In the pipeline?

There is no doubt that the Russian property market is hot at the moment, with an unprecedented rate of activity, and foreign investors pouring in. Figures from Jones Lang LaSalle put the amount of foreign direct investment to the end of September 2006 at $2.85bn (€2.18bn), compared with just $420m for the whole of 2005.

Morgan Stanley Real Estate made its first investment in Russia earlier this year when it took a 10% stake in RosEuroDevelopment, a company active in the retail, logistics, office and residential sector in Russia; Raven Russia, an AIM listed company in the UK, has already committed $600m to logistics property and is committed to other ‘warehouse’ properties; and Meinl European Land bought four large shopping centres in Moscow for more than €400m in the spring of 2006.

But with a few exceptions those foreign investors who are hitting the Moscow market in droves are not institutional investors, like pension funds and insurance companies, which in the main are very conservative.

The message coming from European pension funds it is that sooner or later they expect to invest in Moscow real estate - but not for the time being. Most have not even reached the stage of actively considering it. For instance, Mn Services which invests on behalf of several Dutch pension funds does not invest, and a spokesman for the Dutch pension fund SBZ said they would not be investing in the near future.

For Danish fund ATP’s non domestic real estate allocation, the strategy is to focus on a relatively few locations outside Denmark, and Moscow does not figure at the moment.

“Every third year we reconsider our strategy and what we do is to take a global approach and then ask where do we want to go next to change strategy,” says Michael Nielsen, CEO of ATP Real Estate. “Whether or not it will include Asia, Russia or India next time it’s difficult to say. For us we think it creates value for us only to focus on limited specific areas where we hope to be a good player.”

In any case little will change in the near future since ATP’s next three yearly strategic review is not due until the end of 2008.

Ireland’s National Pension Reserve Fund is also in no hurry to invest in Russia.

Real estate manager Ian Gleeson commented: “I think there may be opportunities but it’s a market we haven’t actively considered right now. I would imagine that it is one that we will have to consider given the reported interest that is being shown in that market. We don’t really have a view on it at this moment. To some extent we look at what managers introduce to us by way of opportunities.”

An exception to this current lack of activity is the Dutch fund ABP, which at the moment is giving active consideration to Moscow. “At present we are doing a study on the subject,” said spokesman Michel Meijs “We do not want to anticipate the outcome. Somewhere in the first quarter [of 2007] we will have formed an opinion.”

Another is American fund GE Pension Trust. It has invested in a Russian real estate investment fund through Fleming Family & Partners alongside the Fleming family and Austrian conglomerate Immoeast. The fund invests in top quality commercial properties in Moscow and St Petersburg.

Mark Jagger, managing director of Jones Lang LaSalle in Moscow is not surprised that pension funds are holding fire for now. “Most of the investors we are seeing are more opportunistic - property companies, high net worth individuals, private money, mortgage banks and a bit of investment bank activity but that tends to be mainly through the IPO market rather than direct investment in real estate.”

He noted that this is typical in an emerging market. “You tend to find that in markets like Russia which are going through this stage where transparency and the maturity and depth of the market are improving by the day, you get the more entrepreneurial investors getting in at the first stage, and they are followed by the institutional investors which enter when they feel the ground’s ready. The question is when, not if.”

Darrell Stanaford, managing director at CB Richard Ellis in Moscow points out that what is happening in Moscow is following the pattern established elsewhere in developing Europe. “I think if you look at the history of investment in central Europe - in Warsaw and Prague - in the past you found there were various waves of investors coming in.

“Certainly pension funds were the most conservative in the last wave. But at the same time even
pension funds will put a portion into more risk taking assets such as the Hines development fund, which is taking development risk.”

The Hines Group has set up three funds for investing in Russian real estate and is investing a large portion of its third international fund in Moscow.

Nevertheless there is already some interest in Moscow from institutional investors, though so far this has not fed through into actual investments to any degree.

Evgeny Semenov, associate director, department of capital markets, Russia and CIS at Knight Frank thinks that the obstacle to institutional investors is a lack of the right kind of opportunities: “The market is not mature yet; there are not enough institutional quality assets. Institutional investors are conservative and buy prime property that is already leased out. Unfortunately until now there are not enough such properties. But all of them are looking. Big investment companies are looking. And a number of mutual funds are looking. It will take a certain period of time in order to generate these assets which can later on be acquired.”

It will be in the next two or three years when the market is more stable that there will be an influx of investment from institutions, believes Jagger.

“We are at the development stage on the cycle now,” he said. “A lot of deals being done tend to be forward funding deals, the investor is taking a degree of development and construction risk and he will factor that into his investment return. In two to three years’ time those buildings will be built. That’s a very different investment proposition. You will be valuing an income stream underwritten by a real estate asset, and that creates a different mindset for the investor. He is making more of a call on the stability of the income, the fundamentals of the real estate asset and the overall market conditions.”

 

Because the market is relatively underdeveloped there is scope for growth in all sectors. Demand in the office sector is driven by a lack of suitable office space. JLL estimates that the demand of class A office space is equal to that in Paris, but the availability of that space is just 5-10% of that in Paris. Developments are going up all the time but the foreign money going in is to finance projects that are still to be built.

Retail developments are set to take advantage of Russians’ increasing spending capacity. So far their appetite for credit has been muted, but this is changing. There is long way to go before borrowing reaches the levels seen in the US and Europe. In Russia personal credit stands at just 5% of GDP, compared with 75% of GDP in the US, and 50% of GDP in Europe.

“Russians tend to be willing to spend a high proportion of their net income and that creates a healthy environment for retail products and therefore retail commercial investment to support that,” says Jagger. “Supply of retail space in Moscow could double on a per capita basis without creating oversupply”.

According to Alexander Shatalov, a partner of IntermarkSavills, it is the commercial, industrial and retail sectors that are the more mature and transparent markets. “These are able to meet the investment criteria of western funds,” he says. “That said, there are many more investors seeking deals than vice versa. Residential, at this point, is the least developed and transparent market. There is a complete scarcity of investment grade residential products and, furthermore, the domestic sales market has been so hot that there was little incentive for developers to sell to institutional investors.”

Reflecting the risks of the market compared with the more developed real estate markets of western Europe, yields are higher, but as the market matures, more yield compression is expected. JLL reports yield on retail property at 10-11% at the moment, but this could compress over the medium term of two to three years to 8-9%, as a result of an influx of new investors and new money. Yields on offices, currently around 10% could drop to 8% over the medium term.

Such a huge growth in investment money going into Russian real estate raises the question: Is this a bubble that is going to burst? Jagger thinks not.

“A lot of the office projects to be delivered in two to three years’ time will have been pre-leased two to three years earlier,” he says. “We don’t foresee a significant oversupply in the office sector at this stage. We do anticipate the market will grow to where there is a healthy level of vacancy, which is good for any market, it creates more of a balance in the situation.”

Semenov is also optimistic. “Demand is high and demand is pushing supply. I don’t think there is a bubble.”

But he does think there could be a correction, though not for a year or two, and not in prime property. “I don’t think a good product would have any significant problem with compression of the rental rates or with enormous vacancies, as happened in eastern Europe. The capacity of the market here is much bigger than in eastern Europe,” he says.

 

There are other positive aspects to the Russian investment environment. Political risk seems to have retreated somewhat. Under the terms of the constitution Putin is due to step down in 2008, and it would need a constitutional amendment for him to stay on, but he is a popular leader.

The economy is strong. Russia’s GDP growth is expected to be 6.5% this year, and its estimated budget surplus is likely to be 7.5%. Russia’s sovereign debt is now rated as investment grade.

Nevertheless all is not rosy. Corruption is one concern. “Corruption exists and it is getting worse - there is no doubt about that,” says Stanaford. “But that is an issue for developers, not for investors. Once you have title to a property, you are buying a stabilised asset and there is very little opportunity for corruption to influence negatively on an investor. The development process where you need hundreds of permissions is the place where corruption becomes an issue.”

Following on from that is the issue of land title which is also in the process of reform but is still not up to the standards of more mature markets. Natalia Takhtarova, director of the Institute for Property Registration, Assessment and Taxation, says this is a negative for investors.

“The main obstacle for institutional investors to come and play a big role is that property rights are not clarified yet. The urban planning code has been adopted, the housing code has been adopted. A lot of legislation has been approved recently but it’s a matter of implementation of the legislation.”

The rights of ownership of any land that is sold off may be questionable, she says. And under contracts unfair terms may impact on investors.

“The rights granted in contracts by the Moscow government are accompanied by encumbrances,” she says. “If someone buys land under contract
they have to accept responsibility for following a schedule of construction. If for some reason the schedule is broken, for example a delay in getting building permits, or arranging the supply of electricity, then the developer can be thrown out. The Moscow government may say you did not deliver in time, so we will have to give this contract to someone else. That is a big risk for investors in the development process.”