People in the Know: To Choose Rationally

Why did Avalon group choose the Raven Russia fund for the creation of Megalogix? Were there many potential investors?

There were a number of potential partners; we spent more than two years on decision-making.

What made you decide?

Firstly, Raven Russia was created especially for investment in warehouse real estate. This is an enormous plus. The fund does not run from warehouse real estate to the construction of residential complexes or shopping and entertainment centers. People are focused on a certain segment [of the market]. Secondly, the fund possesses the necessary and real financial resources, which are extremely important in the realization of such large-scale projects. And thirdly, and most importantly [for us], our views on the development of the business and our personalities coincide. It is important, who you specifically see before yourself as you will be talking to this person - from this you develop the perception about the partner. What is his way of thinking, what does he say, more importantly, what does he do and is he focused on achieving results and is prepared to take risks like you are. The business views of the managers from Raven Russia coincide with ours.

You have announced a large-scale project. But other companies such as MLP, Eurasia Logistics, etc, have also announced no less large-scale projects. Do you not think the market will become overstocked?

There are certain parameters on which demand for warehouse areas is assessed. In general, in the country it will be some time yet before it is satisfied. If you look at European countries and their warehouse infrastructure, even under a different degree of economic development, the unsatisfied demand in our country is still quite a lot. Obviously, in Paris there are twice as many warehouses as in Moscow. In London there are 2 sq.m [of warehouses] per person and in Prague there is 1.2 sq.m per person. To directly compare Novosibirsk with Milan is impossible - it is necessary to take into consideration the economic parameters [of these cities]. But there are also other factors that increase the needs of large Russian cities for modern warehouse complexes. As a rule, they not only operate within the city, but also as distribution centers for huge territories. Furthermore, existing warehouse infrastructure has not only become outdated, but is also not where it should be: it is within cities. And this enormously burdens the transport arteries and the environment. In addition to warehouses being necessary in cities, they must also be in the correct place.

Have they already started to be built in the correct place? Before they built where they managed to get land.

Practically everywhere there are long-term plans of development of the territories, providing for the construction of industrial and warehouse premises as a feature of large settlements. Logistics parks are serious premises. A warehouse complex with 100,000 sq.m of usable space assumes a stream of more than 4,000 transport units per month - such goods traffic should not be in a city, but [should be] placed accessible by transport from it. Coming back to demand: even if all the announced projects are realized, they will be insufficient. The realization of a project for the construction of a large logistics park takes 2-3 years. When someone announces a period of a year, this is fantasy, two years [is necessary] at least. If we take those companies you named, plus Megalogix and some more companies that are realizing projects that are not chains, and we combine them altogether, the volume is still insufficient in quantitative terms. Of course, if all the premises come onto the market at the same time, a local glut at that time is possible. For example, if in Novosibirsk all the announced projects came onto the market at there same time there would be a temporary glut. But generally the chance of such a situation happening is slim. The shortage of design and building capacities, complexities in obtaining power capacities, a sharp and constant rise in the prices of building materials, and serious problems in the financial markets affect the time it takes to realize development projects. We have huge plans, but it is necessary not only to judge the situation on what the media says, but to look at what is really going on. Having analyzed this, we do not fear a future glut. When a company announces plans, it is only possible to really understand whether or not it will really be realized when the contractor comes to the construction site, brings the building materials, machinery, etc – then it is already difficult to stop the process. It would be very, very expensive. We are currently realizing projects in Novosibirsk and the Rostov region – there are no other premises at the same stage of construction as Megalogix. This year we also plan to start construction on six sites with dates for them to be out into operation in the fourth quarter of 2009. In none of these cities are there similar projects at the stage to start construction.

In reference to announcements about plans and their realization. Do you expect any development crashes?

"Crash" is a very strong word. Let's take a premises. A question - how big is it? If it’s 50,000 sq.m then the crash will be bigger. But the companies that realize such projects, as a rule, are skilled enough and professional enough to avoid this. Otherwise they would not have such financial resources. I don’t think that a long-term developer will experience a crash. Although the periods for construction may increase or the development of the premises may be frozen at an early stage (design). All of this can come from problems of a financial character. Real problems can arise for small developers who are realizing individual projects of a small scale. As a rule, such projects are carried out thanks to money lent for short periods of time at a high rate. And money is becoming more expensive, and the possibilities of prolonging credit lines are dim. Another problem of these developers is their [limited] opportunities to rent out the areas. It is necessary to understand that tenants will choose those who develop chains: these have standardized conditions, whether it be in the Primorskoye territory or in the Leningrad region; they are reliable landlords; they have clear, transparent rates. In small premises the quality of tenants is different. As a rule, the average or small sized companies which need smaller areas and are interested in short rental periods, and as a rule cannot provide high-grade maintenance of rental obligations. With small development companies there are also often problems with competence. Among businessmen there are many people who like the warehouse theme - it is popular - but they poorly represent themselves. Therefore they create premises unsuitable for operation: either the walls fall down, or the roof collapses, or the floor caves in. Nevertheless all these complexities are solvable. There are no problems that can’t be solved, there are only problems in which it is unpleasant to be engaged. A crash may happen in one case: if a site is incorrectly chosen, the premises is constructed, and to maintain it is impossible by virtue of transport restrictions. I personally know a number of such examples: people used old warehouses, and in their place tried to construct new premises, not taking into consideration that the territory around it was not so industrial, but built up with apartment buildings. But even in this situation there is a solution - reorient the warehouse into a shopping center or something else.

You have mentioned problems with financing. This is a sore point. For a long time we have tried to convince each other that the crisis which has happened in the rest of the world will not touch Russia. Now assessments have changed and there are forecasts that a number of projects will be reconsidered, frozen, there will be no money, etc. How does this not affect you?

The Russian economy is already essentially integrated into the world economy so the recent problems will affect our country. The question is only to what degree. It is already difficult to obtain financing for projects from Russian banks. And if they do offer financing it is at such a rate that makes the realization of projects ineffective.

At 18 per cent? What was it previously?

Different. Rates now can reach up to 25 per cent per annum, and there are even no such resources. And western banks have practically ceased their activity in the [Russian] market. If previously real estate was something promising and reliable, then in view of the mortgage crisis in the US, today discussion about any project in this area causes skepticism, especially if it refers to outside their native territories.

And how do you solve the problem with financing? Do you have problems?

No. Raven Russia entered the market rather recently and has available financial resources. This really helps. The other thing is that these premises have already been constructed, leased and are the property of the company, and those that are under construction, are at such a stage of readiness, and already have the design financing.

Do you get it at a reasonable price? For what?

Reasonable. The rates and conditions of credit are acceptable. I’m not prepared to comment further.

How comfortable in principle is it to work in the regional markets?

I heard a paradoxical thing: in places where administrations are interested in attracting investors, it is more difficult (because of high competition, etc) than in "usual" regions.

Is this true?

Yes and no. With our experience it is possible to tell whether the authorities are interested in the arrival of large investors. Investors who invest in the development of infrastructure receive comprehensive support.

What does "comprehensive support" mean?

It means that the heads of the cities or regions simply take an interest in the realization of a project. They also help investors solve a lot of problems. First of all they reduce the administrative barriers. They help to solve problems with natural monopolies, in connection with gas, water, roads. There has been no territory where we have worked where interest and support have not been shown. As for the question as to where it is more comfortable to work... There are territories where authorities want to realize a certain mega project - for example, a large technopark, which will include logistics and industrial enterprises, offices, etc. This involves the development a much larger land plot measuring hundreds of hectares. This means that it is necessary to create an enormous infrastructure to develop and build up the whole territory. For this purpose a pool of investors is necessary. And when there is a collective, time is always spent on settling mutual interests. Especially when authorities have the desire, but there are no real opportunities and they are not ready to actually do something. In a number of other countries if the authorities are interested in the realization of a project they will provide the land at a comprehensible price, and will construct the infrastructure. In Russia this still doesn’t happen. And, say, in Kazakhstan, in Astana, the authorities will be engaged in the question of land, will bring engineering there, will supply the investor and will say: just build, and we will solve everything for you.

Is there a terrible situation at the moment with investors in Kazakhstan?

They have a difficult situation for other reasons: there is no free money. Developers have seemed to be very strongly dependent on international financial institutions. But the authorities have already solved this problem and, in my opinion, rather effectively.

Do you obtain support from local partners or work independently?

We don’t have any business partners in the regions. We work under the following scheme: We have specially created a development company, which has divisions in each of the cities where we are carrying out a functioning project.

All problems - with the land, with contractors, designers - we solve them within the limits of our own structure. But we actively work with administrations as our projects are large and have significance in the given territory. If a logistics park is not constructed not in the correct place the city could simply be paralyzed by virtue of transport problems. So it is impossible to do invisibly like it would be, for example, to open a kiosk. Thus, we first of all lean on the support and help of local administrations.

You keep referring to "territories," can you not give any specific examples? For example, you have a project in Perm. Everyone says that this city is rather closed to external investors and that it is unbelievably difficult to enter the market if the investor does not have a strong "local toehold." Have you experienced this? Or by virtue of the fact that your projects are urban do you not come across such problems?

The company is developing 20 projects in the territory of four CIS countries. To give any individual assessments of authorities would be very wrong on my part. We have good working relations with everyone including with the administration of the Perm region and the city of Perm – we are currently choosing a site there. Such premises like ours require large land plots and rather high capacities – energy, water, gas. The problem is that there are not o many such land plots.

Some authorities hold tenders for infrastructural land plots.

In Khabarovsk we participated in such a competition and won. For us it is not a stumbling block to receive land through a tender, in rent or within the limits of an order. In many cities we simply buy sites on the secondary market. The main thing is that the cost of the land plot and the cost of its engineering and transport maintenance are included in the economy of the project as a whole.

Why has Avalon group mainly decided to engage in the warehouse business? In fact the main structure of your activity is trade in tea and logistics.

All companies actively search for new variants to use their strength and capital. Where there is a return on invested money, address it. But the main thing is competence: if you understand a subject, you will invest there more freely. Our company has worked on the market since 1991 across the whole territory of Russia, in Belarus, in Ukraine and in Kazakhstan. The tea business is one side of our activity. Let's look at this. We have a production facility near Moscow, a marketing company and 35 affiliates and branches in Russia and the CIS. The raw material comes from India and Ceylon, the equipment from the US and Europe, and the finished product [a pack of tea] should be accessible to a buyer in a shop on the corner. This corner is frequently several thousand kilometers away, and delivery of the product there demands the corresponding competence in the field of logistics. Therefore in 2002 we established Avalon Logistics, setting a goal for ourselves to create a national logistics operator. Successfully developing in this direction, we nevertheless collided with the problem of a distinct deficit of warehouses, suitable for providing a quality service to our clients. It is possible to spend mad amounts of money on advertising a product, but if it does not appear on the shelves, it is money thrown away. And for it to get there it needs to be both made and brought on time to the retail chain, and the commodity order to be completed. When this business becomes large scale, it cannot be done in an old warehouse - the volume of mistakes becomes simply critical. Class A warehouse complexes are simply a more effective way of business dealing. On these sites labor productivity is higher as is quality, speed, and safety, and the cost price per commodity unit is lower. It became clear very quickly that there was no infrastructure. And if there is no infrastructure it is impossible to create a national logistics operator. Therefore we began to consider the warehouse real estate market, to look for land plots and investors and begun this program.

How do you assess the market of contract logistics in Russia? It seems to me it is absolutely insufficiently developed.

I agree. There are currently no strong national scale operators. And not only in Russia, but also in the territory of the whole former Soviet Union – it is still now economically and logistically a single zone. There are currently practically no large logistic operators - European, American or Asian - in our market, in terms of the volume of services offered by them. Just because there is no infrastructure. How do you organize a logistics business in say, Krasnoyarsk?

Besides a different clientele, it is necessary to have a long-term rental contract suitable for conducting modern business. If you need 100,000 sq.m, almost 2,000 warehouse personnel are required – who will need to be recruited, trained, and technological processes will need to be initialized. If the infrastructure is not adapted for your needs or you rent under inconvenient conditions (for example, the owner [of the warehouse] is not completely reliable) it is possible to lose very serious amounts of money. This is one of the principal causes as to why western logistics operators do not actively develop business in our country. Among Russian logistics companies there are some very bright examples that have reached certain results, but not huge scale. The market can still be called empty even though there are many small operators who operate 1-2 warehouses and compete among themselves. For everyone pricing and the organization of business processes are also a barrier to the development of a high-grade logistics industry in the country.

When I tried to find out about the rates of logistics services, they spoke to me about "market" prices, i.e. they need to be agreed individually.

Yes. But eventually in the market standards will be set; from the point of view of quality of services and their set. Pricing will be more transparent. This process, which is already beginning, will result in a reduction in the number of functioning operators and their integration. If you look at the development of the world economy geographically, the location of our country is key in the process of the transport corridors connecting the East and the West and in turn that means good prospects for contract logistics, and also for the developers working in the field of warehouse real estate.

How do you solve the problem with suitable staff for contract logistics?

With difficulty, as there simply aren’t enough qualified personnel in the country. We involve expensive managers from other countries and they train local manpower. To launch a warehouse site it is necessary to train people for 2-2.5 months. We employ them and we train them, not serving clients and not making returns until we launch the warehouse. If the personnel is not prepared, today it will come to the site, and tomorrow there will be enormous problems.

I remember how I was recently served at Lensmaster: Two saleswomen had a queue of unhappy customers because they did not know what they were doing.

You give a good example. A modern logistics complex works by the principle of a shop: with radio terminals, with scanners. The enterprise works 24 hours a day, 30 days a month. That means night and day shifts. If my memory serves me right, every half an hour a truck should be filled. This commodity stream can only be served by high automation business processes and highly qualified personnel.

The freight handler today does not have the most important job in the warehouse, the operator which controls all processes by the means of electronic commands now is most important. There is not much manual work in modern warehouse activity - it is necessary only when repacking the goods and in the individual selection of an order.

Lets return to the subject of warehouse real estate. Developers here, as a rule, are engaged in routine construction - class A and B boxes.

Yes and no. The majority of premises, naturally, have a standard specification. This relates to the height of the storage, the loading on floors, mezzanine floors, the width of access roads, loading zones, etc. This infrastructure serves approximately 80 per cent of the market, this is what is needed. But in Russia already warehouses that have been specifically ordered are now under construction. To tell the truth there are three kinds of the main clients: retailers, goods manufacturers and logistical companies.

And why have you put logistical companies in third place?

In the Moscow region they occupy almost half of the quality warehouses. I have not ranked them, I simply listed them. But it is still early to put logistical companies in first place - the market has not reached here yet. Mentality has not changed in the majority of us yet: we are all still small Napoleons, we want to do everything ourselves and don’t want to believe that professional logistics operators are becoming more numerous and cheaper. But also in our market already there are examples whereby the manufacturer allocates its own premises on a site and a logistics operator serves it. This is so-called outsourcing contract logistics. There is also a number of built-to-suit projects whereby the developer builds a warehouse according to the specifications of the customer. We are currently completing negotiations with a very large foreign manufacturer that is going to work in Russia and needs a special warehouse. Its production demands a non-standard racking system, it will be impossible to use this building for mass storage. Such projects assume a certain system of relations between the developer and the customer, and different rental periods (up to 20-25 years). I can count more than ten of such projects.

What is the profitability of the warehouse business? Everyone says that the cost price of construction is increasing to say $1,200-$1,400 per sq.m. Is this true?

The cost price is growing. By our estimations, it now ranges from $750 to $950 per sq.m excluding VAT - both in Moscow and in the regions. We still have the wrong belief that construction should be cheaper in the regions than it is in Moscow. This is a lie. Beyond the Ural Mountains, for example, it is more expensive. And to live there is more expensive. The cost price of construction in Novosibirsk exceeds Moscow. The increase in cost price is connected with the general situation - with the sharp rise in prices for building materials and building services.

Why?

There aren’t the capacities for a large volume of the construction. If the work is not extended - and it cannot adequately be extended for developers, the cost of building materials and as result, the cost price of construction and the rental rate grow.

It is paradoxical: in the market there are more and more projects and developers, competition increases, and rates grow.

In the past year some building materials have risen in price 30-40 per cent, the cost of services of building and design companies has grown, there is no concrete, armatures, metal constructions, etc.

And what about rental rates?

Last year there was an opinion that they would fall. Rates are growing. It is possible that they may fall, but there is no objective reasoning for this. How can they fall if all the components of them are increasing? Including the cost of financing. Now rates are $125-$130 per sq.m a year, and we believe that by the end of the year they may grow up to $135-$140. Now landlords choose tenants more carefully.

You too?

Of course. Good tenants are a key condition for the success of a project. The possibility of attracting project financing directly depends on how well the tenants correspond to the estimated criteria.

How do you check them? Do you have a system?

Each company has a system of an estimation, banks have theirs. Naturally, it is a question of what assets the tenant has, how it will obligate the contract. Contracts are for 7-10 years, tenants provide bank guarantees and deposits, advance payments - a certain set of standard things. Reputation - if the company is international, the large requirements to support its ability to maintain its rental obligations can be lowered by virtue of its high business reputation.

Avalon group is a Russian investment company. Its activities include warehouse real estate, contract logistics, software products and consumer goods. The company was established in 1991. The company has a staff of more than 2,000 Russian and western experts.

Alexei Gushch was born in 1966. In 1993 he graduated from Moscow State Institute of International Relations as an economist-foreign affairs specialist. From 1993-1998 he founded and co-owned several private companies. Since 1998 he has been the co-owner and general director of Avalon Group. He is married with three children.