Money-Growing: Investors Breaking Into the Provinces

Russian cities with a population exceeding 1 million are gradually running out of vacant sites as the number of projects grows. But each region has its own specifics that Moscow firms, investors from neighboring provinces, and, especially, foreigners have to take into account.

Construction of commercial properties has been launched in practically all major developed cities across Russia and the CIS (former Soviet republics), such as St. Petersburg, Novosibirsk, Nizhny Novgorod, Alma-Ata, Kazan, Samara, Perm, Kiev and many others.

Properties are being erected and markets formed through the efforts of both local and external investors. But regional firms still lack experience in commercial property development while outsiders often fail to understand local specifics.

The conference “Commercial Real Estate in Russia: Management, Investment, Development,” held in St. Petersburg in late September, was partially aimed at filling up those gaps. The delegates discussed investment strategies for purchasing and financing projects, risk management, management and maintenance of finished properties, etc.

Alexander Sharapov, vice-president of the Managers and Developers Guild, believes that retail developers are most active in the regions, closely followed by the office sector. The warehouse sector in the regions is still in the earliest stages of development with storage facilities being erected for “own use” while speculative development projects are rare.

The same is true for quality office properties (that can be rated as class A). Companies erect them mostly for their own use, built-to-order projects being rare, and office properties almost never make it onto the market. Some cities suffer from a dire shortage of offices, such as Yekaterinburg, for example, where the International Commerce Center, currently under construction, will be the only class A property.

In all the major cities the demand for commercial properties considerably exceeds the supply, according to market analysts. Sergei Riabokobylko, chief executive at Cushman & Wakefield/Stiles & Riabokobylko, notes that while rates are growing, the supply of quality properties in the regions remains low due to increasing demand.

Provincial Pioneers

Regional commercial property markets develop unevenly. For example, Moscow has 0.35 square meters of office space per head while in St. Petersburg that figure stands at 0.16 square meters, in Samara it is 0.08 square meters and in Novosibirsk it is 0.15 square meters (source: Knight Frank).

Moscow and St. Petersburg are commonly recognized market leaders. Commercial properties grow rapidly in Kazan and Novosibirk, as well as Perm and Kaliningrad. The ongoing construction boom in Kaliningrad began in 2002, the Managers and Developers Guild reports. These days, the city has some 130,000 square meters of office space, of which, however, only 15,000 square meters can be rated as class B in terms of their technical condition and level of property management.

Office centers in Kaliningrad fall into three groups. 60% occupy the premises of Soviet-built scientific-research institutes and factory management headquarters taken over by joint-stock companies. The second group – some 20% – includes redeveloped administrative buildings. Such is the MarinPo building on Sovetsky Prospekt, and a BIN-bank office on Vasilevsky Square. Office properties under construction make up the third group.

Developers are most active in the city center. Most projects have been launched by local companies. The Kaliningrad Business Center group of companies leads the way in office development, accounting for nearly half of all class B office properties in the city. Three large multifunctional centers with a total space of 40,000 square meters will have been commissioned in Kaliningrad by the end of 2007.

Annual rental rates range from $180 per square meter in former administrative buildings to $360 in newly built complexes in the city center.

The retail market is the fastest growing, with the total volume of retail properties – small vendors and mobile kiosks excluded – exceeding 200,000 square meters, according to the consumer market department at the Kaliningrad mayor’s office.

By the end of 2004, Kaliningrad had approximately 450 square meters of retail space per 1,000 residents. (In Moscow that figure now stands at 100 square meters of retail space within shopping malls per 1,000.) Retail rentals considerably exceed office rates - $600 to $1,800 per square meter.

In the first six months of 2005, the city of Perm saw office properties on the first and second floors of residential estates being offered for rent. Such properties make up 34% of the total supply. Nowadays, Perm has some 15 office centers where tenants are provided with a package of extra services, including security, cleaning, catering, etc. Most of those properties are located in the city center, in the Leninsky and Sverdlovsky districts.

Former scientific-research institutes and administrative buildings, too, are rented out as offices. Those properties – accounting for 8% of the total supply – are to be found in almost every part of the city.

The minimum monthly rental rate registered in the city stood at 120 rubles per square meter while the maximum rate was 1,200 rubles. The highest demand in 2005 was registered for properties of up to 100 square meters with good quality interiors, offered at relatively moderate rates of 500 to 550 rubles per square meter per month.

Regional Traits

What is common about the regional markets is that they yield high returns, says Natalia Pirogova, financial director at Fleming Family & Partners (FF&P). While returns on retail development projects in Moscow bring 16-20%, in some other large cities the figure is even higher.

Investors take an interest in regional markets where quality properties are scarce and returns are high. The key risks investors face in such areas are poor legislation and lack of transparency, says Pirogova. Technical problems to be taken into consideration when planning development projects in the regions are those that arise from the difficulties of managing properties from a distance.

As to the management of a finished property after it is commissioned, the opinions of leading regional market players differ.

Mark Afraimovich, managing partner at the Torgovy Kvartal (Retail Quarter) group, believes that management companies are needed in every part of the country where commercial properties are being erected.

For his part, Oleg Lugovoi, general director of the Novosibirsk-based management company ABC Office, believes that investors are so excited about the prospect of high returns they barely attach any importance to property management, because for the time being – given the low level of supply – the market easily absorbs virtually all kinds of properties.

Few tenants – with the exception of major international firms – when moving into new offices or shopping malls in the provinces ask who manages the property. The dearth of property managers and maintenance companies is felt in all regional cities, most experts agree. Conclusions as to how to invest, what risks one should be ready to deal with and how to run finished properties can be made proceeding from the state of affairs on each particular market, and the local specifics.

Northern Markets

St. Petersburg has 14 square meters of non-residential properties per person, says Alexander Sharapov. But the statistics are misleading as the figure of 14 square meters refers to all types of non-residential space, including properties operated by public services.

The true state of affairs on the local office market is such that the demand for quality properties considerably exceeds the supply, despite a large number of projects launched over the past few years.

In terms of investment appeal, St. Petersburg ranks second only to Moscow, says Cameron Sawyer of GVA Sawyer. Risks and returns on real estate investment in St. Petersburg are still high, according to market consultants.

This year saw a number of landmark events. For example, in early 2005, Orient-Express bought a 93.5% stake in the 5-star Grand Hotel Europe. In another important development, Stockmann secured a freehold to a plot of land and a complex of buildings in a central location – on Vosstania Square – near the Moskovsky Train Station. The office property market witnessed a large investment deal where the RGS-Nedvizhimost realty firm purchased the operating class B office center President.

The St. Petersburg city government has introduced the practice of selling government-owned shares in major hotels, shopping malls and office centers. This year, the city has sold its shares in two large hotels, the Moskva and Oktyabrskaya. The company Mercury secured the right to develop and run the celebrated DLT department store. The government also plans to sell its stake in the Atrium business center at 25 Nevsky Prospekt, the first-ever class A office property in St. Petersburg.

The city authorities have approved a list of 11 strategically important projects and five strategic investors entitled to certain privileges, i.e. tax exemptions and the right to secure plots of land for development, Bekar reports. The largest projects on the list are the Marine Fa?ade envisaging development of a 450-hectare plot of land in the western part of Vassilyevsky Island, and the Baltic Pearl residential development on a 208-hectare plot in southwest St. Petersburg.

Market analysts put the rate of return of office development projects in the city at 28-35%. 17 office centers – six class A and 11 properties rated as class B+/B – are slated to be commissioned by the end of this year, Colliers International reports.

The largest are the second phase of the River House business center on Akademika Pavlova Street (17,000sqm, class B+), the T4 business center (16,500sqm, class B) on Sedova Street, Sheremetev (13,000sqm, class B) on Prospekt Stachek, and a business center on Levashovsky Prospekt (11,200sqm, class B).

Class A office rents are noticeably lower than in Moscow. Offices here are rented at $600 per square meter per year, on average; although there are offices in central St. Petersburg rented out at $500 per square meter, says Alexander Sharapov.

In the first six months of this year, six modern shopping malls were opened in the city, the smallest being 8,000sqm. Beginning in 2005, the total supply of retail space grew by 140,000sqm to 1.3 million square meters.

The Vyborgsky, Primorsky and Central districts have the best provisions in terms of retail space. One foreign firm active in the city is the Finnish firm Rautakesko of the Kesko Group. The company has secured a 100% stake in the local DIY chain Stroimaster, hitherto owned by local group Teks. The deal was valued at 19.6 million euros.

Finnish Stockmann has bought a complex of buildings on Nevsky Prospekt from the German firm SPAG; Sweden’s IKEA is currently raising a 120,000-square-meter Mega mall in the village of Bugry. Another mall of the same chain is under development in Kudrovo (150,000sqm). Anchor tenants in both malls will include Auchan and Obi.

Those are just a few of the variety of deals and projects being launched on the St. Petersburg market.

Novosibirsk is another regional market worthy of attention. The major Russian banks Lanta-Bank, Sberbank and Vneshtogbank have offices in the city. One of the most recently commissioned projects is a 14,000-square-meter business center where offices are rented at $300 per square meter, VAT excl. The property was built in 2004.

Globex Bank is set to build a large shopping and leisure center – the Frunze Shopping Quarter – in Novosibirsk. The bank plans to launch construction on Frunze Street next spring and to commission the 65,000-square-meter property in 2007, says Vladimir Yegorov, head of investment projects at Globex. The bank has purchased the project from the Inter-Bank Investment Group, or MIG, by buying into Torgovy Kvartal Novosibirsk. The projected investment is over $70 million.

Oleg Lugovoi, head of the company ABC Office and chairman of the Novosibirsk guild of property managers, says reports of local players preventing external investors and developers from entering the city market are mere rumors. In truth, a lack of financing is felt in the city, he says. Although the construction of offices and shopping malls is underway, supply is unable to catch up with the demand. Rents at shopping centers stand at $40-100 per square meter.

Office rents are paid in rubles, as in many other Russian regions. The average market rate stands at 1,100 rubles per square meter. Properties in business centers are still sold in pieces – a practice that differs from that adopted on the civilized European markets. The city is short of prime office properties, such as those being developed in Moscow. At the same time, Novosibirsk has already seen a deal where an entire office building was sold for $2,000 per square meter.

Until recently, investors in Novosibirsk had to pay so-called town planning levies to the authorities, says Lugovoi, but local entrepreneurs have succeeded in putting an end to the practice. Building plots are available either as long-term leaseholds, or a freehold title can be secured at an open auction.

Lately, the development of logistics parks has begun in the city and its suburbs while industrial estates are gradually being withdrawn from the center, as is the case in Moscow.

Investors and Risks

Investors show interest in all commercial property sectors in the regions, Cushman & Wakefield/Stiles & Riabokobylko reports. In particular, foreign investment funds such as FF&P and Invesco examine properties which could be worth buying, explains Maxim Kunin, a consultant at Morgan Stanley.

But, professional consultants are convinced, regional cities have no grounds for harboring illusions that investors themselves will arrive in large quantities and will immediately set about building or purchasing properties. Regional governments could benefit from the introduction of various schemes aimed at attracting investors, following the example of St. Petersburg or Krasnodar.

Anton Avdeyev, board chairman at the Reim SMT real estate company, believes that this work should begin with the presentation of a development company, a “pretty package” of a project. Besides, investors, especially foreign companies, want to see a detailed business plan. Even those whose projects are not likely to yield high returns still have a chance to attract investors, such as pension funds active on the Scandinavian investment market, Alexander Sharapov is convinced. Those types of companies are willing to enter Russia.

Admittedly, U.S. funds are still cautious about Russia, due to the high risks. Incidentally, most foreign investors shun projects with returns over 30% because they anticipate high levels of risk.

Then, there are conservative investors who are ready to put up with low returns as long as the project is viable. The easiest way to catch their attention is to present yourself and your projects at an international exhibition, such as MIPIM or MAPIC. Regions benefit from joint participation at such events.

Some of the commercial property sectors are more appealing to investors than others, says Anton Avdeyev. For example, businesses ready to invest in office developments “queue up for” a share in those projects, he says, as the office sector is well-studied, both in terms of development and property management (if an investor is interested in the title to a finished property). The retail center is a specific field; managing such properties requires specialized skills.

Another serious risk that deters foreign investors is poor legislation, in particular, regulations governing the construction sector where obsolete rules and provisions are still in force, says Oleg Lugovoi.

Furthermore, in every region both Russian and foreign developers also face local risks. For example, in some Russian cities it is still impossible to secure a building plot or have it reclassified so that it can be used for a different purpose without agreeing the terms with local officials on a personal basis.

Maxim Kunin sets out a list of risks investors should be aware of in Russia. They are risks arising from the legal procedure of securing building plots, the shortage of real estate investment consultants, fluctuations of rental rates on the market, and so on.

Smaller risks – of a more technical nature – include obsolescence, as even now shopping centers built some 5-6 years ago are being downgraded to a lower class. Today, the book value of all commercial properties commissioned before 1998 is below 10% of their market value. But the world market knows buildings that never grow obsolete. For example, the Seagram building erected in New-York in 1958 has still not been filled up entirely with tenants. Although designed especially for Seagram, the development proved universal, suitable for any tenant.

The Benefit of Management

Many players still do not realize that once completed, a development needs a competent manager able to ensure property maintenance and settle disputes between the landlord and tenants, maintains Vladimir Rodin, deputy head of the Gorod management company.

Yet, such an approach is effective only where a management company is fully aware of all the peculiarities of landlord-tenant relations, including financial issues, and where the landlord has a clear understanding of what he is paying the management company for.

Russia’s regional markets still lack transparency. Even in Moscow, says Rodin, about two years ago nobody was willing to divulge data about the prices they charge and the profits they make, let alone to publish such information in open media.

Today, however, it is possible to say that the Moscow property management market has been formed, the rules of the game are more or less clear, and tenders are held in 70-80% of cases. “These days, our company operates and maintains some 130,000 square meters of state-owned and private properties,” says Rodin. “For our services, we charge $4-7 per square meter per month, or $50 to $85 per year.”

When deciding to hire or dismiss a management company, the landlord is often guided by the desire to cut costs. That results in the emergence of a large number of office developments that lack any clear concept. By deciding not to hire a manager developers should be aware that in doing so they will have to bear full responsibility for the state of their properties.

Moscow witnessed a case where two floors with the offices of top executives of tenant companies were completely flooded. It transpired that for four years before the accident the management company had neglected the need for regular roof repairs because the agreement between the landlord and the management firm did not specify that the latter was obliged to do so.

Even the most developed cities are still not prepared to accept the services of management companies in full. Many owners hire building maintenance organizations to provide cleaning services and repairs but few are ready to commit their properties to someone else’s trust. Some management companies active in St. Petersburg have already spun off their maintenance subsidiaries into separate firms.

That may as well be regarded as a specific trait of the St. Petersburg market, says Yuri Koltsov, deputy general director in charge of property management at VMB Trust. “We have also set up a separate company offering maintenance services on the market. Of course, landlords are interested in the savings they can achieve by following our advice. For example, we oversee the installation of engineering systems with the view that we will maintain them ourselves, and prepare them for commissioning. That may save tens of thousands of dollars for the landlords.”

The demand for building maintenance services provided by management companies is somewhat higher on the Russian market, while such services as asset management, financial management, valuation, market positioning, optimization and re-profiling of commercial properties are not as popular, according to the experts.

Building maintenance includes services such as drafting an operational budget, maintenance of engineering systems, cleaning, development of adjacent territories, insurance, risk valuation, legal counsel, catering, setting up dispatcher services, a reception area, and parking facilities.

In the opinion of Yevgeny Yakushin, head of property management at Business Computer Center, landlords may set up their own maintenance companies, but specialized firms have more advantages, although their services are more expensive.

For a standard set of their services they charge $2-2.5 per square meter per month, for a 5,000-square-meter class B office center. The same services provided by one’s own maintenance firm would not exceed $1-1.5. But services offered by professional managers are of a much higher quality as they are provided by competent and well-trained staff.