Embankment (25,000sqm) and the Krylatskiye Kholmy business park at 19, Krylatskaya Street (57,000sqm).

Particular hope is attached to the Moscow International Business Center Moskva-City. The launch of such an ambitious project will boost the supply of top-quality office properties, as well as the number of pre-sale and pre-lease deals, says Oleg Myshkin. Construction is being carried out by the development companies Enka, Kapital Grup and Severnaya Bashnya; the latter was set up by a group of executives from the Severstaltrans transport company for the development of the 27-story class A office complex Severnaya Bashnya (Northern Tower) with a total area of 74,900sqm.

By the time the first building of the Moskva-City complex – the first Bashnya Na Naberezhnoi (Tower on the Embankment) by Enka – was commissioned all the properties there had already been taken up.

But, says Vyacheslav Aksyonov, there are still other projects, no less grand and of just as high quality, which can compete with Moskva-City. Among them analysts point to the project for a class A office center on Kutuzovsky Prospekt, located almost opposite Moskva-City, with a total space of 300,000sqm. Yulia Nikulicheva adds that so far the completion level at Moskva-City remains low and is having little effect on the office space market.

Some experts predict that commissioning of most of Moskva-City’s projects could be delayed for various reasons such as a lack of financing, changes in concept or in the line-up of investors. But they also consider it highly likely that new major investors will join the City projects, just as some of them may shift their attention towards less ambitious projects within the Third Ring Road, which could be completed at the same time or even earlier than City’s offices, says Ilya Shershnev, development director of Swiss Realty Group.

At any rate, should the existing economic tendencies prevail, the market is likely to become saturated with top-class office properties within 18 to 24 months, with rates stabilizing at a level acceptable for both landlords and tenants, say Knight Frank’s analysts.

Retail – Quality and Provinces

In 2005 the retail real estate market, too, will be far from saturated with quality properties, says Yulia Nikulicheva. Low occupancy rates registered at certain unsuccessful projects do not mean the market is saturated, and with the construction of professional retail properties the contrast between successful retail centers and those with a failed concept will grow all the more obvious, further undermining the position of the latter, Colliers International experts are convinced.

But even with the market still unsaturated major retail chain operators – traditional anchor tenants in retail centers – are quite fussy and refuse to pay higher rental charges even for properties within successful retail centers, Nikulicheva adds.

“Rental rates in Moscow will grow for properties in well-located retail centers, such as Atrium, Okhotny Ryad,” she says. “But rates for less well-located properties outside the city center may decrease under pressure from tenants.”

According to JLL reports, rental charges for anchor tenants in Moscow range from $120 to $200 per square meter a year. Knight Frank analysts report that top-class retail centers charge ordinary tenants $500 to $1,000 per square meter per year. Annual rental charges in the high street retail sector, where Tverskaya Street, Novy Arbat and Stary Arbat still lead the field, reach $5,000.

In 2005 Colliers International expects significant deals to be effected on the market of investment sales for retail centers. Market specialists also anticipate stronger competition between retail operators. Knight Frank analysts note the growing competitiveness of domestic retail chains, despite the influence from Western companies.

In the long-term market analysts expect the arrival of such major retail operators as the U.S. corporation Wal-Mart and the British retail chain Kingfisher, which is set to invest over $600 million in the development of 60 hypermarkets across Russia, with at least five of them to be opened in the capital, Knight Frank reports. The first hypermarket is due to open in 2006.

A total of 250,000 to 300,000 square meters of retail properties are scheduled to be commissioned in the 4th quarter of 2004, according to Knight Frank. Each year Moscow’s retail real estate market grows by approximately 400,000sqm, of which most are commissioned in the 2nd and 4th quarters of the year, which can be explained by the desire of retailers to open new outlets at the beginning of seasons, not during end-of-season sales. Major retail centers are also expected to open in the Moscow satellite towns of Podolsk and Krasnogorsk.

But, in the opinion of market analysts, retail properties in other regions will expand even faster than in Moscow. Economic growth in the regions will continue to attract western retail operators. Unlike Moscow, the regions do not have as many administrative barriers that impede the effective implementation of development projects, says Ilya Shershnev.

Warehouse Paradox

Growing income levels and consumer expenses in Russia are generating a boom in demand for prime warehouse facilities among logistics operators and consumer goods manufacturers. Anticipation of new retail operators’ entering the Russian market makes logistics providers, such as the National Logistics Company, FM Logistic, and others develop their new properties more actively.

Nevertheless, construction of warehouses is still proceeding slowly, and for at least three more years the market is unlikely to be saturated with quality warehouse facilities. According to an evaluation by Knight Frank experts, the demand – including both potential and latent – is at least 4.5 million square meters, while the unsatisfied demand for quality warehouse facilities is not less than 1.5 million square meters.

As the gap between demand and supply widened over the past three years, rental charges grew 6 per cent. According to Ruben Alchudzhyan, director of the warehouse department at Colliers International, today the annual rental charges for warehouse properties range from $140 to $160 per square meter per year.

Although Knight Frank analysts say the current level of rates has nearly reached its limit, the moderate growth is likely to continue for another couple of years. With rental rates soaring and an enormous gap between demand and supply the yearly rate of return for warehouse development projects is estimated at 18-21 per cent.

Yulia Nikulicheva estimates the return on warehouse projects to be slightly lower – at 15-17 per cent, but specifies that so far that segment has seen no investment deals, which is why all the estimates are made on the basis of expert evaluation only.

But, on the whole, says Nikulicheva, the situation on the warehouse properties market is unique, because it remains absolutely unsaturated with rental charges higher than in most European countries (only London’s warehouses are more expensive), lower construction costs than in the retail and office real estate sectors and a considerably shorter construction period – 3-6 months. Despite all that, the market is developing slowly, and few ‘non-core’ developers are eager to put up money in the construction of warehouses.

Alchudzhyan recalled that in 2004 some developers said they were launching several large-scale projects that will only be completed in 2005, for example, the warehouse complex Logopark -- a joint project by agricultural producer Belaya Dacha and French building giant Bouygues Construction. Alchudzhyan links the delays in development of new warehouse properties to problems arising from land use issues.

Knight Frank forecasts that some 350,000sqm of warehouse properties – nearly 75 per cent of the planned volume – will be commissioned by the end of 2004. In 2005 analysts expect the completion of about 600,000sqm of prime warehouse facilities. Most of them will be leased or sold before construction is completed.

Over two-thirds of projects, either finished or under construction, are built for specific clients according to ‘build-to-suit' schemes, says Ilya Shershnev. Western express delivery firms, such as the world’s leading logistics operators DHL and TNT, have decided to start building their own storage facilities in Russia in 2005, Shershnev reported.

Speaking of other trends, Ruben Alchudzhyan has noted developers’ interest in the construction of production and warehouse complexes. The company Kulon is developing its project Istra and there is also a 50,000-sqm storage facility on Yaroslavskoye Shosse and the small, 10-hectare Industrial Park Domodedovo near Kashirskoye Shosse.

“Development companies are sometimes contacted by domestic and Western firms seeking to launch production facilities not far from their warehouses,” he explains. “The small plots of land the developers have to offer do not suit them. That is why developers build industrial parks that include both warehouse and production facilities, but that tendency cannot be called universal. There are only a few of those types of projects and for the time being warehouse complexes are in the highest demand.

“Last year I said that the year 2004 would be a turning point. It has indeed been a turning point, though in terms of trends, not volumes,” says Alchudzhyan. “Several large-scale projects have been commissioned increasing the supply of prime logistics complexes, hence there was no stagnation. It is possible that in 2005 the situation will change more radically. We are aware of several large-scale development projects for a total of over 300,000sqm, which are to appear on the market next year. As to how many of them will be realized, only time will tell.”

Architecture and Management

In the opinion of Oleg Myshkin, completion of the development projects Dukat III (being developed by Hines) and Ermitazh Plaza on Krasnoproletarskaya Street (Forum Properties) will establish new quality standards for modern office centers in Moscow.

One of the most important tendencies in the development of Russia’s office real estate market is the arrival of world class architects in Russia, such as the Dutch architect Erik van Egeraat, U.S. firms Swanke Hayden Connell Architects, and Hellmuth, Obata + Kassabaum, Inc (HOK), says Myshkin.

“The anticipated increase in the supply of high-class commercial real estate will trigger inevitable changes in the landlord-tenant relationship as clients become more demanding and property owners will have to adjust to those high demands,” says Konstantin Baranov, marketing director at M+W Zander Facility Management CIS.

“In addition to location and engineering systems, even today tenants want to know what management company will be running the property. Many western tenant-firms – major companies that rent or buy the entire building, as well as tenants occupying smaller properties – are holding open tenders for property management more frequently.”

The property management market will develop, too, to meet the growing demands of customers. “Thus, M+W Zander Facility Management CIS is currently testing a new program, developed in Germany and adapted for Russian conditions,” says Baranov.

“That program will help automate reporting and control over routine operations on sites, and find new solutions for improving the servicing of infrastructure. Such projects are still new, but they are by no means premature. The management market is growing fast and keeping up to date is no longer enough -- we have to be ahead of it,” Baranov is convinced.

As regards the introduction of new construction know-how, in the opinion of Aleksandr Ksendz, an advisor with the appraisal firm NEO Tsentr, 2005 will see a boom in steel-frame buildings. Today steel frames are used largely for construction of large-span buildings such as covered parking areas, industrial and warehouse facilities, retail properties and sports facilities. Logistics operators expect that 2005-2006 will see more warehouse facilities in the Moscow Region being built using steel frames.