Money-growing: Unappreciated Potential of Leasing

Those properties are for the most part encumbered by tenancies, held by small businesses who would be happy to secure freeholds themselves but cannot afford the purchase. Leasing companies are ready to do that for them with a view to convey ownership to them – on a lease basis.

Financial leases are quite common in many industries, particularly, on equipment market. Analysts report that 45 to 50% of construction equipment is being sold today in St. Petersburg through financial leases. But in real estate such schemes are still rare.

Rosregistratsiya [Federal Registration Service] for St. Petersburg and Leningrad Region reports that that so far the city has seen only 20 leasing deals involving commercial properties. Meanwhile, the demand for such services is taking shape. Those who generate it are first and foremost small and medium-size firms including manufacturing companies who cannot afford acquisition of properties in view of skyrocketing real estate prices.

Bank loans are not always affordable for them either as they fail to provide sufficient security, while a financial lease could prove an alternative source of fundraising. Smolny (the St. Petersburg city authority) is ready to test the scheme.

Properties With Makeweight

By the end of 2006 the St. Petersburg property fund plans to sell approximately 900 nonresidential properties, mostly built-ins and annexes. The average final price now stands at $1,000 per 1sqm, although small centrally-located built-in spaces are often sold for much higher prices. For example, in November an 84sqm first floor property at 13 Zagorodny Prospekt was sold for $2,840 per 1sqm; a 60sqm basement property at 57 Bolshaya Morskaya was acquired for $2,265 per 1sqm.

KUGI, the St. Petersburg state property management committee, orders sale of all properties let at rates below 50 c.c.u. (1c.c.u. is approx. 35 rubles or 1 euro) per 1sqm. Those are for the most parts properties situated on city outskirts, in the courtyards without direct access from the road and semi-basements, where the rent is paid in advance till the end of 2009 or for a longer period regardless of the size of rent and location, if a tenant is exempt from rental charges for 12 months and longer in payment for capital repairs cost, and finally if the occupant himself has filed a bid for acquisition of the property (then his application will not be satisfied only if the property in question is located on one of the 11 streets recognized as commercially appealing). Under the law in effect tenants enjoy no priority right to purchase their properties. At auctions they have to vie with outsiders who are quite often far better-off.

“That is a stalemate, indeed. Small entrepreneurs take over rundown properties from KUGI, refurbish them at own expense and then are forced to compete with major businesses for them. They have dug their own grave having increased the market value of their properties by repairing them. I believe that is extremely unfair. It is necessary to campaign for amendments to the federal privatization law,” holds Valentin Botsvin, head of the economic security commission of the public board for small businesses under St. Petersburg governor.

“The new law is yet to be adopted but the city administration is nevertheless interested in tenants who have sufficient financial vehicles to bid and win tenders,” says Vladimir Zhukovsky, deputy chairman of the St. Petersburg property fund in charge of economy and finance. “In fact, there are two such vehicles – mortgage loans and financial leases. The former is obvious and clear. But it does not work yet as here we are facing a legal problem – a time gap between the transfer of title to the buyer and registration of the mortgage deed. In this case the lending bank is exposed to risks. Eliminating the conflict is possible only by amending legislation on mortgage lending. That is why leasing takes on special importance today.”

The property fund has already signed framework agreements on cooperation with several leasing companies (Zest, Globus Leasing, Baltinvest and a leasing firm run by Nomos Bank). The list is not closed yet. Officials welcome all serious market operators to cooperation. “In 2007 we plan to sell at least 1,000 nonresidential projects. More than half of those have tenancies in place. As a rule, occupants have been holding tenancies there for years, they pay rent regularly, which means their businesses are quite stable. They are quite reliable partners for leasing companies,” Zhukovsky says.

One of the first companies to sign a deal with the municipal property fund was Zest. The company is ready to buy properties with a view to let them for a period of 24 months and longer. The client is required to make a down payment of 20% of the total amount. Zest is ready to consider properties offered at auctions for the initial price of at least 2 million rubles.

“We start with examining the market value of the property concerned and possible risks that may arise from the acquisition,” says Svetlana Ryasnaya, deputy general director at JSC Zest. “Before making a bid we set the maximum price we are ready to pay for the lot.” The company has not taken part in any auction yet but over the past eight weeks it has already received 30 applications from tenants. The total portfolio of bids has exceeded $3 million.

The company JSC Baltiisky Leasing already has experience with auctions, albeit negative. “We also had agreed with the client on the stop-price and included the clause to the effect in our leasing agreement. During the auction it was exceeded more than twice. We withdrew our bid. What was there to do in such a situation? It is impossible to revise the deal during the bidding. Admittedly, in that case the tenant himself was not ready to acquire the semi-basement property on Vladimirsky Prospekt for $4,500 per 1sqm. He told us he saw no way how he could possibly recover such costs,” says Vladimir Naimark, commercial director at Baltiisky Leasing.

The same happened to a client of the leasing company XXI Vek. “We had agreed on the price of 2 million rubles but at the auction it jumped to 10 million. Is it possible to build cooperation with leasing firms when we cannot be certain about prices?” XXI Vek’s general director Larisa Pushilina wonders. Valentin Botsvin says: “Only after the federal government enshrines the bona fide entrepreneur’s right to buy out the property, even if at a market price, it will be possible to forecast the price of the deal. Then we will witness a real surge in demand for leasing services on the market of municipally-owned real estate.”

But then, the property fund believes that as early as today financial leasing has good prospects; the main thing is to hire a competent appraiser capable of estimating the price with a high degree of precision. Vladimir Zhurkovsky hopes that the city will see the first deals in late 2006 – early 2007.

Advantages Vs Disadvantages

One of the main advantages of the leasing scheme for the buyer is the profit tax reduction as leasing payments are charged to the prime cost of produced goods; besides, the company is allowed to use accelerated depreciation. “Leasing is a unique vehicle for supporting the real sector of economy,” holds Tatiana Pozdnyakova, head of the Northwest Leasing Association. “It offers advantages to companies who pay payroll taxes and report their takings in full.”

Nevertheless, leasing schemes are still rare in real estate. There are several reasons why it is so. Not all leasing companies actively promote their services due to certain problems of legal nature. “There are certain contradictions between the Civil Code, laws on financial leases and registration of titles to real properties,” says Irina Moltasova, head of the real estate leasing department at JSC Zest. “That is exactly the reason why leasing agreements have not yet become popular.”

From a legal standpoint the difference between a financial lease and any other lease is that at the moment the deal is signed the leasing company does not hold the title to the property which it conveys to the lessee. But under the law on registration of title deeds a lease constitutes an encumbrance or restriction of ownership rights. That is why registering a lease agreement is possible only after the leasing company has already registered its title to the property.

But the succession of actions in this case is of fundamental importance. “Namely that succession forms the essence of the agreement. If the order is not observed any controlling agency, first and foremost, a tax inspectorate may construe leasing as a usual tenancy. What does that spell for the leasing company? It loses the right to accelerated depreciation, becomes liable to extra profit and property tax and faces fines,” Moltasova says. The only solution is to apply for registration of both deeds simultaneously and hope that the Federal Registration Service would agree to register both on the same date.

Another serious obstacle impeding the development of that market is the behavior of sellers. “On secondary markets landlords are still reluctant to state the actual sale price in agreements and indicate the book value instead. Nobody is willing to pay profit taxes. Quite often a building worth 10 million is sold for 1 million on paper. Only where new developments are involved real prices are indicated in sale agreements. What kind of problems such situation spells for the lessor? Banks extend loans to leasing companies on security of real estate purchase and sale agreements. The amount indicated in the agreement is exactly the amount the bank will transfer to the borrower, and not a cent more. Even if the property is valued much higher than stated in the agreement,” says Vladimir Naimark.

Time will be needed for the situation and sellers’ mentality to change. “For the time being the market situation is such that the rules of the game are set by landlords. They show no interest in complicated leasing schemes. High liquid assets are scarce and buyers are forced to adjust to sellers’ requirements and raise loans if their own funds are insufficient,” says Tatiana Kirsanova, head of commercial real estate of the Adveks Rosstro company.

It should also be remembered that leasing schemes are not applicable to all properties. “Commercial properties are sold out increasingly often before the development is completed. But leasing schemes are not applicable to uncompleted buildings. Besides, you cannot acquire a plot of land under a leasing deal, which rules out acquisition both of the property and land beneath it,” says Ilya Yeremenko, general director at Praktis Consulting & Brokerage.

But then, leasing companies offer an alternative. For example, if the deal involves the sale of a building and a plot of land beneath, the building is transferred to the client under a leasing scheme while the land is let under a conventional lease. After all payments are made by the lessee under the lease deal he secures the title to the property and the right to purchase the plot. Such a deal has been reported by the company Progress Neva Leasing.

Businesses who are interested in acquisition of properties under an installment plan also have reasons that prevent them from enlisting services of leasing companies. One of those is the timing of deals. Most companies agree to transfer properties to lessees for a maximum term of five years, in rare cases for seven years. Vladimir Naimark sees the problem in the underdevelopment of the entire financial services market. Terms of leases will grow longer as long foreign money flows into the country. “While only a couple of years ago a 5-year lease was seen as an impossible dream today it is a norm. If we live to see 10-year deals then considering triple depreciation deductions allowed under lease agreements, that will allow writing off even a newly built property before the lease expires,” Naimark says.

The Aventin Nedvizhimost realty says it receives quite a few expressions of interest from clients willing to sign lease deals but they are warded off by the fee charged for the service. Interest payments today stand at 8 to 12% in Russian rubles from the cost of the property, depending on its characteristics, risks, etc. In some cases even higher rates are charged. At this, the average profit margin of a leasing company stands at 2 to 4%, according to Vladimir Naimark’s estimates. “The competition on the market is already very strong. In my opinion, rates charged under lease agreements correspond to the current financial situation. Of course, the client would rather buy a property interest free. But then he will derive unjustified profits as another company will pay charges in his stead while the value of the property grows, at least due to inflation.”

The initial payment under a lease agreement usually amounts to 15 to 25% of property value. Another hindrance is buyers’ ignorance of the financial lease legislation. For a small entrepreneur who himself stands at the counter in his shop or serves drinks in his own caf? it is hard to grasp the niceties of the financial lease. Characteristically, the handful of lease deals the market has seen so far involve predominantly industrial properties. Production companies already familiar with equipment leasing schemes apply them in real estate.

The current attitude towards financial leases is reminiscent of the situation on the mortgage lending market of several years ago. Igor Gorsky, development director at Becar Realty, believes that just like mortgage lending the leasing market also needs active government support. “Mortgage schemes were discussed for a decade or so but they would have never been introduced if the government had not taken appropriate measures. Interest rates on lease operations must be lower than on bank loans. Only then that segment will begin to grow,” Gorsky maintains. “Introduction of legal leasing schemes will help legalize financial flows. Mortgage lending is a mass market, financial leasing is more targeted. Properties (especially production facilities) are harder to select and evaluate than standard homes. However, we cannot say which of these vehicles has higher potential.”