View From Within: Native Walls

Ailing Supply

Having a company building is prestigious, convenient and advantageous, according to a widespread belief. By developing its own project a company succeeds in implementing its plans to the full.

“A company occupying an office building of its own is able to organize its work space in line with its own ideas of what an office should be like,” says Elina Zanina, deputy head of commercial real estate and development at Miel-Nedvizhimost.

“Running your own office implies an independent infrastructure, your own security system. The premises can be organized to conform to the specifics of your business; in particular, it becomes possible to organize areas for customers, employees, to partition conference rooms and areas for receiving important guests. In a leased office where the space is already partitioned doing that is virtually impossible.”

Demand for office space is prompting developers to speed up construction of modern administrative buildings. The volume of new construction is growing permanently in Moscow, Cushman & Wakefield/Stiles & Riabokobylko reports.

While in 2002 about 200,000 square meters of office space was developed in the capital, by the end of 2005 supply is set to grow by over 600,000sqm. However, says Leeds Property Group, few companies order the development of buildings for their own use, but the situation is likely to change in the future, primarily, as a result of the increasing interest in the real estate market shown by several major corporations.

“One of the trends of the modern stage of development on the Moscow office market is the stable demand for the acquisition or development of office buildings for personal use generated mostly by large commodity companies, financial structures and banks,” says Regina Lochmele, an office real estate analyst at Colliers International.

“These days, most deals involve the acquisition of finished buildings or buildings under construction that were not initially conceived as an abode for a specific company. The companies opting to secure the titles to a building plot and developing their own projects are increasing noticeably within the structure of demand for personal office buildings.”

According to Leeds Property Group, demand is highest for plots in central and northern Moscow. Many consider it a matter of principle for the building to be situated within one of the city’s office corridors – along major highways in the areas around Leninsky Prospekt, Leningradsky Prospekt, and Volokolamskoye Shosse, says Sergei Ryabokobylko, senior executive director at Cushman & Wakefield/Stiles & Riabokobylko.

One of the latest location requirements is that the office building should be situated within the boundaries of a particular office district. One such rapidly developing area is the Derbenevskaya Embankment where Enka’s offices and the Derbenevsky business park, built by the EkoOffice group, are situated. In the same district Mirax Group is currently developing a large office center.

A shortage of vacant office space in the city center is forcing companies to open offices along the Third Ring Road and beyond. A company seeking to move into a new building quickly does not have many options, says Sergei Ryabokobylko. This is especially true in the case of companies with special business requirements not taken into consideration by developers during ordinary projects.

Construction and Reconstruction

Over recent years Moscow has witnessed the emergence of about twenty custom-built office buildings developed to order by specific companies. Some of them were built from scratch; others – especially those within the Central Administrative District – are old mansions that underwent reconstruction.

“Earlier old buildings were, for the most part, pulled down to be replaced with new properties. These days, they undergo renovation,” says Kaido Kaarma, Park Towers’ director of new construction at Miel-Nedvizhimost. “Such mansions are especially popular with major companies who purchase them for their head offices. Owning an office in a 19th century mansion in the historical center of the city substantially enhances the company’s image.”

For example, MTS has opened its head office of 1,110 square meters on the premises of two 17th century mansions (4 and 2/10, Golutvinsky Pereulok [lane]). Both buildings underwent reconstruction during which their facades were restored and the unique arched vaults were preserved.

Another example is that of a 4,547-sqm building at 10/12, 1st Kazachy Pereulok, renovated to accommodate the headquarters of Almazy Rossii Sakha. Sistema-Gals acted as a developer in that project. What makes the project unique is that during its implementation a small 17th century merchant house underwent reconstruction and a new mansion was built on the basis of extant 19th century drawings.

The classic design of the fa?ade of the 5-storied building includes a glass atrium which imparts modernist features to the overall design. Experts believe that this is one of the first office buildings in Russia that completely meets the requirements set for representative offices of major companies.

Historic facades have also been preserved during the redevelopment of a 5,700-sqm building at 18, Tsvetnoi Boulevard into an administrative compound for Absolutbank. Construction of new office buildings in central Moscow is often slow due to the complicated procedures of securing building plots, which often prompts companies to consider reconstructing existing facilities.

The MIAN Corporation was lucky to have its new office built at Krasnaya Presnya. “The company was not looking for any particular address,” says Anatoly Morozov, general director of Mian-Development.

“Several years ago we obtained a site at 22, Krasnaya Presnya where we initially planned the development of an entertainment center and bowling alleys. However, having studied the various options, we decided that developing an office building at that address would be most profitable. Even more so as the rapidly developing company would soon be interested in a new office anyway.”

Sergei Ryabokobylko notes that construction of office buildings for personal use is the prerogative of large Russian companies, banks, and companies that need special-purpose facilities unavailable on the market. Companies developing their own buildings focus more on the solution of technological problems than on maintaining corporate image.

This is true for banks that have special requirements for the premises where they serve customers and where depositaries are situated, as well as for car dealers who need showrooms for car sales.

The Nezavisimost car dealership built its own office building and a showroom on Leningradskoye Shosse; a similar project is currently being developed in the same area for Porsche’s representative office. Developing office buildings for personal use is an advantage for companies who run several offices across Moscow. In such cases construction of a single administrative building is economically expedient.

A good example of such construction is DaimlerChrysler’s office at 40/2, Bolshaya Ordynka. The building is erected in a hi-tech style popular with office developers in Western Europe. The combination of glass, steel and wooden panels, spacious halls, panoramic lifts and car showroom all make the building unique and rather impressive. The 6,361-sqm building was developed by Sistema-Gals.

Quite often companies interested in personal office space buy properties under construction. Thus, they are spared the additional problems linked to the selection of a plot and are able to introduce changes to the layout and technical equipment adjusting the building to their specific needs, Paul’s Yard experts note.

Among those who opted for unfinished buildings are OAO RZhD (Russian Railways) who bought a building at 41-43, Bolshaya Spasskaya, and Slavneft whose head office in Pyatnitskaya Street occupies a building purchased by the company before the end of construction and adjusted to its needs.

Sellers and Buyers

The purchase of an office building for personal use sends out a clear message that the company is doing well financially. When making a decision to buy an office building companies consider several factors such as location, the company’s requirements and the prospects for development, which may affect the choice of property.

Andrei Petrov, head of office real estate at Knight Frank, says that purchasing a large property at the early stages of construction entitles the buyer to a discount of at least 10-%. But the purchase is only worth it if the buyer needs at least 5,000sqm of office space.

Sometimes a company that has ordered construction is replaced by another customer before the project is completed, Blackwood reports. This is what has happened to the 15,000-sqm class A office center at 29, Brestskaya Street, developed by Kapital Group for a specific customer. Before the construction was completed the customer withdrew from the deal and the office center was offered for lease.

And, vice versa: an 8,000-sqm building in Bolshaya Ordynka developed by the KRT company for lease caught the attention of LUKoil, and KRT agreed to sell the entire property to the oil company.

Igor Pankratov, head of investment management at Region-Development, notes that newly built office buildings are of more interest to the buyers, because unlike offices erected several years ago they possess better design and infrastructure characteristics.

Mikhail Gets, head of commercial real estate at Blackwood, says that developing an office building for personal use is cheaper than buying a finished business center. Nonetheless, sometimes the company has no time for construction and the decision to purchase a business center is made quickly.

Most often this happens when mergers and acquisitions are involved. The classic example is the merger of two major oil firms – Slavneft and Sibneft. For the time being, each of them still operates under its own brand name, but the headquarters of the nascent corporation has already been established at Baltschug-Plaza, one of the capital’s best business centers.

Major insurance firm Rosgosstrakh, too, preferred to purchase a newly built property instead of developing an office center of its own. The company has bought an office building at 40/3, Bolshaya Ordynka. Experts tend to put the rapid growth on the market of office sales down to the increasing number of speculative construction deals.

Key Players

According to Knight Frank, purchasing or developing an office building is a good option for companies involved in the production sector of the economy whose internal rate of return does not exceed the rate of return on real estate. Usually, that figure stands at 10 to 12%.

Russia’s energy companies, with their large financial flows and high rates of return, are also active players on that market because they are interested in investing spare cash. They purchase properties either for personal use or for operating a ready-made business.

For example, an office building on Mokhovaya Street was developed for the Reuters news agency; one of the three buildings of the business center at the Kadashevskaya Embankment was built for Commerzbank.

The Perm financial and industrial group has bought the class A office center Central City Tower at 22-24, Ovchinnikovskaya Embankment. Eastern Property Holdings has purchased the class A business center Berlin House at 5, Pokrovka. Experts say that this speaks for the growing interest in commercial properties on the part of major corporations.

Office real estate investment in the Russian capital is actively practiced by the famous restaurant chain McDonald’s. As of today, McDonald’s owns office buildings at Ulitsa 1905 Goda (3,000sqm), in Gazetny Pereulok (10,000sqm) and in Klimentievsnky Pereulok (2,000sqm).

Banks also order construction of new office buildings, with Sberbank [Russia’s major savings bank] holding the lead in terms of office space built. Most of Sberbank’s properties are new buildings, but the bank also commissioned the reconstruction of a building on Preobrazhenskaya Ulitsa [Street]. The number of stories was increased.

An additional incentive for a company with spare cash is the possibility of obtaining a mortgage in the future. Some buyers of business centers are companies that pursue speculative ends. They are primarily interested in buildings requiring reconstruction. Such buildings undergo renovation and modernization to be sold at a higher price later.

The 20,000-sqm building at 24, Ulitsa Radio, earlier occupied by the Tupolev Design Bureau, was put up for sale in 2003, Igor Pankratov of Region-Development reported in 2003. The dilapidated property was offered at a low price of $500 to $600 per square meter. The company that bought the building invested extra funds in the project to partially change the fa?ade, windows and the flooring.

Today, office space in the same building is offered for sale at a price of $2,000 to $2,200 per square meter. Similar deals often involve industrial estates redesigned as office space.

Experts also mention unit investment funds among the potential players interested in acquiring office buildings. For the time being, however, such funds are not rushing to take part in projects. According to Igor Pankratov, for shares to be sold, investment funds have to offer investors a rate of return higher than they would get by depositing their money with a bank.

The situation on the commercial real estate market of the capital is such that achieving high rates of return – 18% and higher – is possible only by investing in class C office buildings because the higher the class of an office building, the higher the costs are, while the rate of return on the project drops. For example, leasing out class A buildings brings an annual rate of return of 12-13% in hard currency, and class B 15-18%.

At the same time, unit investment trust expenditures include, in line with trust management regulations, resources obtained for running the fund, including expenses for a special depositary, registrar, auditor and appraiser – a total of 2% from the fund’s income. Approximately 1% is spent on advertising by the fund. An average of 1% is spent on technical maintenance and current repairs of the building. Thus, the total expenses account for at least 4%.

If seeking to achieve higher rates of return, the fund buys a class C building. After a certain period of time – considering that such funds are profitable if they are set up for a period of at least three years – the value of that business center will fall considerably against the backdrop of the ever-growing volume of new construction, with the class of existing properties dropping.

Another problem is the lack of transparency in the sale of property. Unit investment trusts are strictly controlled by the authorities and, therefore, all their deals must be in full compliance with the law. Russian companies are not ready for that yet, according to Region-Development experts.

Andrei Petrov says that not all companies interested in a respectable office property actually consider purchasing. Some of them enter into long-term tenancy agreements before the end of construction. That option is often used by companies with very high internal rates of return, such as telecom companies.

For a company whose internal rate of return exceeds the rate of return on the real estate market it makes no sense to withdraw considerable funds from operations in order to save costs on property. For example, VimpelCom has signed a 10-year tenancy agreement with an option for the purchase of the 15,000-sqm Wave business center at 8, Akademika Sakharova Street.

Signing an agreement at the early stages of development allows the company to introduce certain changes into the project in order to preserve corporate identity. Besides, such an approach means more favorable financial conditions, a minimization of decoration costs, and helps to save time otherwise wasted on obtaining different kinds of permission.

Ups and Downs

Few development companies are capable of building a top-class office building. What it takes in addition to resources is an understanding of the task set.

Only a few developers in Moscow – such as Sistema-Gals, CMI Development, Forum-Properties, etc. – are successful in that sector, says Sergei Ryabokobylko. A number of companies that would like to consider constructing their own office buildings cannot do so because the options are just not there.

Experienced developers already have enough orders to last them for several years. Development is a risky business, Andrei Zakrevsky, Sistema-Gals’ vice president says. The success of a project is largely dependant on a competent marketing policy and on various other factors.

Working in tandem with the future landlord helps to decrease the developer’s risks. Development of a custom-built property is easier because the customer himself is interested in the success of the project, and all the sides are satisfied with the choice of location.

At the same time, there are certain drawbacks. A developer has to discuss virtually every step with the future landlord, including the planning of the layout and engineering systems, the choice of construction materials, the location of parking areas and entrances, which may protract construction.

“Fortunately, our company has never encountered those kinds of problems,” notes Andrei Zakrevsky. “We have developed a number of custom-built offices, including the headquarters for DaimlerChrysler and MTS. We are currently working on Siemens’ headquarters. Our clients are highly professional companies who are aware that a comfortable, modern, beautiful office is a prerequisite for success.”

Often, a development company decides to keep a finished business center instead of putting it up for sale. The Barkli Corporation has decided against selling Barkli-Plaza, a business center it is currently developing at the intersection of Prechistenskaya Embankment and 1st Zachatievsky Pereulok.

Companies mulling relocation to a new office have to consider lots of factors and clarify many issues. “A company that begins construction of an office for their own personal use is getting involved in a rather risky enterprise, as nobody knows what the market, political, economic situation will be in the future,” says Aleksei Mogila, development director at Leeds Property Group. “It could turn out that a custom-built office, if put up for sale, will fail to attract buyers. As a rule, such offices are decorated very pompously inside. That sort of style is especially popular with natural resources companies. There are enormous reception areas, spacious offices for executives, etc.”

Currently, an office center on Karamyshevsaya Embankment is up for sale, noteworthy for its outlandish semicircular design. The building was initially supposed to be used as the head office by a company that had ordered its construction. As a result of the ambitious plans of the customer, who had insisted on construction of luxurious halls and spacious offices, the loss of potentially usable area has amounted to nearly 50% warding off any prospective buyers. Consequently, the building has proved slow to sell.

Another example is an office building near the Park Kultury metro station that underwent reconstruction to suit a particular customer. The first two floors in the renovated building were supposed to be used by a bank while the upper floors were to be used by a consulting firm, the co-founder of the bank. The developers had taken into consideration all the specifics of the customer’s operations, as the company needed large conference rooms. But then the plans changed. As a result, the first two floors were taken over by another bank while the upper floors still remain vacant because companies with other profiles are not interested in the layout.

Money, the Decisive Factor

“To buy a good office building one has to be ready to pay $20-40 million,” says Aleksei Mogila. “Buyers are, for the most part, Russian companies because Western firms are still afraid of buying property in the Russian capital, and hence, only a handful of deals involve Western capital.”

According to Igor Pankratov, the deals involving the sale of office buildings registered last year could be counted on the fingers of one hand and the sale prices are all secret. Large Western firms prefer legal transactions. Russian companies seek to minimize costs, which is why deals may include two parts – official and unofficial. As a result, the value of the deal is never made public. During evaluations of properties experts base their conclusions on the local monthly rental rate multiplied by the payback period (usually 5 years).

For example, properties in class A business centers in downtown Moscow are leased out at the rate of $600 to $700 per square meter; outside the Third Ring Road the rate is $350 to $400. Today there are projects in the planning stage and under construction which could potentially be put up for sale, but their owners are waiting for the situation on the rental market to become less ambiguous, says Sergei Ryabokobylko.

Experts at Paul’s Yard note that when a property is sold in small blocks a square meter cost more than when the entire building is sold. But the strategy of selling “in parts” is linked more to the property’s high liquidity, or by the lack of an investor who would be ready to buy the entire property, rather than the owner’s desire to make more money.

According to Blackwood, class A office buildings are sold at an average price of $3,000 to $3,500 per square meter. In smaller buildings prices can be as high as $4,000 to $5,000 per square meter. On the other hand, large buildings of over 1,500sqm are offered at $2,800 to 3,000 per square meter.

The purchase by the Bank of Moscow of a 4,400-sqm building at 4, Brodnikovsky Pereulok in Yakimanka, is valued by market experts to be worth $4,800 per square meter, excluding VAT; the acquisition by the Rossia insurance company of a 4,300-sqm building at 3/3, Prospekt Mira is valued at $3,050 per square meter, excluding VAT.

“Development or acquisition of a business center for personal use was one of the main trends of the year 2004,” says Andrei Petrov. “We believe that this process will continue in 2005 with the number of players in that segment increasing considerably.”