Money-Growing: Tenants Forced to Splash Out

The changes spell a drastic jump in rates for certain categories of tenants. The city administration, often referred to as Smolny after the name of the historic palace where its headquarters are located, says that the move is aimed not only to increase budget revenues but also to create equal conditions for tenants by eliminating privileges for those of them who rent properties from the city government.

At the same time, the city officials are taking measures to increase budget revenues from commercial properties. KUGI, or the city’s main property management directorate, is renting out about 3.5 million square meters of non-residential properties. The impending revisal of rates will affect some 20,000 tenants.

Mass Approach

Unlike Moscow where rental rates for municipally-owned properties are set by independent appraisers hired by the authorities, St. Petersburg adopted a procedure of mass valuation on non-residential property as early as 1997, the first time such a procedure was adopted in Russia.

Experts at the City Real Property Inventory and Valuation Directorate (GUION) applied a comparative sales method, i.e. direct modeling of the tenancy market with the help of multiple correlation-regression analysis.

“Our counterparts in the capital have traditionally followed a different path by calculating rental rates proceeding from the market value of a property established by a hired expert. Such an approach is considerably more costly. We, on our part, do not need to spend budget funds on case-by-case market valuation,” GUION’s deputy head Sergei Gribovsky explains.

However, the mass approach that seemed ground-breaking when it was first adopted has grown obsolete over the past eight years.

“Since then, both the structure of the commercial property market and absolute prices have changed significantly,” Sergei Gribovsky says. “The city sees the formation of new areas appealing to businessmen, and new centers of influence, i.e. metro stations, pedestrian streets, commercial zones, etc.

“The structure of demand has changed as the demand for quality properties has increased, while the interest in properties of lower quality has dropped, accordingly. Thus, the patchwork of market rental rates itself has changed. It should also be kept in mind that back in 1997 the non-residential property market was rather lackadaisical, sluggish and non-transparent. Today, as market activity has increased and credible and comprehensive data have become available it has become possible to calculate rates with higher precision.

“To begin with, we have examined open source offers. Secondly, we have invited students to take part in field research. Posing as would-be tenants they contacted landlords and agreed on an inspection of properties. By gathering data we kept in mind that KUGI’s properties have certain technical specifics. It was not easy to find enough analogous properties on the secondary market.

“Then we decided to employ another method of research, i.e. to have such properties evaluated by hired experts. They were inspecting the properties and providing express evaluation of rental charges. Then the accrued data underwent statistical analysis. As a result, our database includes 1,893 properties (while in 1997 there were only 500) and we came up with a sample which, in terms of its characteristics, has proved close to a general aggregate. And this means our new model is agrees with the market situation.”

Lucrative Difference

The fact that KUGI’s rents fail to catch up with market rates saw confirmation following an experiment launched by the City Property Commission in the fall of 2004. Since then the commission has held a number of test auctions at its sessions.

If a vacant property is sought by several contenders the bargaining begins and as a result the property can be rented out at a rate considerably exceeding the rate set on the basis of the established calculation procedure. This is especially noticeable in the city center.

The government has received 31 bids for a 26-square-meter property at 11 Zhukovsky Street. While initially the rate was set at 148 conventional currency units (based on dollar or euro rates) per square meter per year, the tenancy was signed at the rate of 500 c.c.u. (1 c.c.u. = 35 rubles).

A 155.7-square-meter property at 32/1 Sadovaya Street attracted 16 bids. The rate grew from 33 to 130 c.c.u. per square meter per year. A tiny property of 10.8sqm at 13 Sennaya Square increased in price from 104.4 to 770 c.c.u. per square meter after 11 bids were made. Of course, not all city-owned ‘built-ins’ are so popular and the given examples are hardly indicative.

“We see that retail properties are the most undervalued; as for offices, especially those accessible from internal courtyards and situated above the ground floor, the rental rates set by the city are comparable to market rents,” believes Mikhail Zeldin, president of Avers Group.

Peterburgskaya Nedvishimost (St. Petersburg Real Estate) agrees that the gap in rents is especially felt in the sectors of the most sought-after properties. For example, a privately-owned multifunctional property in Bolshoi Sampsonievsky Prospekt is rented at $20 per square meter per month while an analogous built-in property in the same building costs 4.5 c.c.u. per square meter. Naturally, the state of KUGI’s property leaves a lot to be desired.

Municipal rates at Staronevsky Prospket, where properties are coveted by boutique retailers, stand at only $40-50 per square meter per month, while the average market rate in the area is $80, the Bekar realty group reports. Given such a discrepancy, it is hardly surprising that the sublease market is booming. For example, Igor Gorsky, head of Bekar Commercial Real Estate, reports that the leasehold title to a retail property on Suvorovsky Prospekt was sold for as much as $100,000.

As a rule, tenants renting space from KUGI set the price of the leasehold on the basis of the difference between the city rates and those charged on the market, providing for a certain discount for would-be buyers. Sometimes, for example, where large properties are concerned, the difference accrued in the course of a number of years is taken into account.

Although, says head of commercial real estate at Peterburgskaya Nedvishimost, Lilia Petrova, few companies risk selling leaseholds these days as they are reluctant to assume the risks arising from the possibility that KUGI might revise its rates, and opt to sublease instead. Real estate operators agree that the tenancy market has seen fewer speculative deals lately.

“The city property management directorate is closely following the developments on the open market, promptly responding to changes,” says Igor Gorsky. “Properties being subleased are, for the most part, those received from the city government a number of years ago when the gap in the rates was still very noticeable, indeed.”

Tatiana Kirsanova, head of the commercial property department at Adveks-ROSSTRO, says: “KUGI increased the rate of its conventional currency unit to 35 rubles in 2005 while the market of privately-owned properties was still operating largely in the dollar zone. The city rates for many properties are now nearing those charged on the market. Hence, the drop in demand for subleases. These days, subleases are still widely spread only where highly liquid and expensive properties are concerned, on Nevsky and Vladimirsky avenues and other main thoroughfares where the acute shortage of properties is felt and prices have risen beyond reason. Subleases bring returns to tenants who hold leaseholds on preferential terms but such companies cannot openly sublease those properties – or else, they would lose benefits – so they resort to semi-legal schemes, under the guise of various agreements on joint operations.”

Bet on the Rent

As of January 1 sublease deals will most likely become even less common. The basic principles of calculating rental rates and the main factors – location, floor level, type of entrance, etc. – taken into account will remain the same as those in effect now.

As before, the government will proceed from whether the property is being rented for retail, office or industrial use. Correction factors – 0.7 for urban territories and 0.9 for out-of-town areas – remain in force, too, with miscalculations being taken into account.

To avoid errors, GUION has revised the list of streets and thoroughfares that affect rental rates increasing them from 54 to 794 points. Furthermore, the government has compiled a list of 240 price-forming roads for industrial and warehouse facilities.

The new procedure takes into account proximity to local centers (63 for office and retail properties; 28 for industrial facilities and warehouses) and the character of development in the area. The city is divided into 5 price zones: the city center, moderate price zones, depressive zones, satellite towns and suburban areas.

GUION has switched to calculating rates proceeding from the location of entrances, not from the location of the center of the building. Hitherto, properties facing the street and those facing a courtyard could be of the same price as long as the distance between each of them and the center of the development was the same.

The new procedure is more detailed. For example, Apraksin Dvor (marketplace and storage area) is no longer seen as a closed-in courtyard, with its internal rows and lanes – Yagodny, Chernyshov, Grafsky and others – being regarded as city streets. Properties facing those lanes are grossly undervalued, because, in line with the effective procedure, they are accessible form the courtyard, and hence, cheaper. Preliminary estimates show that those amendments are likely to push up budget revenues by over 3 million c.c.u.

Besides, the new procedure lifts the ban on the use of properties situated within courtyards by retailers, because shops operating there have proved quite successful. As a result, the number of properties leased to retailers is likely to triple, from 4,690 to 14,675, while the budget proceeds will grow by some 50 million c.c.u.

“To alleviate the financial consequences for tenants, rates will grow once a quarter throughout 2006 while benefit-holders will be granted an 18-month transition period,” says Alexei Chichkanov, KUGI’s first deputy chairman. But even with higher rates being phased in gradually the government anticipates an increase in budget revenues by over 40% next year.

“We are not set to punish businessmen financially, but want to eliminate existing dumping practices. A situation where some tenants pay for properties at free market rates while others pay at city rates amounts to de-facto government support of certain firms,” says GUION’s chief Dmitry Kurakin. “Today it is very difficult to foresee the consequences of introducing the new procedure. They will largely depend on how well we have done our job. In my opinion, we have succeeded in making considerably more accurate calculations. But it is still a massive procedure, which is why an error within a 10% margin is still possible. I would like to remind tenants who may consider the new rate unjustified that the individual appraisal procedure has never been abolished.”

Under St. Petersburg law, detached buildings and properties of more than 1,000sqm are subject to individual appraisal. But even a tenant occupying a small built-in property has the right to present the results of such an appraisal to GUION should he disagree with the rate calculated on the basis of the mass procedure. Individual appraisal results are enforceable by law.

Mikhail Zeldin does not doubt that the demand for independent appraisers’ services will grow significantly. But, revising rates set on the basis of mass procedure has been extremely difficult lately, he says, because KUGI would not even look at an independent appraisal report unless it received approval from GUION.

But then, Zeldin continues, there were no grounds to demand a re-appraisal, as the rates charged by the city were, for the most part, below the market level. “Now it is crucial for GUION and independent appraisers to establish constructive cooperation as our workload will, of course, grow. I hope that GUION will show tolerance towards the conclusions of experts especially while the new procedure is being tested,” says Zeldin.

Real estate companies are very cautious in their prognoses of how KUGI’s initiative may influence the market as a whole. Mikhail Zeldin anticipates an increase in rental rates set by private landlords as well, at least in the first few months after the new rules come into force.

“I don’t think KUGI’s new policy will blow up the market. At any rate, there is no room for further growth in rates for privately-owned properties,” holds Igor Gorsky. “Nor are we likely to see the mass exodus of tenants from municipally-owned properties, although businesses attach great importance to stability. Respectable firms may consider relocation if the city moves to double charges without offering tenants any guarantees that it will not do so again before the deal expires.

“If KUGI is to compete with private landlords in terms of the level of rates, it should comply with the generally accepted trade usages, in particular, stipulating the timing and procedure of any revision of rates in the contract. Today, KUGI de-facto assumes the role of a real estate operator, not a property manager. A company renting properties from the city government is faced with a variety of problems arising from technical maintenance, ensuring security, etc.

“Many tenants are not happy with that. In wanting to shift such cares onto the shoulders of professionals, they opt for properties in privately-owned business centers. The issue of price is not the most important here.”

“The main disadvantage of renting properties from KUGI is the lack of stability,” Lilia Petrova agrees. “It is often the case that upon securing the leasehold to a rundown property a company puts it in perfect order by spending considerable funds on the renovation, whereupon KUGI pushes up the rate saying that the state of the property has improved significantly.”

City Hungry for Cash

In addition to the introduction of new procedures for rental calculation, Smolny is taking a number of other steps to increase budget revenues from city-owned property. As of October 1, 2005, some 900 commercial firms were denied the discounts on rental payments that they had previously enjoyed. They include farmers’ markets, non-government education and cultural organizations, scientific research companies, bathhouses, etc.

Anticipating a migration of tenants in the wake of the rate increase, KUGI plans to introduce a fee for the transfer of rights under tenancy agreements; its size is yet to be set.

In 2006, Smolny plans to step up sales of low-income properties through auctions. So far, the city government has been auctioning off properties where the rent does not exceed 30 c.c.u. per square meter per year. They are, for the most part, small built-ins and basement facilities in commuter areas and suburban districts. In the near future, the limit will be raised to 50 c.c.u.

Besides, tenants who pay 50-75 c.c.u. per square meter annually will be granted the right to make bids to purchase. Admittedly, so far the government has not considered target-oriented sales to tenants, as such schemes are against the law. Businessmen willing to secure a freehold title to their properties will have to take part in auctions where there is always a risk that some other company will win during bidding, especially if the property is of particular commercial value.

Properties, however, will be put up for sale along with the leases in place. If an outsider wins the bid he will have to honor previously signed deals with no right to revise rents of their own accord or evict a bona fide tenant.

“Many companies had looked forward to such a move on the part of the government. Practice shows that the higher the rent is the more serious the tenant is about the property – funding repairs – and the more willing he is to purchase the freehold,” says the head of the Property Fund, Andrei Stepanenko.

Another strategically-important issue is trust management. KUGI has pledged to transfer some 200,000sqm of municipally-owned properties to the trust in 2006. Admittedly, for the time being the scheme has failed to operate properly.

Ever since the summer of 2004 when the city legislature passed a law on trust management, not a single property has been put in the trust of privately-owned companies. Yuri Borisov, chairman of the Guild of Managers and Developers and managing director at IB Group, hopes that eventually the situation will change.

“We are eager to see KUGI publish its first list of properties to be transferred to the trust of property managers,” he says. So far, the City Property Commission has announced its plans to transfer four buildings – at 7/9 Nevsky Prospekt, at 18 Bolshoi Prospekt of the Petrogradskaya Storona district, 67 Kamennoostrovsky Prospekt and 27 Izmailovsky Prospekt – to trust. But the terms of the bids for those properties are yet to be set.

Borisov says: “Our company has had quite a lot of success running city-owned properties. While the previous regulations were still in effect the city government transferred two buildings on Petrogradskaya Storona to us. They have been redesigned as class C office centers and leased out at market rates. For example, offices at Office House at 7 Lev Tolstoy Street, with an occupancy rate of 95%, are rented at 246 c.c.u. per square meter. Our rates considerably exceed those set by the city; moreover, that difference will be preserved even despite the impending increase in city rental rates.”