MONEY-GROWING: Time to Gather Stones Together

Economics of Construction

By the end of 2004 the overall supply of warehouse properties in Moscow and the Moscow Region stood at approximately 1 million square meters, of which some 450,000sqm were rated class A and B+, according to Colliers International. There were only 69sqm of warehouse facilities per 1,000 residents. Those figures show that the potential of the market is high. By comparison, in the West there is 200-700sqm per 1,000 people.

Last year development and logistics companies decided to join their efforts in order to eliminate the shortage of warehouse space. Domestic and foreign companies laid plans for the development of numerous warehouse complexes in the Moscow Region. Many projects, however, remained on paper last year, some of them stalled by red tape and problems related to securing plots of land for construction.

This year the market players continued their work aimed at implementing their projects. Because the market is still young and has not been completely divided up, companies that act quickly are likely to earn good profits in the future, either letting out warehouse properties or using them for their own needs.

However, there is no simple answer to the question as to what pays more: developing your own warehouse, renting or buying.

“In principle for retail and logistics companies it is better to rent a warehouse without having to invest large funds in the construction or purchase of the property,” says Aleksandr Fedotov, head of marketing at the National Logistics Company (NLK).

“In actual fact, however, companies are faced with a lack of decent options, high rental rates or sale prices which convince them of the need to develop a warehouse of their own that will meet their requirements or they resort to the ‘built-to-suit’ schemes where a warehouse is built by a developer exclusively for a company.”

The amount spent on the construction of a property with an economic life of 25 to 30 years is equivalent to the sum of rental payments for 3.5 to 5 years, according to Swiss Realty Group. If a property is purchased, the buyer will have to pay all the usual extra market charges that can be as high as 100% of the property value. As a result, the warehouse will cost the buyer 7-10 annual rental payments.

On the other hand, construction and purchase of a warehouse require the withdrawal of substantial financial resources from circulation or taking out expensive loans. Stephan Newman, warehouse real estate consultant at DTZ Zadelhoff Tie Leung, says that logistics companies often opt to rent warehouses according to their existing contracts, while manufacturers prefer to buy properties so they can control them.

The requirements for warehouse facilities set out by logistics operators and manufacturing companies are very different. While logistics firms need a universal property to cater for a variety of clients, a manufacturer needs a warehouse that is ideal for storing its products.

With the Russian warehouse facilities market still at the initial stages of development the amount of investment required to enter it is relatively low, $10-15 million. That sum is enough to build a warehouse property of 20,000 to 30,000sqm at a prime construction cost of $500 per square meter, which covers the cost of building the carcass and doors, and installing sprinkler systems, air conditioning and heating systems.

Extra spending is required for obtaining various kinds of permission from the authorities, tapping into external engineering systems, design, project management, warehouse equipment (shelves, loaders, etc.), and on repaying bank loans if they were needed.

Ruben Alchudzhyan, head of warehouse real estate at Colliers International, expects speculative development of warehouse facilities – i.e. development for lease – to reach the level of 150,000 to 200,000 square meters meeting international standards.

The most important expense item is the cost of land. The amount of spending depends on the location and proximity of a plot to Moscow.

Swiss Realty Group sets the average price of land at $100,000 per hectare at a distance of no more than 15 kilometers from Moscow, $50,000 per hectare for a plot 15-30 kilometers from the city, and $30,000 at a distance of 30-50 kilometers. But those are average figures produced without taking into account the value of land along the Rublyovo-Uspenskoye motorway where the most expensive plots are situated with prices of one hectare of land costing as much as $300,000.

According to Miel-Nedvizhimost realty, the average price of a one-hectare plot at a distance of 50-100 kilometers from the Moscow outer ring road (MKAD) fluctuates between $300 and $1,000. The price of a plot depends not only on the proximity to the city limits but also on its legal status, availability of approach roads and communication lines. The procedure of changing the category of land, too, can cost a fortune.

Vitaly Mozharovsky, a partner with Pepeliaev, Goltsblat & Partners, says that it is possible to build a warehouse on urban or industrial land as long as the property to be built is not for agricultural products. But if the plot in question belongs to the category of arable land it will have to be reclassified. The procedure often costs more than the plot itself.

In practice, the average cost of transferring land into a different category stands at approximately $100,000 per hectare. That amount may be higher or lower depending on the proximity to the capital, the engineering infrastructure in place, the quality of the soil and other factors. However, it should be noted that especially valuable arable land is not subject to reclassification at all.

Aleksandr Fedotov notes that there is an acute shortage of vacant land that can be used for warehouse facilities. “Most plots available fail to meet the requirements, located on a slope, poor location, say, too far from the road or deep within a residential area,” he says. Registering the title for the plot and obtaining all the necessary permission and approval can also prove to be quite time-consuming and costly.

Bureaucratic procedures – quite costly, by the way – can take 6 to 24 months, according to the National Logistics Company. Stephan Newman, of DTZ Zadelhoff Tie Leung, believes that the problem lies not in the shortage of plots but in their condition.

“In the Moscow Region there are a variety of industrial land plots,” he says. “But given the lack of transparency [in issues related to title and other legal subtleties], unlawful privatization of land, lack of engineering lines, etc. a great number of those plots cannot be used for development.”

Enlisting the support of local government bodies is vital when tackling these problems, Newman says. “When developers become certain of a normal working relationship with the local authorities, we will see stable growth in new properties,” he is convinced.

It is virtually impossible to speak in general terms of the potential return on the construction of warehouses for sale or lease. Every individual project is different, with some projects being profitable, while others are loss-making.

The amount of spending on the development of a warehouse facility depends on a whole series of factors, including the terms and conditions on which a plot is acquired, the cost of laying communication lines, the cost of borrowing, etc.

“Our financiers believe that such projects are only profitable when mixed schemes of financing are used, such as, mezzanine loans, junior loans, senior loans, long term mortgage loans with long-term – 10 to 14 years – borrowing from Western banks,” says Marina Mazur, deputy general director and head of marketing at Kulon.

It is worth noting that Western banks are more likely to grant a loan, especially a cheap one, to someone who is able to prove that he does not really need money badly and applies international accounting standards. Western banks are hardly likely to fight for the right to extend cheap long-term loans to little-known Russian firms who are trying to enter the market while it is still growing.

Quality Control

Given the keen demand for warehouse facilities, the quality of properties developed by certain companies may prove inferior to what would be the case if competition was stiff. Of course, all real estate segments include class A, B and C properties.

But even the Moscow residential real estate market that grew by leaps and bounds in the period 1999-2004 has never seen the emergence of top-class closed residential estates completely meeting the Western standards set for prime residential properties. Logistics experts admit that the problem of low quality warehouses already exists.

“Very often what we have as a result is a warehouse that fails to meet modern requirements, with uneven ceilings, low-quality floors, lack of space for maneuvering trucks, etc.,” says Fedotov. “And yet these buildings attract tenants because of the unsatisfied demand. This is a temporary situation, and warehouses are built to last for long periods.”

Some of the class B warehouses on the market are either newly built or renovated properties. High demand for class B properties makes it possible for them to vie quite successfully with class A and B+ facilities. Moreover, some companies – such as equipment manufacturers, commodities suppliers – do not place great emphasis on the category of the warehouse.

However, the modest quality requirements set by those companies must not be used as an excuse for economizing on development costs. “In about five years the market will be saturated and properties that are less convenient and of poorer quality will not be in demand at all,” says Alla Laoz, public relations manager at FM Logistics. “I do not think that respectable companies will go that way.”

Swiss Realty Group experts name several reasons why we can expect a large number of top class warehouse developments, as well as reasons why such expectations may not be justified. On the one hand, considering that 90 percent of the projects are implemented for further lease, not for sale, developers are unlikely to sacrifice quality -- after all, the product is expected to make a profit in the long term.

Furthermore, many projects are being developed to suit specific tenants and meet their expectations. Most importantly, demand is generated by firms whose requirements for the quality of properties are very strict. They are major logistics operators and retail chains.

On the other hand, the market will see the arrival of numerous warehouse facilities of poor quality as the result of work by unprofessional developers with low levels of financing. They are quite likely to save money on decorations, engineering equipment, etc.

“Foreign developers will most likely build class A warehouse facilities because they want to occupy the highest niche of the market,” says Newman. “And while certain Russian companies build properties of lower quality in an attempt to make money fast while demand soars, other Russian logistics operators are building class A properties and attracting major international tenants. Such operators can rightfully be considered worthy rivals to world brands.”

Analysts at Knight Frank note that “rather than implementing the project on their own, certain logistics firms opt to buy a finished property or alter the design at the construction stage.” That is the method Knight Frank itself has chosen. Today the company is in talks with international logistics operators on the development of class A warehouse projects in the town of Vidnoye, outside Moscow, and on Simferopolskoye Shosse [motorway].

Players Have Placed Their Bets

Commercial real estate analysts on the whole and warehouse market analysts in particular have put forward rather interesting forecasts for warehouse rentals for the year 2005.

In the opinion of Marina Mazur, the average rental rate for class A warehouses situated in the immediate proximity to the Moscow city limits will stabilize at $160 per square meter per year (excl. VAT); properties in Moscow will be let at $180-190 per square meter per year. The rates are not likely to change because “in 2005 we clearly do not expect new properties to be commissioned in quantities sufficient for satisfying the existing – let alone the ever-growing – demand,” Mazur explains.

Alla Laoz believes that rental rates will grow. “The percentage of growth is difficult to forecast,” she says. “But they will rise because of the growing cost of land plots, construction materials, energy and labor.”

Ilya Shershnev, development director at Swiss Realty Group, believes that the growth potential of rental rates was virtually exhausted last year and, therfore, in the year 2005 the growth of nominal rates will be moderate and is not likely to exceed 5%.

Aleksandr Fedotov assumes that the commissioning of major logistics parks by Western and Russian firms, expected in the years 2005-2007, may bring about a drop in rental rates for class A warehouses to about $110-120 per square meter per year, excl. VAT.

Fedotov expects sales of class A and B+ properties to increase in the year 2005, boosting the demand for more warehouse properties. Furthermore, prices for secure storage services will grow evenly, as today there is a certain gap between warehouse rental rates and the cost of secure storage.

Stephen Newman is less optimistic. He says that with the arrival of new warehouse facilities that will be developed within the next 18 to 24 months rental rates may drop by 10-15%.

“Despite the fact that the relatively low number of new offers for warehouse properties does not satisfy the ever-growing demand, rentals rates have increased only slightly,” he says. Newman admits that owing to the growing demand for warehouses “Moscow and the Moscow Region are unlikely to face a collapse of the warehouse properties market similar to what has happened in Poland.”

Trends

NLK experts doubt that this year will see the expected completion of all the warehouse projects with a total space of over 700,000 square meters.

For the time being, the construction of the majority of those properties has still to get underway. “According to our estimates, even in favorable circumstances, not more than 300,000 to 400,000 square meters of class A and B+ warehouse facilities will be commissioned in 2005,” says Fedotov. “Most of them will not enter the market until the end of 2005 or early 2006.” Therefore, the demand for class A warehouse properties – estimated by Colliers to stand at 0.5 to 1 million square meters – will not be satisfied.

Swiss Realty Group expects Moscow-based and regional developers involved in warehouse construction to continue their expansion in the capital and the surrounding areas. Regional companies are entering the Moscow market while the Muscovites are breaking into the provinces. Western logistics operators and developers will still focus on Russia. “The logistics business is growing very fast in Russia and that is why it is very promising,” says Laoz.

Incidentally, several years ago Western developers planning to construct warehouse facilities in the Moscow Region could not enter the Russian market because of the administrative hurdles. Perhaps, this year some of them will eventually be able to launch their projects. For example, ProLogis is expected to arrive in Russia in the near future.

“In addition to projects by major logistics companies and experienced Western developers we can expect a massive inflow of non-institutional investors and developers,” says Shershnev. Those include the owners of small land plots, industrial estates and unfinished properties.

“Giving in to the general enthusiasm on the warehouse properties market, they will offer as much as 300,000 square meters or more of new warehouse facilities to the market, according to preliminary forecasts,” says Shershnev. That category of ‘developers’ partially forms the segment of smaller facilities offering properties of 5,000 to 15,000 square meters.