MONEY-GROWING: Office Expansion

Moscow investors and construction companies are keeping up, and developers in the region are trying not to lag behind. Major Moscow office tenants now consider it fashionable to open what they refer to as “offices in the countryside”.

The office real estate market is not growing as quickly as the residential and retail sectors. Market experts say this is normal, as the residential market is usually the first to grow, then people seek foodstuffs and leisure and only then do they realize that they also need a comfortable work space.

Moscow, however, is the exception to that rule: the development of prime office space began in the Russian capital way back in the first years of its transition to a market economy, along with top class residential estates and hypermarkets. The foundations of the first Class A business centers were laid here even before the construction of modern shopping malls was launched.

The state of affairs in many Russian cities today is such that the supply of quality office space – whether newly built or redeveloped – is meager while demand is huge. The market lays open to the growing number of players.

While two years ago offices meeting top class criteria were hard to find even in cities with populations of over 1 million, these days their number is growing, says Sergei Lobanov, head of the interregional real estate department at Miel-Nedvizhimost.

They include such ambitious projects as the International Trade Center in Nizhny Novgorod (similar to the Moscow World Trade Center). The new facility, featuring conference halls, retail areas and offices, will be built by local developers and the International Council of Shopping Centers. Moscow real estate consultants say they are receiving more and more orders from the regions.

“At the current time we are witnessing the active expansion of Moscow-based and foreign firms into the regions,” says Yelena Kolesnikova, consultant to landlords and corporate clients at Cushman & Wakefield / Stiles & Riabokobylkо (CWSR).

“In the years 2004-2005 a much larger number of commercial real estate projects were implemented compared to earlier years,” Sergei Lobanov says. “I think, the rapid growth in commercial properties in the regions will continue over the next few years.”

Regional office space markets differ greatly from that of Moscow. They resemble the Moscow market in its early stages of development. But experts believe that the process will be faster in the regions.

Assessing Regions

The progress of office real estate development across Russia varies considerably from town to town just as the regions themselves differ greatly in terms of their growth rates.

For example, the per capita income for St. Petersburg stands at $4,080 per year, according to the State Statistics Committee. In Samara it is $3,132, Yekaterinburg $2,916, Omsk $2,856, Novosibirsk $2,496, Perm $2,388, Nizhny Novgorod $2,136, Rostov-on-Don $2,124, Ufa $2,124, Chelyabinsk $2,080.

The shaping of the office market depends largely on the economic and national specifics of a region. The commercial property market grows faster in regions where the social and economic conditions are more favorable.

By way of comparison, Moscow has 0.35 square meters of office space (regardless of class) per resident. In St. Petersburg that figure stands at 0.16 sq.m., in Rostov-on-Don at 0.3 sq.m, in Novosibirsk it is 0.15, and in Samara 0.08 sq.m., according to Knight Frank.

Economic conditions in the Russian provinces have never been equally favorable. The country’s transition to a market economy revealed all the weak points with several regions falling well below subsistence levels. The survivors were the coastal regions that caught the attention of travel operators, and areas rich in natural resources.

As world oil prices soared, vast raw material resources helped many regions of Russia get their second wind. Experts propose various classifications for the regions. One of those was proposed by the Institute for Energy and Finance, which Vedomosti wrote about earlier.

They suggest dividing all the Russian regions into three groups: group A, including 27 developed regions, group B comprising 26 medium developed areas and group C of 29 less developed regions. Group A includes Moscow, St. Petersburg, along with the Moscow and Leningrad regions encompassing the two major cities, with Russia’s highest rates of GDP per capita, developed labor markets, transport and banking.

That group also comprises regions rich in natural resources and production facilities, such as the Krasnoyarsk, Sakha, Vologda, Belgorod and Lipetsk regions. The third, least developed group, accounting for about 20% of the country’s population, includes some Siberian and North Caucasian republics.

Major Moscow-based and foreign companies seeking to take root in the provinces focus their attentions primarily on the Volga district, the Urals, Russia’s Far East and Siberia, as well as the capitals in former Soviet republics: Kiev, Astana, Yerevan and Baku, Yelena Kolesnikova says.

“In the regions offices are growing rapidly in large business cities with a high level of commercial development, be it the southern ports with huge flows of goods, or the Far East that is seeing the influx of Asian businesses from China, Korea and Japan, and investment,” says Alexei Averianov, general director at NAI Vesco.

“Local extracting companies run offices in large oil and gas producing centers of Russia such as Surgut, Salekhard, Nefteyugansk and Khanty-Mansiisk. In some cases those are very large and modern office centers.”

Who Is Building What, and Why?

Surveys by market analysts and numerous conference reports show that St. Petersburg is the most highly developed Russian region in terms of office real estate development. The Northern capital is following the Moscow scenario.

But, unlike the Moscow market, the St. Petersburg office sector has virtually no prime office buildings available on the open market, the majority of Class B+ office facilities are being built to order. The situation is approximately the same in many other cities where smaller business centers are usually built, for the most part, by local developers, while large-scale projects are carried out by Moscow-based firms and foreign developers and investors.

Moscow companies involved in office development are arriving in the regions pursuing various goals. Some are building office facilities for their own use, such as consumer services companies, acting as a sole property owner, developer and investor all in one; others are building fulfilling orders from local landlords, while still others develop projects for the open market.

Yana Kuzina, head of strategic consulting and valuation at Noble Gibbons in association with CB Richard Ellis, agrees. She says that many commercial projects in the regions are financed by Moscow firms. Developers active on the open market are for the most part involved in the construction of multifunctional properties. Office centers as such do not bring high profits, Kuzina explains.

International companies are not eager to make money on regional office development; as a rule, they open representative offices in provincial cities in order to do their core business there.

To that end they need offices of an appropriate quality and that is why they agree to spend money on constructing office space. They often enlist the services of Moscow-based real estate consultants and developers experienced in the construction of prime business centers.

“The most common scheme is where a large raw material company, an industrial or a financial group erects buildings for their own use,” says Antonina Lairova, research analyst at ABN Realty.

“Practically all the international real estate consultants operate in the regions, including Colliers, Knight Frank, Cushman & Wakefield / Stiles & Riabokobylko, Noble Gibbons,” says Alexei Averianov of NAI Vesco. Moscow developers active in the provinces are SKholding, RosEuroDevelopment, Avgur Estate, and Stroimontazh.

The rate of return for offices in the regions stands at 16-18%, according to Noble Gibbons. For office projects entering the open market that figure is 13-15%. Buildings developed for multiple purposes yield even higher returns of up to 20%.

For Whom

Consumer services companies account for the majority of office tenants in the regions, says Yelena Kolesnikova says. A variety of insurance firms, retailers, banks, financial services and hi-tech companies, including mobile telecom operators run offices across the country.

NAI Vesco reports that the highest demand for office space is generated by local small and medium-size businesses. Companies from Moscow, St. Petersburg and foreign firms are present, too. The largest tenants are Philip Morris with operations in Rostov-on-Don, Rosneft, Volvo, and UralSib (Yekaterinburg).

The number of foreign firms seeking to launch their representative offices in Russia is growing. According to Noble Gibbons, CSFB runs offices in Kiev and Moscow, Procter & Gamble has offices in St. Petersburg, Kiev, Novosibirsk, Yekaterinburg, Rostov-on-Don, and Minsk. PricewaterhouseCoopers has opened offices in St. Petersburg, Tolyatti and Yuzhno-Sakhalinsk. Ernst & Young’s regional offices are situated in St. Petersburg, Novosibirsk, Yekaterinburg and Yuzhno-Sakhalinsk. Citibank has opened branches in St. Petersburg, Kiev and Alma-Ata. Intel runs offices in Novosibirsk and Nizhny Novgorod. The companies are driven not just by a desire to enhance their image and facilitate field research – they are also attracted by the cheap workforce.

Local Hindrances

Yelena Kolesnikova says the office property market in the regions is faced with several serious problems that impede its development. Those problems are a lack of analytical data and statistics, which effectively enables landlords to set rental rates arbitrarily. Also, there is the problem of poor marketing both at the early stages of the projects and after the completed developments are presented to the market.

The quality of construction is low, there are no uniform standards and no experienced consultants, and there are gaps in the legislation governing the development and maintenance of commercial properties. But the main problem is the regions’ failure to attract investment.

Sergei Lobanov has proposed his classification of all the hindrances that office developers are faced with in the provinces. Firstly, local businessmen oppose the projects, fearing stronger rivals from the capital. Local governments also create numerous administrative hurdles. Then, there is a dire shortage of professional partners such as realty consultants, analysts, management companies, etc. Relations with local partners are complicated due to lack of mutual trust and frequent failure to honor commitments.

In fact, while the locals think: “Let’s not allow those self-conceited guys from the capital think they are the kings here,” their Moscow partners say: “With or without them we still have projects in a dozen other regions.”

Money Is Always Scarce

Lack of financing is one of the key problems. Rich investors are ready to spend money on regional office development, but sometimes their willingness alone does not suffice. Every region pursues its own policy in order to attract investors.

An interesting approach is exercised by the Krasnodar and Rostov regions. In an attempt to attract investment their governments have set up a string of investment agencies, both at home and abroad.

Anatoly Ushakov, head of the regional programs department at the National Direct Investment Agency, believes that Krasnodar and Rostov are Russia’s most active regions in terms of investment policy.

The Krasnodar authorities have set up a joint-stock investment fund modeled on the partnerships between the government and the private sector widely practiced abroad. The government acts as a partner in the Krasnodar fund with a 30% stake, offering financial guarantees to private investors, thus alleviating their risks.

The capital in the fund amounts to about $150 million. The fund is set to raise finances for all the promising projects in the region.

To spark interest among foreign investors the regional government has held road shows in Great Britain and the U.S. Krasnodar officials also attended the international real estate forum MIPIM in Cannes, and succeeded in securing more foreign investment for Krasnodar than there is in St. Petersburg, market analysts say.

As Sergei Riabokobylko, senior executive director at the Cushman & Wakefield/Stiles & Riabokobylko, put it at a recent conference, the cost of acquiring commercial properties in St. Petersburg is lower than Krasnodar. Perhaps, this is because Krasnodar delivered a brilliant publicity campaign in Cannes.

The Rostov Agency for Investment and Development (RAIR) was set up by a team of professional managers responsible for the region’s investment policy. They look for investors, oversee development projects, etc.

Most Russian regions do not make much effort to attract investors, who come of their own accord. There are towns, of course, where municipalities venture on publicity campaigns in Moscow. For example, in the course of 12 months the Penza administration published data on a 370-hectare plot of urban land put up for sale in the town, allotted for new housing construction, and another 160 hectares for mixed-use developments.

The structure of capital varies from region to region. But the trends are similar in cities with a population of over 1 million.

Matt Lewis, investment analyst at Noble Gibbons, has studied the cases of Yekaterinburg, the prosperous Urals industrial area, and Kiev, the capital of Ukraine. Moscow investors account for 5% of the funds invested in Yekaterinburg’s office development projects, local funds make up 95%, while foreign investment is virtually non-existent.

In Kiev, Muscovites account for some 15%, local investors 60%, while the share of foreign investments is about 25%. Some 15% of Yekaterinburg’s office projects use bank loans while in 80% of cases the financing comes from the funds of the developers or the companies who ordered construction. Only 5% of projects receive financing from investments funds.

In Kiev, bank loans account for some 30%, the companies’ own funds 55%, while investment funds account for 15%. The leading investors in Kiev are Mandarin Plaza, Arena Entertainment, ISA, Podol Plaza, HCM, and NCH. The key banks providing loans to developers are Raiffeisen, HVB, and Ukraina.

The Russian ruble remains the main currency unit in commercial property deals across Russia.

Classification Provincial Style

Given the dire shortage of high quality office space in this country, companies in the regions solve the problem of housing just like their Moscow colleagues. They rent rooms in former Soviet-era research institutes, basements, residential apartments, schools, etc.

In the Russian capital the total space of Class A offices, according to leading realty consultants, stood at nearly 1.5 million square meters in early 2005, while Class B office space amounted to 2.8 million square meters.

While, for example, in Kazan, a city with a highly developed commercial property market, there are only four operating Class B+ business centers with a total space of 14,700 square meters. In St. Petersburg, the total space of Class B+ offices stands at 100,000 sq.m.

The classification of office buildings in the provinces is highly conditional. Attempts to apply Moscow standards have proved futile, even in St. Petersburg. Moscow experts designate regional offices as belonging to Class A or B solely for their own convenience.

The regional office markets are still too short of business centers whose properties match the Class A criteria of Moscow. It would be more appropriate to describe successful office projects in the provinces as “high-quality”, says Yelena Kolesnikova.

Many international companies would like to buy offices in completed developments in the regions, while local developers are set on selling off their properties. However, they are still unable to offer true Class A offices.

As a result, many foreign firms are forced to act as developers for their regional offices. Knight Frank’s analysts believe that for the time being regional tenants, too, regard their offices not as a corporate asset whose category can help boost profits but as a loss that needs to be minimized.

Regional offices can be described as high-quality developments provided they are built from scratch or redeveloped for office use. On the other hand, local developers are starting to understand that the quality of the existing supply fails to satisfy tenants arriving from other cities and that higher quality means higher rental rates, Kolesnikova notes.

That is why there is hope that international standards will soon be adopted by the regions. The ever-increasing influx of foreign tenants and real estate consultants will introduce the relevant criteria, something that many market analysts agree on.

But it should be taken into account that regional markets are not as large as that of Moscow and the developers’ prosperity and the stability of their positions will depend on how soon they begin their work and how sound is their approach.

Northern Venice

St. Petersburg is considered a highly developed office region not just in terms of the volumes of projects already launched but also because it has followed Moscow’s lead. The improving investment climate of the Northern capital attracts both Russians and foreigners.

Matt Lewis notes that St. Petersburg is one of the few Russian cities where the city government is directly involved in attracting investments in the city economy.

St. Petersburg’s economy has begun growing rapidly, GVA Sawyer’s president Cameron Sawyer said at a commercial property conference. The rate of return from office centers under construction is estimated at 28-35%.

Although St. Petersburg’s market is smaller than that of Moscow, investing there has more prospects than in Moscow where returns are dropping. The demand in St. Peteersburg is high while the supply is low. The administrative risks are lower here than in the capital.

Investors are ready to conquer St. Petersburg’s office sector in spite of its biggest single drawback – the characteristics of the buildings described as Class A and B have nothing in common whatsoever with the internationally accepted standards. Office classification has never been fully accepted here.

But the city’s great advantage is the transparency of the local government’s policy towards investors and developers based on principles that are the direct opposite of those in Moscow, holds Sawyer.

By the end of 2004 St. Petersburg had some 740,000 square meters of space in business centers, according to Colliers International. Another 170,000 square meters of office space will be commissioned in 2005.

The largest of those will be the second stage of the 17,000-square-meter River House complex on Ulitsa Akademika Pavlova (Class B+), the 16,500-square-meter T-4 business center on Ulitsa Sedova (Class B), 13,000-square-meter Sheremetev on Prospekt Stachek (Class B), and an 11,200-square-meter business center on Levashovsky Prospekt (Class B).

Annual rental rates in the Class B+ segment stand at $450 to $480 per square meter; Class B offices are rented at $300 to $320 per square meter.

According to Knight Frank, St. Petersburg has four remarkable business centers – Atrium at 25 Nevsky Prospekt, Swedish House at 2 Shvedsky Pereulok, Belye Nochi (White Nights) at 23 Malaya Morskaya Ulitsa, and Severnaya Stolitsa (Northern Capital) at 36 Naberezhnaya Moiki.

City–Pacemakers

Kazan, the capital of Tatarstan, is one of the most successful Russian cities with a population exceeding 1 million. It is one of the few provincial capitals where the retail property market is already nearing saturation with nearly 1 million square meters of total space. The commercial property sector attracts huge investments. Oil money is also available here.

Kazan’s most popular business area is the Vakhitovsky district in the city center, Noble Gibbons states. Class B offices are let for up to $270 per square meter per year.

The total supply of office space of various classes stood at 375,000 square meters by the end of 2004. Detached business centers account for 220,000 sq.m.

Properties positioned as Class B+ include the 4,000-square-meter Tataria commissioned in 2002, the 3,200-square-meter Suvar built in 2003, 3,000-square-meter Taif (2003), and the 4,500-square-meter Sakura (2003).

The base rental rate there stands at $220-260 per square meter per year. All the four developments were built from scratch. One of Kazan’s leading developers is the company Suvar-Kazan. Class C and D offices with rental rates of $120-140 per square meter account for most of the supply.

The Big Four of Moscow’s leading real estate consultants are active in the Russian cities with populations of over 1 million. For example, CWSR is an agent for one of the Kazan projects.

The company has hired and trained a team of local consultants whose task is to oversee the final stages of development at the Idea business park project in central Kazan. The total space of the development is 30,000 square meters, including 13,073 square meters of rentable office space. The building will be ready for furnishing this summer.

In Nizhny Novgorod there are some 40 business centers including both newly built and redeveloped properties, according to Noble Gibbons. The total supply stood at 1.2 million square meters at the end of 2004. Top quality business centers account for 140,000 square meters of the total office space in the city. Large and newly built developments are concentrated in the city center.

Over the past two years, rentals grew by 60%, reaching $140 per square meter per year by the end of 2004. Newly built office centers are leased out at annual rates of $350-420 per square meter.

The average sale price is nearing $800 per square meter across the city, and up to $1,100 in the prestigious historic center, while the maximum rate runs as high as $1,500-1,700.

The 22,200-square-meter Stolitsa Nizhny business center, comparable to Class A-B properties, offers 15,800 square meters of office space let at $300-480 per square meter, incl. VAT and operating costs. The 6,000-square-meter Class B Teledom complex is currently under construction to be put up for sale at $1,350 per square meter.

Jones Lang LaSalle is involved in a number of projects in Novosibirsk. One of those is the Class A center on Ulitsa Shevchenko featuring both offices and hotels. The 19-story development will have a 162-space underground parking area and a 66-space outdoor parking lot.

Novosibirsk has about 200,000 square meters of office space, including 12 Class B business centers. They are, in particular, the buildings of Lanta-Bank, Sberbank and Vneshtorgbank. Some of the properties of the new generation are quite spacious, like a 14,000-square-meter business center commissioned in 2004, with offices let at $300 per square meter, excluding VAT.

2004 saw the commissioning of an 11,000-square-meter facility where rentals are $300-350 per square meter. Many Moscow developers are present in Novosibirsk. Well-known locals are Sibirskiye Sotovye Sistemy (Siberian Cellular Systems), Stroimir and Sibirstroiinvest.

Sibirstroiinvst is set to develop what may become the city’s largest office center – a 29,000-square-meter Class A office center. The Transservis oil company plans the development of a 28,000-square-meter office and retail center on Krasnoyarskaya Ulitsa, intending to raise investment of $15 million.

Knight Frank has drawn up a list of office centers of the highest quality operating in prosperous Russian cities with populations of over 1 million. The building of the International Commerce Center in Yekaterinburg is one of those. The development is the best in the city in terms of quality of construction and services rendered. The center has 2,500 square meters of space for rent with offices let at approximately $500 per square meter. The second stage of the complex will have a total area of 51,000 sq.m. Samara’s top quality office buildings are Skala, Big Ben and the offices within the Ladia residential estate.