Money Growing: Size Matters

The average rates of profitability of commercial real estate projects (class A and B offices, shopping centers, class A warehouses) in Moscow without taking into account credit debts are estimated at an annual level of 15-18 per cent. Further still many investors aim for a yield of 20 to 30 per cent and more. It is not surprising that market participants are trying to 'take more and throw further’: using their land plots most profitability and building not just big complexes but huge ones.

The enlargement of office real estate projects can already be considered a trend: premises are becoming higher and the office space inside has increased. In the first quarter of 2007 several multi-functional complexes were announced, each with a total area of more than 400,000 square meters.

Mirax Group and Altius Development have announced the planned construction of a multi-functional complex with a record volume of investments totaling $2 billion, according to preliminary figures. The multi-functional complex with a total area of more than 500,000 square meters will be located where the Third Ring Road and Kutuzovsky Prospekt meet, on the territory of the first building tools factory named after Kazakov.

Globeks Bank plans to invest more than $600 million in the construction of the multi-functional complex 'Slava Business Park' with a total area of almost 550,000 square meters on the territory of the second clock factory. On Kievskoye Shosse, London & Regional Properties are investing $850 million in the construction of a multi-functional complex.

And this is not taking into account the legendary Nagatino i-Land, as a result of the construction of which there will be more than 1 million square meters of office space.

According to Oleg Smirnov, deputy director of Jones Lang Lasalle's financial markets and investment department, the interest in giants is becoming the image of the moment, the aspiration to create something special, to draw on the best experience of large-scale constructions in the world's capitals and the commonplace growth of a company's personnel, many of which work to the principles of saving working space and not on optimizing its business processes.

The output of large-scale projects on the market, naturally, forces experts "to overestimate values" - to speak about future saturation of the market, to depict a future of lower rates and an increase in the times for the recovery of outlay.

Such a prognosis could sound pessimistic for developers, however at the moment the speed of building has not slowed down: analysts come to the opinion, that we should not expect the market to be saturated for at least another several years, if it is at all approaching. So, by the most optimistic forecast, demand and supply should be equal by 2010. At that time the amount of office space should reach 10 million square meters. But as is well known, on the Russian market, few projects are put into operation on time. Last year 1 million square meters were put into operation from a planned 1.36 million. This year 1.6 million square meters are proposed to be built. However in the first quarter, in all, 117,800 square meters were put into operation, which is 26 per cent less in comparison to the same period last year.

According to the forecast of MIEL, demand for office space in Moscow will be met around 2011 and 2012. Aleksei Belousov, commercial director of Capital Group holding, says that the market is not close saturation. And, at the moment, from the point of view of investment in commercial property, Moscow, according to profitability, is one of the leaders in the world.

Igor Galitsin, general director of Becar Commercial Property Moscow, also does not see a problem: "It is worth recalling the conversations that were especially popular when work on the 'Moscow-City' project had only just started. Many analysts predicted a glut in the market. However this has not happened, despite most of the space in the business centers having already been sold."

The point of view exists that in the case of lots of office space being put on the market in large office projects talk will quickly turn not to the collapse but to the redistribution of demand. "With the introduction of large establishments markets will get closer to saturation," says Dimitry Ivanchenko, the leading analyst of consulting company Russian Research Group. "But simultaneously the market is turning into a stage of competition between formats and concepts."

Already now, when speaking about the deficit of commercial space, specialists imply the deficit of quality space. "As an example", continues Ivanchenko, "there is already every basis to suppose that after lessors have moved to 'Moscow-City', office space at the business centers which they earlier leased will not be in demand. The demand for business centers of a higher class has considerably grown in the last few years." Accordingly, owners will have to either lower the rates and class of the 'old' business centers, or carry out costly reconstruction in order to meet demands.

"The stabilization of rental rates in Moscow will happen depending on the location of the offices", predicts Spartak Agayev, a mortgage broker at holding company SKM Group. "As an example, the most stable office space has been located in the centre of the capital inside the Garden Ring. The so-called 'Kremlin Segment' of the market will most likely not be affected by a fall in rates, as a location near to the Kremlin will always be exclusive and there will always be many who desire such office space."

Building a Monster

In order to examine who was right, one needs to wait until the appearance of this office space. There is a risk that by no means everything will be built. It is possible that a project will not enter the market at all or not in the same form as it was announced.

First of all there is the usual problem of a lack of funds for their construction. The way out of this situation, it would seem, is simple and intelligible - build them using borrowed money, as in the rest of the world. "At present 99 per cent of investors in the construction of commercial property establishments take out credit," says Aidar Galeyev, director of a department at MIEL - Commerical Property, "so to take them out of circulation and put them on hold for a long time does not make any sense from an effectiveness point of view" At the moment according to MIEL's data, the rate of profitability is from 15-30 per cent against 12-12 per cent respectively.

Timor Pestov, vice-president of AG Capital, agrees with him: "It is more advantageous to construct with borrowed funds on account of the usual effect of financial leverage."

There are various means of raising borrowed funds. Under a project it is possible to organize a share investment fund, a joint-stock company or get credit at interest. "Sometimes a scheme of co-investment is used in construction. "For example, the lessee at the stage of signing the contract will pay approximately 50 per cent of the price of the premises and in the future will make the payment in stages tying in with the stages of construction," says Galitsin. "As a result the co-investor becomes the full owner of the premises. However in a situation where there are several proprietors of one building it considerably complicates the management of the premises and worsens the opportunities of its subsequent sale."

"If 100 per cent of your own funds are used then the time it takes to recover the outlay of the project is considerably reduced, there is no constant control over any sort of investors," argues Galitsin. Managing such projects are much easier, so is selling them."

However, builders more often than not do not have 100 per cent of the funds for the project, and without credit it is not possible. "Here another problem raises its head - the amount of risk (legal, design, market, etc.) the creditor is ready to take on.” By virtue of that in Russia, there are complex procedures of approval and sanctions," continues Pestov, Banks are not prepared to finance the majority of projects of foreign developers at the initial stages. However, the main corporations in Russia are part of financial and industrial groups which include commercial banks. And developers can get credit at the stage of receiving the approval documentation."

But in this case the disputable question is whether it is possible to consider credit received from affiliated banks, as the investors own funds or as extra.

The normal share of extra means from the point of view of commercial banks is 30-75 per cent (can be up to 80 per cent) of the total amount of the project. However the actual structure of financing for each project, as a rule, is rather cloudy. The organizational-legal scheme may include a long chain of legal entities which, first, and most often, are limited liability companies (at best closed Joint-Stock Companies) and, secondly, may be outside of Russia.

Large developers have, if they are organized in the form of Open joint-stock companies and their shares are listed on a stock exchange, a structure of capital that is transparent only at the holding company (the open joint stock company itself) level," explains Pestov. "For large Russian companies typically the share of extra capital and shares is 30-80 per cent. At the earlier stages of the development of the company, it, as a rule, this increases, and decreases during following periods, including due to the attraction of investor funds on the stock market."

Abroad will help

Foreign investors are still drawn to the high rate of capitalization of 10 per cent which offices generally make. In comparison with London where the rate of capitalization is 4 per cent, the capital in Russia promises greater benefits. "The rate will go down with the mass entrance of large international market players with lower expectations of profitability," says Ageyev. "These companies will not make profit on each object, as is done by many developers at present, but on the gross output of products."

"Premises financed with foreign funds, have their own specifications. In the West a fund created for investments in real estate, can earn 6-7 per cent annually whereas investments in the purchase of ready real estate premises can bring about 11-12 per cent annually.

However, Smirnov says that high prices and a large area of a building frequently serve as the severing moment. As a rule, transactions above $300 million demand the separate coordination of internal funds, transactions above $500 million in general are rare for the Russian market. "The inflow of new players is constant, this year 10-15 have entered the market, however only a few of them actively close transactions," he explains.

In most cases funds are focused on long-term income and prefer to buy ready objects filled with tenants. Above all they are interested in buildings with a good location, a faultless legal title, and good quality tenants. Rental agreements should correspond to western standards, guarantee deposits should be provided.

Western funds prefer to buy maximum class premises, rather than, for example, class B buildings. They, perhaps, bring high profitability, but are more risky in the long term, and depreciate more quickly.

In addition, funds show interest in hotels. Firstly, those hotels that can be managed by western tenants, thus receiving guarantees of fillability. "In most cases it is funds with separate programs of investment in the given segment and funds which have concluded an alliance with operators. Alliances with operators or the receiving of guarantees from them with reference to individual projects essentially raise the appeal of hotel projects, says Smirnov. For office centers the presence of a managing company is minor in comparison with hotels. "Managing companies for office buildings can be chosen afterwards while the involvement of a hotel operator at an early stage of the project allows changes to be made to the concept/lay-out as they require. It is possible to manage a badly designed office building, but for a hotel - it is much more difficult, many operators may refuse to participate in such a project."

Some funds incur development risks, through buying options. "That is to say they incur obligations to buy a real estate premises after it will be handed over to the state commission, at fixed price. In this way, the developer has the opportunity at end of construction to fix profit, and the fund hedges the growth in price of the real estate.

Most funds work under this system thought here are exceptions. For example, a London and Regional Properties fund bought some bought some premises at the development stage that were basically uncharacteristic for the market. As a rule, funds which are headed by experts well knowing the specificity of the Russian market adhere to such a strategy. For example, London and Regional Properties' former managing director "Bazela" David Dzheovanis, and deputy general director of RAInKo Azamat Kumykov own 25 per cent of the Norwegian Eastern Property fund.

But not all large western players who are interested in Russian real estate are already here. Many of them are only preparing to enter the market, that’s why in the near future there won't be any problems in the liquidity of real estate. Only a macroeconomic shock can cause the market to fall or a sales wave. However, funds that invest in real estate, calculate all these risks. For now the economic situation in the country seems to them stable and positive.