Elsewhere: Realty Market Still Rising

Based on surveys and interviews with more than 250 of the industry’s leading authorities, Emerging Trends states that 87% of the respondents believe profit growth will be “modestly good” to “excellent” over the course of the year, and that real estate investments will outperform bonds and equities.

Paris Overtakes London

The report ranked Paris as the top overall investment market for risk-adjusted returns out of the 27 markets listed. Last year’s landmark event in the capital of France was the opening of a 47.5 million square meter office park in Ile de France.

That has enabled Paris to outstrip London in terms of office space. Cushman & Wakefield / Healey & Baker believe that France’s office real estate market will continue to recover over the next few years. Statistics show that as of today, some 3.3 million square meters of office space have been developed in the strategically important parts of Paris. Paris is also rated highly in the development prospects category.

Milan ranks second in the overall investment category, and ranks first for retail investment prospects, with 67% of the respondents recommending buying retail properties there. The city is also listed as a promising development market.

The capital of Great Britain, for many years seen as the European business center, ranks third for overall investment prospects, although it is not highly rated as a market in which to buy any specific property type. “The attraction is that economic growth is clearly well entrenched. Those surveyed consider it (London) a fairly safe market,” the report explains.

Lyon, categorized as a secondary city, ranks fourth in the overall investment and development potential categories, reflecting investor and developer willingness to search beyond major markets for opportunities. Rounding out the top five for investment prospects is Brussels, viewed as a favored market due to its status as Europe’s government city.

There are, of course, a few markets where no one sees the slightest crack in the cloud cover. Berlin and Frankfurt tie this year for the accolade of “worst market outlook in Europe.”

The German capital has witnessed intensive growth of supply in the office sector while infrastructure facilities still fail to meet the high standards set for business activity in one of Europe’s largest cities. It would be more logical to start with the building of an airport before developing offices, Kate Gimblet, realty consultant at Economics & Investment Research, says.

In Short Supply

The report points to “too much money and too little product,” driven by plentiful capital from a variety of sources: institutions, private equity funds, public companies, limited partnerships, venture capitalists, hedge funds, private syndicates and individuals.

“The intense competition for prime assets has forced almost everyone to search for overlooked corners of markets,” the report says.

“As a result, assets that were once shunned…are now in considerable demand. ‘Look for asset management potential’ and ‘refurbish and reposition’ are the new mantras.”

In contrast to the 2004 report, the 2005 Emerging Trends finds that the outlook for developers has improved, particularly for mixed-use developments. “They (mixed-use projects) may ultimately be the only way to build modern high-quality office, retail, and residential space in a size that will satisfy growing investor appetite.” In terms of property types, shopping centers are again expected to produce the highest total returns in 2005, while retail parks outrank residential as the second favored investment choice. The residential sector is listed as top choice for development, followed by shopping centers and warehousing/distribution space.

Turkish Gambit

The results of the best development markets survey were somewhat surprising. Istanbul tops the rankings as it offers scope in most sectors and a vibrant, entrepreneurial high-growth economy that is aspiring to join the E.U. Moscow follows with its huge potential market and rising incomes, although political considerations complicate the picture.

According to the report, Moscow with its huge potential market and rising incomes is the second-best development market after Istanbul. However, as far as investment is concerned there is very little scope because the suitable standing assets are limited, and Russia, unlike the Central European countries, has huge domestic equity capital that does not require the same risk premium as western capital, nor does it engage in the same level of due diligence. One of the main factors that impede investment in the Russian capital is imperfection of the banking system.

Russian banks are unable to offer long-term loans that are so highly sought after by developers, while western banks are exercising caution, notes Holger Mueller, head of the real estate committee at the European Business Association. Mr. Mueller anticipates no considerable changes in that sector in the medium-term.

“Developers complain about expensive loans,” agrees Vladimir Pinayev, director for Russia/CIS at Jones Lang LaSalle. “At the same time, foreign banks are increasingly active in breaking into the Russian market.” However, for the time being Western banks are extremely cautious.

CIS banking systems are among the riskiest in the world, and remain vulnerable to external shocks and potential government policy reversals – illustrated by the current pressure on Ukrainian banks due to domestic political instability and the turbulence in the Russian banking sector this summer, Standard & Poor's Ratings Services said in a report published recently. The report, CIS Banking Systems: Mixed Prospects But Common Risks, is a broad, first-ever pan-regional look at the banking prospects and risks in the CIS region that fills an informational and analytical gap for market participants and investors.

"Although most of the 12 CIS countries have made great progress in transitioning to market economies, much remains to be done, particularly in the banking sectors," said Standard & Poor's credit analyst Ekaterina Trofimova, author of the report. All banks in the region face numerous and large challenges: the development of financial intermediation, the expansion of product ranges, revenue diversification, efficiency improvements, and the introduction of more sophisticated tools for operations and risk management.

Reflecting these weaknesses, most of Standard & Poor's ratings on banks in this region are in the lower to middle range of speculative grade.

This growth potential varies from country to country, however, as the report shows. The banking systems of Kazakhstan, Russia, and Ukraine lead the pack and have the largest growth potential.

"Despite the growing divergence of policies and in the performance of the CIS banking systems, one thing they share is exposure to a variety of common risks," Ms. Trofimova said. "These risks include: high economic and industry risks; cyclical volatility; low population wealth and high income inequalities; underdeveloped regulatory and legal systems; varying accounting practices; weak bank financial profiles; and limited confidence in the banking system.”

Investors Shun Uncertainty

So far, CIS banks have grown mostly inside their home markets without much foreign investment. They are beginning, however, to increasingly look across their borders, driven by the needs of major corporate clients, improving macroeconomic conditions, and increasing intraregional cooperation and trade. Although international banks are still mulling over the region, they have not identified the region as a target market or articulated a pan-regional strategy, the S&P report reads.

Perhaps Russia could improve its banking system by pursuing a policy aimed at strengthening the ruble. S&P notes that Russia is becoming a classic victim of the Dutch disease, as it has been confronted with massive oil revenue windfalls, subsequent pressure on its currency, and a threat to the competitiveness of its industry.

S&P credit analyst Helena Hessel notes that over recent years, particularly, in the second half of 2004 Russia sought to neutralize the problem and strengthen the ruble through massive currency interventions.

S&P analysts believe that that approach is no longer viable. On the contrary, they are convinced that if they gave up the interventions Russia would only benefit from a stronger ruble. The rapid strengthening of the real ruble rate would stimulate restructuring of outdated industries, by undermining their competitiveness, Hessel said. Economic restructuring would help accelerate Russia’s integration in the global economy and the WTO.

Another reason why investors still underestimate Russia’s potential is the lack of guarantees. Most of all investors shun uncertainty, notes Stephen Wilson, head of the DTZ Zadelhoff Tie Leung Moscow office. Istanbul has finished ahead of Moscow because it offered certainty. Turkey has decided on EU accession which gives solid guarantees to investors.

Mueller believes that another factor that undermines Russia’s investment climate is its inhospitality, unwillingness to let investors enter the market. Many companies note that Russian investors dominate in this country. On the one hand, this is because of the large amounts of free cash, on the other by poor knowledge of the foreign real estate market and, subsequently, a lack of a worthy alternative to investing in Russian real estate.

Clash of the Sectors

It is obvious that investment strategies should be developed separately for each of the commercial real estate sectors. The authors of the PricewaterhouseCoopers/Urban Land Institute survey believe that the best sectors to invest in 2005 will be shopping centers and retail. Retail is the path most trodden to date, but there is still an overwhelming need for more. The Russian economy is growing and incomes are growing with it, so there is pent-up consumer demand, explains the report.

Respondents believe that investors should seek investments and development opportunities in regional centers beyond the major cities. Significant potential exists for shopping centers and food store–anchored district centers and retail parks. Moscow appears to be significantly undershopped, particularly for high-quality shopping centers, the report says.

The purchasing capacity in Moscow is ten times higher than in Warsaw, says Vladimir Pinayev. He anticipates rapid growth in the retail real estate market.

Prices for shopping areas will grow steadily as competition within the Moscow outer ring road (MKAD) grows stronger, maintains Holger Mueller.

Analysts also anticipate further development of the office real estate sector. Demand exceeds supply, which is demonstrated by Moscow having the lowest level of office vacancy/availability of all the 27 centers monitored.

The industrial facilities sector also has good prospects. The authors of the survey note that in places where the market for modern industrial/warehousing space is “just opening up”, such as Russia, prime yields are into double digits. In Russia the sector is “waiting to explode”. There is strong demand and the market is severely undersupplied. Problems in this sector include acquiring land with utilities and zoning. In addition to the Moscow area there are “excellent opportunities in the regions”.

Holger Mueller agrees, saying that the warehousing sector is of great interest. Warehouse facilities are extremely limited, though in the next few years there will be rapid growth in the sector, he explains. The opportunities are high, but acquiring land with utilities is difficult, he says.

With regards to the hotel sector, Moscow has a demand for three-star and five-star hotels in particular. In terms of development, Russia, as well as Croatia and Romania present good long-term opportunities.

Sober Expectations

Real estate investments are still largely made where there is a surplus of capital. “Since weight of money will drive markets yet again, most firms are looking forward to another year of profitable growth," the report reads.

In 2004, profits turned out to be even better than last year’s optimistic survey anticipated. That was in no small measure thanks to the rise in transactions seen relative to 2003. Respondents expected more of the same in 2005. A formidable 87% of firms believe profit growth will be “modestly good” to “excellent”. Such a trend is registered throughout Europe. According to the latest surveys by CB Richard Ellis (CBRE), direct investment in European real estate reached a record-high $103 billion in the year 2004.

Growing demand diminished returns on investment last year. Many investors failed to see their demand satisfied, says Nick Axford, head of research and consulting at EMEA, which is part of CBRE,

EMEA analysts expect demand to soar in 2005 while investments will grow only as long as there are investment projects available. At the same time, whatever the scenario of the commercial real estate market’s development, returns will continue to drop.

The growing demand is prompting investors – mostly from Germany and Ireland – to focus on the Eastern Europe countries. Investing in retail real estate in Central and Eastern Europe is high on the priority list of the ever-growing army of investors, according to CBRE’s analysts. At the same time, with enormous volumes of money available, investment projects are relatively few, which results in lower returns.

In Russia, the situation is similar. “Too many investors, too few facilities worthy of attention,” Pinayev says. Holger Muller believes that one of the main reasons the Russian market is highly appealing for European investors is the stably high rate of return and clear-cut diversification of real estate sectors. Further development will depend on several factors, the main one being measures to protect investors’ rights in Russia.