Money Growing: High risks of high class

Class A and B office projects have lost serious appeal to developers and investors. Rates and profitability are falling and risks are growing. At the same time in the market there are new investors who are attracted by the reduced price of premises and who can easily wait several years till the market recovers. And then make profit on the formed shortage of premises.

Still profitable

In recent years class A and B offices have been in great demand. The level of vacant premises in business centers was 3-5 % and 5-7 % accordingly, and rates reached $2,000-$2,500 per sq.m a year. Now the appeal of office projects has considerably decreased.

Profitability is falling, and the time it takes to recoup costs has increased from 3-5 years to 7-12 years, the general director of Est-a-Tet, Kaido Kaarma complains. Expenditures on the realization of projects were made during the pre-crisis period, and income is estimated in the changed conditions, says Tatyana Chulkova, head of the sales and letting department at Moscovsky Biznes-Inkubator, (technopark Nagatino I-Land). Last summer a developer could count on 30-40% per annum. Now sellers expect profitability of 10-14% and buyers 18-20%, notes Polina Kondratenko, director of the valuation and consulting department at Colliers International. Konstantin Bogdanov, an adviser in the office real estate department at DTZ, considers 13-14% a realistic figure.

Michael Gets, managing partner of Novoye Kachestvo, is more optimistic in his estimations. The returns (IRR) of developers who manage constructed class A premises, have decreased from about 25-30% to 15-20% (when 100% of the company’s own fund have been used). For class B premises they have decreased from about 24-26% to 10-15%. "The correction in the given segment is lower because of a more stable situation with tenants," he specifies.

Chulkova notes that the present profitability of 13-14% is the margin in terms of the sale of projects; rental returns are 7-8%, which is above European parameters of 2-4%.

What place is empty

Hullabaloo around quality premises stimulated developers and investors to realize new class A and B+ projects. As a result the volume of vacant premises has grown not only because of a reduction in demand, but also as a result of new larger projects on the market. According to the results from the fourth quarter of last year and expectations in the first and second quarter of 2009, almost 1.5 million sq.m will enter the market, says Charles Boudet, European Director and head of the office and warehouse real estate department at Jones Lang LaSalle.

The crisis has cancelled the plans of the company to expand. Mass redundancies have reduced the need for premises. As a result demand for new premises is practically zero. According to Novoye Kachestvo, the level of vacant premises is 20-25% in class A premises and 10-15% in class B. According to GVA Sawyer, the level is 12.8% in class A, 14.6% in class B+ and 9.5% in class B-. For comparison: from 2007 results, in these classes 3-4% remained vacant. Premises which have the most vacant areas are class A business centers, which are offered needing final finishing, adds Anna Ledeneva, a senior adviser in the office real estate department at DTZ. Companies do not now have the funds to decorate the premises.

The submarket international business center Moscow-City has suffered the most, where in the fourth quarter of 2008, the level of vacant premises was 25% (GVA Sawyer). The West, Northwest and Southwest Administrative Districts have the lowest vacant premises - less than 6%. A project becomes unprofitable when more than 50% of offices are vacant, says Chulkova. So, developers are still somewhat safe.

In comparison with the end 2008, rental rates have decreased 20-30%. "During negotiations tenants can obtain even bigger discounts, in some cases up to 35-40%, which puts rates on a par with 2007 levels,” concludes Ledeneva.

In 2008 the average rental rates in class A premises, according to GVA Sawyer, were $950 per sq.m a year (excluding VAT and operating costs), in class B were $650 per sq.m a year, and in class В- were $500 per sq.m. Class C premises, according to Peresvet-group, cost $250-$500 per sq.m a year, and in some premises (for example, in the Central Administrative District) reached a level of $800-$850 per sq.m a year at the end of the year.

The biggest fall was observed in the segment of class A business centers of 19%, adds Getz. The rental rate for class B premises has decreased by 15%. The highest rates were in the Central Administrative District, where the average rental rates (class A) at the end of 2008 were $1,050 per sq.m.

Expensive Money

Developers who have rented out or sold projects before the crisis have made profit. Operating business centers with tenants even now make profit, and even though it might be smaller, it’s profit all the same. Some owners such as Enka, refuse to reduce rent, trying to squeeze out the maximum until the very last moment. Other proprietors have become much more loyal. Prices, from being in euros, have changed to US dollars, and often rubles. Rates for offices in most cases have begun to include everything: VAT, operational charges, municipal charges. On the market there are dumping offers of class A offices for 12,000-15,000 rubles per sq.m a year, says Chulkova.

For many tenants it has become more favourable to pay penalties under a current rental contract and move to a new premises offered under more favourable conditions, than to continue to pay old rates, explains Elena Gerasimova, a leading expert-analyst in the consulting department at GVA Sawyer. Understanding this, many owners are prepared to make significant discounts within the limits of current contracts, in order to not lose tenants.

Complexes that entered the market at the end of last year or are expected to enter now are in the worst position. A year ago, when a business center was close to completion, preliminary rental contracts would have been signed for the majority of the premises. Now, on average, no more than a third of premises are already under contract, says Gerasimova. But some premises are successful enough. For example, Dvintsev business center (completion is expected in the first quarter of 2009) by Central Properties, which, according to Jones Lang LaSalle, is 70% filled with tenants, and the Metropolis (completion in the fourth quarter of 2008) is 80% filled.

The premium segment has suffered the most as premises of this class were rented by investment groups, banks, etc. The rate of rent has fallen from $1,800-$2,000 to $1,000, adds Boudet.

The positive side of the crisis is the decrease in expenditures on construction: for example, the cost of cement has fallen 30-40%. Under pre-crisis prices, cost price per sq.m was from $1,200 to $3,500, of which almost 65% could be payments to "sort out land questions" and "obtaining development rights," says Gerasimova. On average, land requires 30-50% of the total sum of investments into a project, specifies Getz.

At present, the cost price has decreased 10-15%, and is expected to further decrease by the end of the year by up to 40%, considers Omar Gadzhiyev, a managing partner at Panorama Estate. According to Novoye Kachestvo, investments in class A office buildings (including expenditures on the land plot) have decreased from approximately $3,000 to $2,500 per sq.m, and for class B premises from $2,200 to $1,600 per sq.m.

In the Central District, according to Kaarma, investments in a premises are from 80,000 rubles to 120,000 rubles per sq.m. In the area from the Third Ring Road up to the Garden Ring the cost price per sq.m is 50,000 rubles to 75, 000 rubles. Actual construction will cost approximately 35,000-40,000 rubles per sq.m.

As the cost of materials decrease, developers are reconsidering existing contracts with contractors. However, this only concerns projects that are at the initial stage of realization. Even if a premises is only 50-60% constructed, the main financial expenditures have already been made.

However, simultaneously with the reduction in price of building materials, obtaining additional funds has risen in price. It is hard to find loans with a lower rate than 16-18%. Those banks that are still providing financing offer loans with significantly higher rates of interest. When using loans, due to the effect of the financial lever, the profitability for the investor can be more than 14-18%, while financing a project themselves, can be a maximum of 5-6%, Gets is assured. Using borrowed funds under such conditions as now (higher rates and shorter terms) can hardly provide a greater effect. On this negative background for developers even a reduction in tax on profit from 24% to 20%, which came into force on January 1, 2009, will hardly provide any significant increase in profitability.

Without taking into account the costs of obtaining credit, the average cost of construction of offices from zero is approximately $2,000-$2,200 per sq.m. You then have to factor in the time factor, operational charges, expenditures on attracting funds, explains Chulkova. As a result, for construction over a period of 3-4 years, the cumulative average cost price per sq.m is $3,200-$3,700.

Developers are looking for ways to optimize projects and expenditures. Anzori Hacia, an adviser to the president of Otkrytiye-Nedvizhimost, suggests changing design decisions in view of lowering the class of office premises, while keeping the potential to raise the class again. This is possible by redecorating and replacing the engineering solutions of the premises. "It is time for the development of universal projects," he believes.

SVP Group has decided to construct a logistics center rather than a business park on Pulkovskoye shosse, www.restate.ru has informed. Initially the company intended to erect a business park costing $1.5 billion on a 65-hectare plot, but now will probably build a logistics complex costing $350 million. "warehouse space is rented out 2-2.5 times quicker than premises in business parks," www.restate.ru quotes a senior adviser at Knight Frank St. Petersburg, Igor Kokorev.

The nearer the bone the sweeter the meat

The economics of projects have considerably changed, but many experts nevertheless consider quality offices as an object for investments. Many investment funds now have an excellent chance to buy quality premises with discounts of 50-60%, the speed of increase in prices of which after restoration of the market will be the highest, marks Getz. Kaarma considers the period from the middle of 2009 to the middle of 2010 as a successful time to invest in class A and B offices: "Developers need finance to complete their projects, and they are prepared to include an investor in a project on beneficial terms." That is what investment groups do.

Marshall Real Estate Fund has allocated $500 million for the purchase of real estate, with an injection of another $150 million from investors. The fund is interested in class B+ and B offices mainly within the Garden Ring, retail premises measuring up to 20,000 sq.m and warehouses.

Investments in class B premises are more prospective due to greater liquidity and lower price, than class A, considers Chulkova. She does not advise to invest in class A offices: "Furnishings and infrastructure eventually become outdated, and offices move into a lower class. For class B offices such loss is less critical."

Gets advises to pay attention to compact premises near the Kremlin: "Small areas in developed business areas will always be demanded." And, on the contrary, the Moscow-City project causes greater doubts. Risks with the liquidity of premises in Moscow-City are huge. Except for the name the territory does not possess any additional benefits for tenants.

Kaarma believes that the profitability of offices in the area of the Third Ring Road is more stable, as now there is general migration to this inexpensive area of Moscow. Class B and B+ offices that are ready to move in and offer areas measuring from 150-700 sq.m in the center are also not doing too badly.

Premises that have been constructed but not leased may also be of interest to potential investors. In this case, discounts of 40-50% are possible, and there are already such premises in the market. In the future they will split up the areas and lease or sell them. Or manage the premises, i.e., conclude rental contracts at a discount of 60-70%. The discount is so great, as the investor in this case acts as the anchor tenant and concludes a long term rental contract. After that it is possible to decorate and furnish at your own expense and rent the space in areas of 150 to 350 sq.m at a discount of 30-40% compared with the initial cost of rent.

Not brilliant prospects

In the first half of 2009 rental rates are expected to stagnate and there will be a downward correction in some premises within the limits of 10-15%, considers Gerasimova.

Olga Yasko, regional director of the analytics department at Colliers International, expects the correction of rates to continue until at least until the first quarter of 2009.Stabilization of rates is expected when they are 30-40% lower and reach the levels of summer 2008.

In 2009-2010 demand will continue to fall for class A office space, first of all by companies in the financial sphere (banks, investment companies); the share of such companies made up 20% of total demand prior to the crisis.

Hidden opportunities

Konstantin Kovalev – managing partner at Blackwood

The decrease in price in connection with the crisis will provide significant returns to those investors that treat the crisis with ease and sense. First of all, simultaneously with a fall in prices, costs are also decreasing. The cost of land is falling at a faster rate in relation to prices for completed premises. Before the crisis demand for land exceeded demand for completed buildings, but now we are observing the exact opposite.

As a result the profitability of projects, the input of which is carried out on a descending trajectory of the market, appears to be higher than had there been no financial crisis in Russia. By selling a project today at a discount, developers are acting at the right moment - in the market there is a wide range of so-called distressed assets which will not only provide profitability, but will also compensate for lost profit (or even losses) of the previous project.

As an example we can consider a project for the construction of a class B+ office center with a total area of 10,000 sq.m. The investor has entered into the project, having spent (everything is calculated per sq.m), say, $17,500, the cost of the building materials and work is $2500 c.u., plus designing and approvals, reception and performance of technical conditions - $500. In pre-crisis conditions the project could be realized upon completion for $129.8 million. Thus, expected profitability would be nearly 40% per cent. Now conditions have changed, and it is only possible to sell the premises with a discount – with the most optimistic estimations for $64.21 million.

The profitability in this case is 14 per cent. Using a share of the obtained funds, it is possible to enter into a new project at the reduced prices (at least 30 per cent, and even 50 per cent cheaper), i.e. to realize a similar project the cost (investments in the project) will not exceed $11.14 million, and at the same time the cost of building materials and work will be cheaper. During the realization of the project the price level will be restored to pre-crisis condition, and the investor will receive profitability of at least 30 per cent from the new project, i.e. significantly higher than if he had preferred to remain with the old project.