Market Know-How: Retailers Rethink Real Estate

Rent or Buy?

Usually, upon finding a property that suits them the retailer does not mind either buying or renting it, leaving it for the landlord to decide whether to sell or to let it. Major retail chains in Russia, however, try to plan their share of the ownership in the outlets they operate.

For example, as early as 2001, Russia’s largest grocery retail chain, Pyaterochka, announced its plans to secure a freehold title to 40% of its stores, either newly developed or purchased from previous owners, and the leasehold to the remaining 60%. (In 2004, Pyaterochka’s sales reached $1.59 billion; by early 2005, the chain operated 445 outlets, including 210 franchising units).

So far, the company has managed to hit their targets. A special survey by Raiffeisenbank – the lead-manager for Pyaterochka’s bond issue – has shown that by the end of 2004 the chain had obtained the titles to 41% of all 235 outlets, excl. franchising units. Thus, the retailer owned 326,000sqm of its total space (warehouse facilities excluded) including 146,000sqm of retail space proper.

The arguments against purchasing retail properties are clear. The cost of acquiring one outlet may equal the 6-month rent for 10 stores. That is why rapidly expanding chains opt to rent outlets and buy the most successful of them afterwards. But at times, simple calculations show that purchasing is better than renting.

Assuming that the price of a square meter stands at $1,000 while the rent is $300 per year, the price of a 200-square-meter property will equal the 3-year rent bill. A grocery supermarket is likely to pay off in less than three years. Market analysts believe that the price of most properties on the secondary market equals the rent of 3-4 years.

A freehold is a secure bet for the retailer – if their retail business fails it will be possible to let out the property. Many agree that the tenancy market is overheating, with soaring rental rates, which means that landlords can earn good dividends.

Vladislav Kochetkov, analyst at the Finam investment company says that quite often the return on letting one square meter equal the return on retail operations per square meter. To stay afloat, supermarkets have to earn $700-800 per square meter of retail space per month. With less successful retailers, that figure can fall as low as $400.

Where net profits stand at 2%, annual income does not exceed $96 per square meter, which is less than a company could otherwise earn by letting space at the rate of $150 to $200 per square meter per year. Even if incomes are comparable, the retail business requires much more effort in terms of organization and marketing, maintains Vladislav Kochetkov.

Many companies have given up retail to lease out their properties. In one of the most high-profile deals signed in 2004, the Petrovsky chain leased its 91 outlets in Moscow and the Moscow Region to Sedmoi Kontinent. The rental proceeds amounted to $495.8 million before VAT, in 2004.

The owner of the Petrovsky chain – PFK BIN – opened 26 supermarkets across the capital since 1997, with a space of 600 to 2,000 square meters and annual sales of nearly $140 million.

Henceforth, PFK chief Sait Gutseriyev plans to engage in development projects only; in particular, he is set to build a chain of shopping and leisure facilities in the city called Festival Malls. The first Festival Mall was due to open on September 24 on Michurinsky Prospekt; two others – both 90,000 square meters – are to be launched in south Moscow before 2007.

A similar fate has befallen the Samokhval chain of stores. By the end of 2004, Samokhval operated 50 outlets with a total space of 25,000sqm in Moscow and 5 outlets in the surrounding countryside. In December, the Samokhval group announced its plan to open stores only in the Moscow Region and in the towns of the Golden Ring, while part of their Moscow properties were to be let out to major retailers.

Sedmoi Kontinent took over three Samokhval outlets of 1,000 square meters each. In the meantime, Samokhval has set out to rapidly acquire properties of over 2,000 square meters in the Moscow Region and Golden Ring towns, according to general director Dmitry Kuvshinov.

Financial group Bridge Holding, too, has closed down its retail project. In December of 2003, the group said it would open 10 supermarkets in Tula, Yoshkar-Ola, Cherepovets, Dolgoprudny, Krasnodar and Sochi in 2004. The group intended to open those stores within its own shopping centers.

However, a year later Bridge Holding gave up on the idea after the first stores failed to meet the targets set. Instead, the group decided to invite experienced retailers into the shopping centers. For example, the properties at the Tula shopping center, occupied earlier by the Apelsin supermarket, are currently rented by Marta Group (Grossmart).

Clothing chain Global USA is gradually shrinking its retail business in order to let its vacated properties. The company owns seven properties in Moscow, with a space of 2,500 to 7,500 square meters. In early 2002 Global USA let out part of its properties to Ramstore – in 4 stores, the chain ceded half to grocery supermarkets.

Over the past three years cooperation has expanded and today Global USA clothing outlets do not exceed 100 square meters in all of the four locations. Experts believe that in the long run the company will completely give up its own retail business.

In some case, store owners grow to realize that the property business is not so simple either, and sell their outlets if they fail to find tenants quickly. For example, in late 2004 the commercial and financial group TFG Partia said it planned to gradually close 17 home appliance stores.

Later it transpired that the company was also looking for tenants for its 11 Domino outlets. TFG claimed it did not plan to sell the properties. But in August Moscow developers started talking of Partia’s readiness to sell off some of its properties. In particular, the company put its Quadro retail center on Kutuzovsky Prospekt up for sale.

The Bosco di Ciliegi company, having acquired JSC GUM, never concealed that its true objective was the landmark department store on Red Square and said it may sell of branches currently being leased out.

By early 2005, in addition to its central department store, the Trading House GUM held the title to seven department stores in Moscow with a total space of approximately 50,000sqm with retail areas over 21,000sqm, and two outlets in the Kostroma and Krasnoyarsk Regions with a total of some 4,500sqm (retail space of nearly 3,000sqm).

In August, one of the outlets – the Moscow department store Budapest (total space of 12,822sqm, retail space 3,335sqm) was sold off to the company New Retail Technologies controlled by former GUM board chairman Lev Khasis.

Dmitry Sokolnikov, the non-core asset management director at GUM, says the company plans to sell other branches, too. They include GUM Krasana near the Lyublino metro station, the GUM on Leninsky near Yugo-Zapadnaya metro, GUM Praga near the Prazhskaya metro, GUM Yadran on Profsoyuznaya Street, GUM Sport on Michurinsky Prospekt and a shopping center on Chasovaya Street rented by Ramstore.

In addition to securing properties on the secondary market, retailers take an interest in investing into the development of retail facilities. Many develop much more space than their chains actually need, seeing development as an attractive means of diversifying their business.

For example, the Kopeika retail operator plans to launch a chain of shopping and leisure centers in central Russia. Analysts believe that the company will benefit from favorable locations with heavy customer flows, as well as from high rental proceeds.

Moreover, the authorities in small provincial towns welcome the development of retail properties providing local residents – in addition to groceries and household goods – with quality leisure facilities, such as, movie theaters, bowling alleys, etc.

Retail centers are currently being developed by Ramstore, Paterson, Samokhval and other retailers. “Russia is the only country where IKEA opens Mega shopping malls,” notes Yulia Nikulicheva, a consultant with Jones Lang LaSalle.

The board chairman of the St. Petersburg-based chain Lenta, Oleg Zherebtsov, says that, unlike their Russian counterparts, major shopping operators abroad do not usually own retail facilities. More often, the title is held by other companies, for example, banks.

According to his data, 70% of Wal-Mart’s properties are not owned by the chain; Tesco and Metro have sold their properties, too. The same trend, says Zherebtsov, has prompted the hypermarket chain Mosmart to sell properties to Hypercentre Investment, a 49% stake in which was sold to Swiss developer Jelmoli Holding. Earlier, all the properties of that chain belonged to Hypercenter, which is controlled by Mosmart’s owners.

One and the Same

Having ownership of a property gives the retailer a number of options. The operator is free to include it in their company assets or to transfer it to another legal body within the group of companies. The former option is not very common in retail.

For example, until recently the title to all the properties of the Sedmoi Kontinent retail chain was held by another company, Stolichnyye Gastronomy, although both companies were part of the same group. Some even said that the chain had intentionally floated Sedmoi Kontinent’s shares on the RTS to avoid any risk to its retail properties. Admittedly, not long ago, Kontinent’s owners moved to register freehold titles to the chain’s outlets with JSC Sedmoi Kontinent. Today the company owns about 15% of all the chain’s properties.

That move was dictated by the expensive rental rates on the market: transfer prices between two affiliated companies cannot be 10% below market rates, which means even renting properties from a company belonging to the same holding becomes too costly.

And yet, there are more examples where retail outlets are owned by a different firm founded by the chain operator for that purpose. Perekryostok outlets belong to the Cyprus-based Alpegru Retail Properties Limited; Pyaterockha properties are held by Remtrans-Avto and Tseizer; Paterson-Invest owns the Paterson outlets and so on. Transferring properties to a different company enables retailers not only to keep their assets in order but also to adjust their financial results without violating the law.

Reporting lower returns is not difficult where one group controls a retail operator and a company – the owner of the property, explains Natalia Zagvozdina, an analyst with Renaissance Capital. Rental payments considerably reduce profits. By increasing or lowering rental payments it is quite easy to report zero net profit or increase it to the maximum. Low profits help minimize taxes while higher profits attract would-be investors.

Analysts have rightly noted the unexpected and unexplainable growth in profits of some retail chains. Quite often companies artificially push up profits before IPOs. For example, in 2004 Pyaterochka reported net returns of 6.7% (revenues of $1.105 million, franchising outlets excl.; net profits of $74 million), although only a year earlier the same rate did not exceed 4.5%.

Analysts’ calculations show that in the course of the 12 months ahead of its IPO Pyaterochka secured the title to a number of properties, and then increased the rate of return to attract investors. Sedmoi Kontinent’s net returns stood at 6% in 2004 (revenues of $495.8 million, VAT excl.; net profit - $29.4 million), compared with only 2.5% in 2003.

Vitaly Podolsky, Perekryostok’s finance director, agrees that pushing up returns is possible within a very short period of time, without violating the law. “The more rapidly the chains develope, the lower is its rate of return. By actively purchasing real estate, the tax on deferred profit grows while net profits drop considerably,” Podolsky says. When valuing Russian chains investors take into consideration revenues, EBITDA and EBITDA returns, because retailers manipulate tax payments and depreciation costs, he says.

Offshore or Unit Investment Funds

A company that holds the title to a property with a retail holding is liable to high taxes. There are several lawful means to ease the tax burden. The most common solution is to register the landlord in a tax haven. For example, in Cyprus, as Perekryostok did.

There is also another solution, widely practiced lately, which is to establish a real estate investment fund. For example, last year the Trading House GUM considered establishing a closed-end unit investment fund that would take over retail and warehouse facilities in Moscow, Kostroma and Krasnoyarsk. Company executives even believed they would be able to attract investors for their new developments. Those plans, however, were never implemented.

Unit investment funds are exempt from profit tax, Eduard Kucherov, head of the tax department at Baker Tilly Rusaudit, said at the time. Profits can only be earned by a member of the fund who sells his share. That is why, GUM could thus be exempt from tax on profits from rent. However, the GUM executives said they had not sought to minimize taxes but to defer tax payments.

Analysts say that many landlords today consider establishing investment funds to minimize taxation. Sergei Riabokobylko, executive director at Cushman & Wakefield / Stiles & Riabokobylko, says that such forms of property management are widely practiced by Western majors, and their popularity in Russia is growing.