In-Depth: Foreign Investment in Russian Real Estate

Since the growth of the Russian economy fuelled on the rising cost of oil, there has been talk of creating ‘international property funds’ devised to take advantage of the rising value of property in Russia. Indeed many funds have been created for this purpose, but few it would seem have made any successful entry into this highly profitable market.

Of course, for many foreigners Russia is an unknown quantity widely perceived as an unstable and corrupt market. Bad news travels fast while the good is often discounted as it rarely sells press reports in a manner that gets them a wide circulation. But still the facts are there for those who want to see them, and now even Standard & Poors has upgraded Russia to a recommended investment level. Why then has there been no avalanche of foreign acquisition of Russian property that could be reasonably expected given the high yields it offers?

The answer to this is both simple and complex, as is almost everything connected with the Russian Federation. The simple answer is that there is actually nothing to buy. International investment institutions have certain criteria that must be met by their property investments: a building with clean title fully leased to reputable tenants on medium to long terms is perhaps the simplest and most understandable. Such buildings are virtually impossible to find in Russia, and even were they to exist, it is highly unlikely that they would be for sale at the moment.

The simple answer is that there are really no buildings that meet international criteria available. In recent years there have been just three well known acquisitions of this type: 11 Gogolovsky bulvar purchased by Fleming Family Partners is perhaps the nearest to the international norm. Berlin House acquired by a Russian-oriented property fund based in Switzerland was a rather special case that demonstrated just how short the market is of suitable product in that the price was inflated due to the problems met by the developer over the 1998 financial crisis. It was the long-term value of the property and the quality of the two major tenants that attracted the purchaser in such a small market. The third building, the Samsung Centre, purchased by Capital Partners from Kazakstan, has now been sold on to domestic investors and it is this fact that leads us to the complexities that differentiate the Russian property investment market from elsewhere.

The concept of privately owned property only re-emerged in Russia some 15 years ago and for many reasons, international standards of modern building construction have been slow in adoption since then. The demand for commercial space led to development based on speed of construction without any real understanding of the latest international standards, Russian firms were not ready for open plan and newcomers had to make the best of what they could get and it is only recently that developers are planning to meet the highest standard in new projects to satisfy the requirements of international conglomerates.

Another difference is that in Russia, development was most often funded by domestic money because of foreign concern about political risk and corruption. Since the turn of the century, the growth in the supply of money thanks to the high price of oil, has led Russian firms to build and own their property and to finance projects for leasing. Only now is the possibility of sale and lease-back to release capital for further expansion under consideration in some circles, and of course leased buildings still give a much better return than would their sale to an investor at the present time.

Thus, the only way foreign investors can make any significant entry into the Russian property market for the moment, is through participation in development projects. To do this however, a clear understanding of the market is required, together with reliable partners. There are many projects and more Russian developers looking for investments, but few of these would be suitable for an international institution wishing to make a viable investment in Russian property. In terms of commercial real estate, there are some 750,000 square metres of office space planned for Moscow alone in 2005, but not all of it will meet international standards, a considerable amount being build-to-suit for Russian firms that still prefer to use their profits to secure ownership of their offices. Other projects may prove difficult to lease because of the poor standard of design or merely the location as compared to others on the market. Sooner rather than later the commercial property market will change in favour of tenants as opposed to landlords, and then only the best will earn rents likely to support the construction and associated costs with a reasonable yield.

Nevertheless, there is demand and a number of suitable projects are in hand or planned, the Krelatskaya Business Park is an example of a new approach to office planning and location, while the International Business Centre along Kutuzovsky Prospect will occupy the very best central site in Moscow.

Residential building investment is specialized in the sense that in Moscow, the City Authorities take at least 40% of the buildings for their own use. What was once a lucrative business has now become questionable. Added to this is the fact that, despite the provisions of the Land Code, only 49 year leases are available for building plots in Moscow. This applies to every type of construction, but it is perhaps more significant for residential property than for commercial buildings where the landlord will have been paid back many times before his land lease comes to term. At which time it should only be a question of renewing the lease, though perhaps at a different land rent.

In the regions, where freeholds can be purchased, the construction of so-called cottages has driven up the price of suitable land to almost unacceptable levels around Moscow. This again puts into question the viability of investment in this sector by a foreign institution. There are however schemes well worth study, provided sound advice on the specific market situation is taken by the investor. There are also opportunities in this sector elsewhere in Russia, notably in major conurbations and areas that attract tourists and retired people, nevertheless note should be taken of involvement by the authorities. All too often they are looking for investment in their own plans, and, as with everything to do with civil servants, commercial and investment interests are not always best served.

The retail sector has recently shown the greatest growth in Russia, as previously the population had access only to the most basic type of outlet because of the shortage of consumer goods available to the general public. Now demand is rising at a very fast rate as the economy becomes stronger and the money supply increases. At first domestic traders used their profits to build outlets, but soon it is likely that they will seek to sell-and-lease-back to raise the capital for further expansion. Cross-border traders have tended to arrive with their own capital for initial implantation, but with the increasing spread of shopping complexes, an opportunity has arisen for foreign investment in the development of these. A good example is the Vinci development Raduga in Saint Petersburg. International expertise and experience are now being brought into play in the retail sector and such shopping complexes will become the norm throughout the Federation as the market develops. International money that understands tried and tested international trading methods has every chance of playing an important role in this sector. Site selection will still depend on sound advice, the layout of the centre and the mix of trader and with time domestic experience will come to match that imported by the cross-border trader. However, there will always be an important place for the international investor in this sector.

One sector that has long been neglected in Russia, as it was considered insufficiently profitable, is the industrial/warehouse market. Initially, buildings constructed in Soviet times were used and converted where necessary. Then, with the development of the retail sector, traders were obliged to meet their requirements from their own resources, as local investors were reluctant to use potentially expensive land to build warehouses that to their eyes offered low returns. This is now changing and the demand requires much more sophisticated facilities. Therefore specialist companies such as Prologis have entered this market. The price of land in prime areas will still continue to inhibit the development of this market, but in time it must offer long term investors an attractive return coupled with capital gain.

To sum up, the way in which the foreign investor can best enter the Russian real estate market is though investment in the development and subsequent ownership or disposal of the property. Each sector has its attractions and difficulties, but what is essential for every one is a sound and detailed knowledge of the market and legislation, coupled with the choice of a reliable construction partner accustomed to working in the Russian environment. Russia is still subject to capital flight and so the opportunities for the bold, but careful investor are numerous. Even when capital flight is lower in volume and much more domestic money is available foreign investors still have the advantage of experience in selecting their targets providing they are well advised.