Money Growing: Square Meters With Degree in Science

The true size of properties falling into the C category is difficult to estimate; they are situated largely in the buildings of former production facilities or Soviet-era research institutes, whose administrations rent out their workshops and offices seeking to make ends meet.

Office letting has proved more rewarding than scientific research and some of the institutes decided to abandon their previous role and surrender at discretion of property developers. Cases of re-organization of such entities are no longer rare in the capital.

Offices Rough-and-Ready

“Letting space has become a traditional source of revenue for scientific research institutes. Almost 90% of their properties are now occupied by all sorts of commercial firms,” Antonina Lairova, senior analyst at Prime City Properties, is convinced. “That is comprehensible for after all those research institutes need to stay afloat somehow."

“In the early stages of commercial real estate development, properties redesigned for office use on the premises of scientific research institutes and hotels accounted for the largest share of market supply," notes Vladimir Zhuravlyov, head of commercial real estate and investment at NAI Global. “Today, with developers carrying out top end office projects, the role played by those older developments has diminished significantly; they are no longer able to vie with properties of new generation."

Nevertheless, given the existing undersupply low-grade offices remain quite expensive. “Being offered no alternative, many tenants agree to put up with high costs and poor quality," says Andrei Barinsky, general director at Forum Properties. “The same rates are sometimes charged in a professional class A office in the city center and in a commonplace building somewhere in the vicinity of Tulskaya [southern Moscow]. Clearly, the latter is rented out short term and in small units, and people are ready to bear with that for a while.”

Igor Lizun, head of commercial real estate at the corporation Reskor, argues that the owners of old administrative buildings are reluctant to undertake redevelopment of their properties. “There are several reasons for that. To begin with, research institutes and state-run organizations who still hold title to those properties cannot afford to rebuild them. Secondly, the demand for those properties remains relatively stable that is why regardless of their poor quality the rates are quite high, $450 to 500 per 1sqm per year. This money is easy to make without having to spend much on refurbishment," he explains.

Lizun puts the cost of upgrading a class C office to class B at approximately $250 per 1sqm, which includes the cost of refurbishment (some $100 to $150 per square meter) plus other spending required, for example, for security guard services, extra communication lines, air conditioning systems, etc. "On the face of it the investment is worthwhile as it will pay back in 2 to 2.5 years even if the upgraded office is rented out at a rate only $100/sqm higher. But the problem is that the legal status of many research institutes and other such properties remains rather ambiguous. The majority of those buildings are government-owned. Once new owners take over the building they take steps to bring it in good order. But where the status of the property remains undefined those in charge of it prefer to collect proceeds by renting out available space "as is" without wasting time and effort on renovation. Thus, they proceed rather from considerations of easy gain.

Lizun cites the example of 32 Nizhegorodskaya Street where tenants are offered large offices for rent in a large building positioned as class B. "In truth, its class is D with all possible faults and shortcomings. But the landlords want as much for it as for a normal office building," Lizun says.

Denis Kolokolnikov, general director at the company RRG, holds that projects to redevelop old NII (Russian acronym for “a scientific research institute”) buildings into prime offices are not as successful as the case is with production facilities. “While a multi-storied factory building provides large spaces, big windows and high ceilings (up to 4 meters and over), with bay spacing of 6x6 or 9x9 meters, good conditions for installation of ventilation and air conditioning systems, older Soviet-built institutes have outdated layout design with corridors and enclosed offices, plenty of small rooms and load-bearing walls, which cannot be pulled down, and ceilings are low. Redesigning a factory as a class C+ office is possible at the cost of $300 to 400 per 1sqm; converting a production facility into a class B property would require spending $500 to $600 per 1sqm. But upgrading a NII building to a top class office is fraught with quite a few hazards, as those properties, for the most part, are old panel blocks,” says Kolokolnikov.

A standard NII building measures 7,000 to 17,000sqm, according to RRG monitoring data.The sale price of 1sqm of space in non-centrally located buildings stands at $1,500 to $2,500, while in the city center it may be as high as $3,500 to $4,000.

“For example, a renovated building of the former institute for scientific research near the metro station Dobryninskaya, measuring some 12,500sqm, went on sale in early November at $3,750 per 1sqm,” Kolokolnikov says. “However, such developments rarely make it to the open market as titles to many of them fail to be properly registered. Besides, landlords may prefer to sell the building directly to their tenants.”

Alexei Zamesov, executive director at the company GK Promsvyaznedvizhimost, notes that the cost of construction and assembly works does not exceed 20% from the overall cost of refurbishment of research institutes, transformed into class B and C offices. Much costlier is dealing with the Soviet-era legacy. Legal and financial risks involved include disputes with minority shareholders, defects of title and measures required to restore title deeds, unexpected problems left unsolved by previous owners (such as outstanding tax claims, long-term leases in place, debts towards third parties), social commitments and presence of other property owners, Zamesov says.

“Indeed, back in the mid-1990s the majority of operators preferred to spend as little as possible on conversion and were letting properties rated as class C and D," Zhuravlyov says. “But in the 2000s the market encountered an acute shortage of prime office space and developers focused on reconstruction projects, aimed at upgrading properties to class C+ and B. With higher rental proceeds, companies involved in refurbishment of obsolete developments secured payback in 2 to 3 years on average. The ever-increasing appeal of such projects changed the line-up of the sector. Today, for a company with insufficient resources it is practically impossible to join a refurbishment project, whereas medium-size and major operators account for more than 70% of supply.”

“Facelift projects with a view to slightly upgrade the property are undertaken by developers seeking to save on project costs and secure higher returns at minimal cost. Major overhaul of existing properties or new construction from scratch on the sites formerly occupied by older buildings are carried out by larger development firms. For example, Mosinzhstroi Development is building the business center Serebryany Gorod (“Silver City”) on the territory of the State Institute for Nitrogen Industry (27 Serebryanicheskaya Naberezhnaya); Forum Properties works on the project Forum Quarters on the site of the Central Research Institute for Allround Automation (8 Mozhaisky Val); AFK Sistema has announced plans to build a mixed-use on the site of the Research Institute for Long-haul Radio at 12/11 1st Bukhvostov Street,” Lairova reports. “Advantages of refurbishment over new construction are self-evident,” Zamesov says. “A developer secures a large plot of land at a relatively low price, access to utilities and power lines, favorable terms of lending through project financing and fewer bureaucracy-related risks.”

Alexandra Kryzhanovskaya, office real estate analyst at Cushman & Wakefield / Stiles & Riabokobylko, says that redevelopment of class C properties is becoming increasingly popular. "There are many reasons for that. Construction costs are lower, besides, those properties are often favorably located. Among the developers specializing in refurbishment of class C and B properties there are ALM Development, Vizavi and Rubin companies,” she says.

“On the whole, the situation with redevelopment of buildings formerly occupied by research institutes is the same as with industrial facilities, it is only that the scale of reorganization is smaller," says Olga Kisarina, head of research and analysis at Praedium. “Developers are interested in NII buildings. Given the existing shortage of building plots they look into practically every site available for redevelopment, refurbishment, etc., with industrial territories, uncompleted developments and rundown properties in need of reconstruction including such as former research institutes among them. Afterwards, depending on commercial appeal of the project and the developer’s specialization he decides on the future use of the project, for example, he may move to redesign the NII building for office use."

“There are companies in the capital who specialize in redevelopment and refurbishment of industrial facilities. Those are Forum Properties, Horus Capital, Vedis Development and others," Kisarina continues. “This tendency is hardly very noticeable, as yet. But while only a couple of years ago such projects were rare today their number grows. The reasons are clear, as plots available for construction are scarce; successfully finalized redevelopment projects emerge and companies specializing in redevelopment accrue necessary experience.”

Lawful Means

There are several ways to acquire such buildings for the purposes of conversion, says Kisarina. The best deal for a developer is where the property concerned, formerly occupied by a NII, has already been re-registered and is owned by a single entity. In post-perestroika years such offers were not rare, as state-run companies successfully went private and secured ownership in their real properties, including their buildings and plots of land beneath them. If this is the case, the developer acquires the property and launches redevelopment in accordance with the adopted concept.

The second option, less favorable for the developer, is a building co-owned by a number of entities (shareholders). The transfer of title is discussed with all shareholders. The developer may act on his own or purchase the building from a mediator (raider). Finally, the developer may acquire the building at an open auction. In some cases the government moves to get rid of such properties and puts them up for sale at an auction, with a view to have them replaced with offices, for example.

Vladimir Shmakov, chief legal counsel at Forum Properties, says that existing scientific research institutes may be conditionally divided into two categories – traditional institutes which have not gone private and are part of the Russian Academy of Sciences, and such “bastions of science” as were transformed into joint-stock companies.

Market participants polled by Vedomosti insist that redevelopment projects are interesting in both cases but each has its legal specifics.

“NIIs that fall into the first category are state-run research organizations, and properties they occupy are federally-owned," Shmakov says. To launch redevelopment of those properties it is necessary to secure approval not just of the organization that exercises operational control over the building, but also of its parent organization, i.e. the Russian Academy of Sciences, and the owner - the Russian Federation in the person of the Russian Federal Property Management Directorate (FAUFI).

Should this be the case the developer must enter into an investment agreement with the state-run entity (NII) on reconstruction (new construction) of the federally-owned property, upon securing approval from all government bodies concerned. “In line with official requirements laid down by the law in effect, securing such a contract is possible on a competitive basis; lately the federal government has stepped up control over observance of those requirements," Shmakov notes. “The investor secures the title to the completed development (such as an office building, for example) only after he has honored his commitments under the investment agreement in full and fulfilled his financial obligations to the government. For example, after he has transferred to the institute a newly built or refurbished lab, offices, etc.”

Dealing with the second group of research institutes – stock companies established as a result of privatization - is much easier from legal standpoint. After all, such NIIs are usual commercial entities, legally entitled to dispose of real properties in their ownership.

“In this case the developer may secure a building plot or a property either by purchasing the property (old buildings and developments requiring reconstruction) directly from the owner - the research institute – or by securing a controlling interest in the company, i.e. by take over the institute and becoming its new owner," Shmakov says.

“An in-depth analysis of the project with a view to detect latent risks is crucial,” Zamesov warns. “When buying a property the developer should exercise usual due diligence,” Shmakov agrees. “It is necessary to track down the history of privatization so as to safeguard oneself against claims on the part of the government and make sure that the title to the property concerned and the leasehold title to the plot are registered properly."

“Old developments have a long history of ownership,” says Anna Kozhushko, legal counsel at the law firm Magister & Partners. “Deals are often made with reference to the most recent paperwork, which is insufficient for detecting all possible risks. For example, if at some point in the past the building was sold without prior corporate approval, in other words, the approval of shareholders, the title to the property even if held by a bona fide buyer may be challenged.”

"As a rule, the alienation of a real property (an administrative building or a laboratory) is for the seller - the former NII - a major deal that requires approval by the board of directors or a general shareholders meeting; the price must be in tune with the actual market value of the real property subject to sale," Shmakov says. The lawyer warns that where the government has retained even just a small block of voting shares in the joint stock company – even if only 2% -- the participation of a government fiscal controlling body in valuation process is required which means basically that financial terms of the deal must be coordinated with the government. Moreover, a peculiar legacy of the privatization era is the so-called golden share, which entitles the government that holds it to ban the deal by blocking or vetoing it, all of which is the same.Shmakov says the buyer is strongly advised prior to the registering the deal to go through the articles of association of the JSC and if needed take measures to secure approval from the governing bodies concerned.

“But then, it is strongly advised to do this prior to purchasing any real property regardless of who the party to the deal is, as acquisition of a real property and implementation of an investment project requires summoning substantial cash resources, hence neglecting the legal cleanliness of the deal with a view to economize on time and lawyers' fees is hardly appropriate," he says.

All to often the developer may find it easier and more rewarding to purchase not just a real property but a controlling stake in the NII itself, especially where the institute holds title to more than just one building, occupying plots that are of interest to developers, scattered across the town or region. “In the majority of cases shares in privatized research institutes are dispersed among numerous shareholders, chiefly, incumbent or former employees of the company who would not mind earning a substantial addition to their salaries or even more so their old age pensions,” Shmakov says. “A bona fide developer needs to exercise great caution so as avoid having their good name well-known in real estate tarnished with accusations of corporate blackmail and using raiders' tactics. The purchase of shares at any rate must be lawful and civilized while the takeover itself must be as friendly as possible.”

This goal is quite attainable provided the incumbent governing body at the scientific research organization, having in its time succeeded in consolidating a large block of shares during the privatization (for the developer it would be better if the leadership holds a controlling interest in the enterprise), is willing to sell it to the developer on mutually beneficial terms, and in doing so, sets a good example for rank-and-file shareholders – employees, with whom it has authority.

In return, Shmakov says, the former management of the NII may ask the developer to assume additional obligations to the company, in addition to paying the contractual price of the controlling interest. For example, the developer may be asked to preserve the team and research potential of the institute, move the research organization to another location and prevent layoffs. Shmakov admits that reorganization and conversion of any enterprise is scarcely possible without dismissing staff, therefore a would-be investor should be ready to make increased social payments as required by labor law and collective labor agreements. This would help avoid social conflicts.

“To be on the safe side the buyer is advised to purchase not only the block of shares held by the state but also the shares of minority shareholders, since this is now allowed by law on joint-stock companies. Or else, the new owner of the institute where shares are held also by the government and minority shareholders, potentially dissatisfied and therefore belligerent, will be restricted in his actions and may be forced to remove the most valuable asset – real property – from the company’s assets for the purposes of future development. But the move may be challenged on various grounds, and hence, is legally unsafe,” Shmakov says.

Upon becoming a fully legitimate owner of the old developments of a former research institute, a developer who plans to build a new office complex on the site, will be obliged, just as any other builder, to enter into an investment agreement with Moscow city hall and transfer a share in the project or its cash equivalent to the city, or purchase the right to lease the building plot from the city government. The developer will then take over the old facilities as he pays off his due to the city hall. This rule applies to any developer who secured a title to the property before reconstruction began regardless of whether the building previously housed a research institution, a factory or a public office.

In the course of negotiating the project with the authorities, registering leasehold and securing approval for construction the developer will have to arrange relocation of institute’s labs, or, if the institute is to be closed, create new research facilities, i.e. to undertake what is referred to as a compensatory project. Such are the requirements set by the municipal law in the capital.

“The government of Moscow has always paid the most rapt attention to the task of preserving the city’s scientific and industrial potential when carrying out projects to regenerate territories, occupied by NII institutes and production facilities,” Shmakov notes. “These days, the city hall exercises control over developers first and foremost in accordance with the decree on additional measures to preserve and develop scientific and industrial potential of the city of Moscow (No. 221-PP, April 12, 2005). The investor obtains the right to apply for permissions and approvals for reorganization of the territory occupied by a research institute only after the compensatory project receives approval from the government expert bodies. But the permission to pull down the old developments of the former research institute may be issued only after the department for science and industry of the city of Moscow signs the acceptance act for installation of research equipment on the new site."

Nevertheless, Zamesov notes, despite all those difficulties developers view reconstruction of industrial territories as an interesting alternative to new construction.