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2010 Real Estate Investment Market - Moscow

11 March 2011
Author: Knight Frank -

Executive Summary

• The total value of commercial real estate purchases in 2010 was about $4.4 billion.
• In 2010, unlike in 2009, the principal objective of most commercial property transactions was investment.
• The commercial property was mostly in demand amongst Russian companies, while the interest from foreign
investors remained at low levels.
• Banks have stepped up amounts of real estate lending, but have increased the share of lending to residential
developments in order to diversify their risk.
• The shift of investor interest from Moscow market to quality commercial property in other cities is expected.
An increasing interest of investors to high-quality projects, which are still under construction, is also expected.



There was a progress towards recovery of the Russian banking system in 2010, largely thanks to the government's actions in 2009 to support the financial sector and due to the policies by the Bank of Russia. A significant growth of deposits in the banking system (by more than 30% in 2010) enabled the steady increase of lending to the Russian economy from the second half of 2010. The loan rates are increasingly affordable: according to the Bank of Russia, ruble interest rates to non-financial organisations have decreased from 13.8% in January to 9.2% in December 2010. The growth of overdue loans as a percentage of total loans also slowed down, and the share of overdue debt started to decline in the second half of the year, partly due to an increase of overall bank lending.

An increase of bank lending to the commercial property segment has helped a number of developers to partially or fully resolve their overdue debt problems. The developers then moved on to taking an advantage of a widening gap between supply and demand for the commercial property by resuming construction work at a number of projects, which had been suspended during the crisis. However, the trend among banks was towards an increase of financing for residential construction, as a way of diversifying their risk. This policy also makes sense for banks because they can stimulate residential demand by issuing of mortgage loans.

Despite the positive trend, a shortage of financing remains. Banks are demanding a higher risk premium compared with the pre-crisis period, either by more conservative valuation of property collateral or by setting high rates of interest. Their cautious behaviour is understandable, since they accumulated large amounts of expensive liabilities (deposits at high rates of interest) during the most acute period of the crisis, which considerably reduced their profitability, and the financial problems that they the companies experienced during the crisis made the banks take over a large number of noncore assets, which respectively led to their need to increase the reserves at the Bank of Russia. Money tied up in reserves is subtracted from amounts that are available for investments to real or financial sectors, which in turn has slowed down a growth of lending and had a negative impact on profitability of banks. Mostly the loans to developers have been provided by the biggest Russian banks, Sberbank and Bank VTB.

Western banks, which stopped giving credit in Russia when the crisis began, are also gradually restarting their lending programmes. Nordea Bank has helped to refinance the up-andrunning shopping centres of IMMOFINANZ Group, and an Austrian developer Avielen A.G. has obtained a loan from the consortium of Polish banks for construction of the Airport-City business complex near to Pulkovo (Saint Petersburg).

Inflationary risks in the Russian economy in 2011 may encourage the Bank of Russia to raise the refinancing rate, which may have a negative impact on financing of the real sector.

Relative stability on the stock market in 2010 has revived the interest of many companies in raising capital by public share placements. There was a significant increase in the number of financing transactions through share sale on stock markets during 2010 in comparison with 2009. The first Russian developer to take this path since the crisis was LSR Group, which raised about $400 million from an SPO in April 2010. The sum was only a half of what LSR had originally hoped to raise, but stock markets do appear to be one of the most promising funding options at present, and other developers may follow LSR's example in the future.



We estimate total value of commercial real estate sales at about $4.4 billion in 2010, which has increased substantially from $2.2 billion in 2009. Mostly the purchases in 2010 were in the office segment (about $3.4 billion).

The transactions were dominated by the completed office properties in Moscow. According to our estimations, the purchases of operating office objects in the Russian capital had a total value of about $3.2 billion in 2010 (i.e. 70-75% of all purchases of Russian commercial property). 55-60% of the represented investment deals and the other deals were purchases by companies of office space for their own needs. The most striking change on the market in 2010 compared with 2009 was in terms of growth in the number and size of investment purchases, while purchases of office buildings for the buyer's own needs grew to a lesser extent.

High levels of demand for office premises have been driven mainly by Russian companies, both from the financial sector (buying mainly for investment) and the real sector. This reflects the improvements in the Russian economy, thanks to which many domestic companies have generated a spare capital having sought for the suitable assets, in which to invest it.

The positive trends in the economy have helped to make commercial real estate more appealing as an investment as vacancy rates declined and rents rose in nearly all segments, increasing cash flow generated by up-and-running commercial projects. Capitalization rates are above precrisis levels and above European levels, though on a downward trend, and rent levels are rising, so Russian commercial property looks highly attractive at present.

The needs of companies as potential users of commercial real estate are highly correlated with their own business activity which is hard to predict on Russia's developing market offering huge possibilities, but is also subject to high levels of volatility. The supply of quality office premises as such has only appeared in the mid-1990s, and the local construction industry is still taking shape. Meanwhile, buildings that were erected earlier are increasingly depreciating and out-of-date, making them liable to declassification. Therefore, the current state of affairs has led to the widespread use of short-term lets, for the periods of 3-5 years, as compared with 15-25 years on developed European markets. Short lets tend to speed up the market processes, since tenants return to the market more frequently than in Europe, which influences the demand. In these circumstances, companies have an additional incentive for buying office centres for their own use, namely, to avoid an exposure to rapidly changing rent levels in Moscow (rate fluctuations on Russian regional markets are even more pronounced).

An increased demand for the finished, highquality office premises has led to the shrinkage of supply in Moscow, and this is one of the reasons for an upsurge of investor interest in unfinished, high-quality premises (the same is true in other main Russian cities). The interest from investors with foreign capital is still quite limited. The risk-to-return ratio in Russia is not yet sufficiently attractive for foreign investors and most of them are still monitoring the market. Some foreign funds have recently quit the Russian market. It was reported in summer 2010 that the German investment fund, KanAm, had decided against the purchase of the Vivaldi Plaza multi-use complex. KanAm already withdrew from the purchase of another office centre, Citydel, in 2009. On the other hand, some players with foreign capital have become more active: the purchase of Bakhrushin House business centre by UFG Real Estate Fund II was an important event in Q2 2010.

The companies from Asia deserve a special mention among foreign buyers of commercial real estate. Rapid development of many Asian economies has created an excess liquidity, which cannot always be invested in the countries of origin, due to the limitations introduced by governments there. Asian investors are therefore keen to find opportunities on foreign markets, and Russia's numerous links with countries in that region makes it a natural object of interest. For example, towards the end of 2010 a Chinese state-owned company Chengtong bought Greenwood - an international exhibition and office centre. The centre was bought for the company's own use.



Office real estate 9-10%

Retail real estate 10-11%

Warehouse real estate 11-13%

* Estimation of capitalization rates for highquality objects in Moscow Source: Knight Frank Research, 2011 

An Improvement of the situation in the banking system has enabled more developers to resolve their debt problems, repaying or refinancing their overdue liabilities. This means that they can switch their attention from the search for capital to development of projects, so that projects, which were suspended during the crisis, can be resumed. However, in many cases developers have chosen to simplify project concepts, which lowers the implementation costs. Some new projects have also been announced, but they are limited in number. Some companies, which were previously focused on commercial property, are expanding their portfolio through involvement in residential projects. This reflects a growing interest of banks in residential project financing which offers a possibility of exiting the projects earlier than commercial projects, as well as a quicker payback of investments. Tashir group offers one example of this strategy: the group has repurchased the Dirizhabl residential project in Moscow from Eurofinans (Mosnarbank). However, Tashir's main assets are shopping centres.

Real estate assets are still being taken over by the banks in lieu of debt repayment. The ownership of real estate is onerous for financial institutions (particularly if it does not generate cash flow), requiring extra costs and creation of special reserves at the Bank of Russia. However, banks find it difficult to sell their real estate assets: it is hard to sell real estate quickly at market price, and even harder to sell at a price that would compensate the bank's expenses associated with the loan, which the asset originally secured. Also, the assets received by banks include many unfinished projects, which are usually illiquid.

The Chairman of the Bank of Russia, Sergei Ignatyev, has said that reserve requirements may be tightened with effect from July 2011. New rules may state that reserves on a non-core asset, which has been on bank books for more than a year, must be 10% of the value of the asset, rising to 35% after two years and 75% after three years. This may explain the statements by heads of several major banks, who said that their institutions would try to dispose of the bulk of such assets before 2012.

Low liquidity, possible growth of required reserves on non-core assets, and the expectations by market players in terms of  price growth of commercial property is pushing banks into creation of their own development structures. For example, VTB Bank has partially acquired the development company Sistema-Hals and Sberbank has plans to create a new subsidiary, Sberbank Development, which will bring together real estate, land plots, and shares in other development companies. Also Otkrytiye financial corporation has greatly expanded its commercial property portfolio, apparently with the intention of pursuing development business.



A gradual improvement of macroeconomic indicators globally and in Russia should lead to the resuming of works on the projects that were frozen during the crisis and to a stronger new projects flow. We may also see investors turning more attention from the Moscow market, where there is a limited supply of projects offering the attractive returns, to markets in other big cities and particularly in Saint Petersburg. There will be more investor interest in quality projects at the advanced stages of completion.

There was a significant growth in the quantity of office property purchases in 2010 and the investor activity is likely to remain strong in 2011. This reflects a sustained interest of Russian companies in buying office premises, both to avoid a negative impact of the volatile rental market and also due to the fact that the investment in real estate is viewed as a good use of surplus cash. Price levels on the office property market look attractive in view of relatively high cap rates (compared with pre-crisis levels and levels in Europe) and our expectation of faster growth of rents in the medium term. This should ensure that the investment purchase volumes in the office segment remain strong and even grow stronger in 2011.

The modern shopping centres ensure a steady and increasing income flow to their owners on a rising market. It is also important to note that the owners of shopping centres in Russia are often not professional developers, and a shopping centre is often the sole asset of its owner. For these reasons, there are very few investment opportunities in this segment. Also the shopping centres are amongst the most highly priced assets on the commercial property market, which represents a serious obstacle to the potential buyers in the current context due to shortages of own and borrowed capital. The transactions with functioning shopping centre assets in Moscow and Saint Petersburg are therefore rare. Investor attention has shifted towards shopping centre projects in the regions and towards the unfinished projects at an advanced state of completion.

Take-up of warehouse premises by tenants was significantly higher than commissioning of new space in 2010, largely due to lack of financing for the new projects in the crisis period. This trend could lead to a situation whereby the vacancy rate in Moscow (where about 80% of all Russian warehousing is concentrated) approaches 0% by the end of 2011. Up to now the purchases of  warehouse properties have mainly been either by end-users for their own use or as a forced sale due to the debt problems, but the growth of demand from tenants has now encouraged an interest amongst institutional investors in acquiring warehouse properties. The buyers with Russian capital are in the majority at present, but the share of western buyers is expected to grow in upcoming years. It is likely that a number of investment transactions will be completed on the industrial and warehouse market in 2011, including some with involvement of foreign buyers.

There has been a gradual recovery of interest in the Russian hotel market from both Russian and foreign investors. The hotel property market in Moscow represents an attractive investment in view of the inadequate quality hotel capacity in the city and relatively high returns in the segment (Moscow is in fifth place by revenue per room among European cities). Such attractiveness of this market was confirmed by a number of transactions in 2010. The crisis has contributed to the higher professional standards on the market, as companies, which are not specialized in hotel business, have wound up their operations, and we expect this trend to continue during 2011. Overall, an increase of investment activity in the segment is expected. The plans announced by major hotel chains for regional development will make Russian provincial cities an target for investors, although the relevant actions to date have been limited to market research and monitoring of the current situation and future prospects. The cities of most interest to potential investors and hotel operators are those where various special events are to be held. Such cities include Kazan (the Universiada in 2013), Vladivostok (the APEC summit in 2012), Sochi (the Winter Olympics in 2014) as well as Volgograd, Krasnodar, Kaliningrad, Yaroslavl and some others, which will host matches as part of the Football World Cup Finals in 2018.


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