Russia: Fairy tale ending or start of a nightmare?
Reforms are crucial to recovery
ALWAYS READ THE small print. It’s one of the cardinal rules of any successful investment strategy but seemingly one that was widely ignored when it came to the Russian real estate market. In the pre-credit-crunch period, investors snapped up billions of dollars-worth of stock in initial public offerings from the sector in the belief that demand and prices for real estate in Russia were heading in one direction only – to infinity and beyond. With the benefit of 20/20 hindsight, that highly optimistic belief in the sector’s prospects looks sadly misplaced. Financing for developers and their customers has all but dried up, with the result that prices for commercial and residential real estate are already down 30% to 50% over the past 12 months and still trending lower.
Although real estate sector indices across the globe were all sharply down over the past 12 months, nowhere comes close to Russia for value destruction. While the Global Property Research emerging markets real estate index registered a 40% fall in the year to the end of March, Russia was the worst performer of any large economy, falling by 95%. Given the scale and the speed of the sell-off in Russian real estate stocks, it’s no surprise that the sector is now viewed as a classic case of marketing hype outweighing financial reality.
“Right from the very beginning we thought the real estate IPO market was a bubble – property prices were at their height and so there was no upside left,” says Thies Ziemke, managing director of Russian fund manager ParusKreml Capital Management. “All the IPOs were based on very high demand and price projections that have since proved to be absolutely wrong.”
Even though valuations have tumbled, Ziemke says that corporate governance concerns and the high levels of leverage at many of the real estate companies mean ParusKreml still maintains a bearish attitude towards the sector. “We don’t look for speculative value, we look for present value,” he says.
Evgeny Fetisov, managing director at Da Vinci Capital Management, takes a similarly cynical view of the value proposition posed by real estate stocks. “The good times are over for real estate,” he says. “The key problem is getting any leverage – most banks are either unwilling or unable to lend to the sector. Without leverage there’s no growth, and so the real estate market is poised for three or four years of muddling through.”
Neil Smith, managing director at Florin Investment Management, agrees. “There’s no likelihood of any recovery in real estate prices any time soon,” he says. “It’s not as if there are thousands of real estate funds queuing up to come to Russia when there are plenty of bargains elsewhere. Why come to Russia for a 15% to 16% yield when you can get 12% to 13% in the UK, for example?” Smith adds that the real estate market in Russia has come to exemplify the excesses of the commodities-fuelled economic boom of 2000–07, which led to property prices losing touch with economic realities. “If people really thought that their money was real they wouldn’t have spent $30,000 per square metre on an apartment in Moscow,” he says. “In a country with virtually infinite land resources there’s absolutely no justification for the levels that prices got to.”
Fetisov at Da Vinci voices a similar opinion. “There’s no reason why residential property in Moscow should cost more than in Paris or London – labour and material costs are lower, wages are lower and the infrastructure is much worse,” he says.
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“Did the market get overexcited about Russian real estate? Yes, we all got overexcited”
Jeppe De Boer, |
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Florian Fenner, managing partner at Deutsche UFG Capital Management, agrees. “At the peak the price of an average apartment in Moscow was $6,000 per square metre, which meant that 80% of the population was effectively priced out of the market,” he says. Fenner claims that a toxic combination of bureaucratic red tape allied with corruption was one of the root causes of the unsustainably high prices. “Everything that was bad in Russia was crystallized in real estate,” he says. It’s no surprise then that some investors should feel that they were sold a pup when they bought into the sector. But as Jeppe De Boer, managing director and head of real estate investment banking at Renaissance Capital, points out: “As far as I’ve been close enough to judge in all the IPOs all the relevant risk factors and valuation assumptions were fully disclosed. But did the market get overexcited about Russian real estate? Yes, we all got overexcited.”
It’s a measure of that overexcitement that a developer such as mass-market housebuilder PIK Group was able to raise $1.8 billion through its initial public offering in June 2007 – the largest-ever IPO in Europe by a real estate firm and the largest share placement by a private-sector company in the former Soviet Union. The IPO valued the company at $11.4 billion and catapulted chief executive Kirill Pisarev and chairman Yury Zhukov into the oligarch league, with each man holding 42.5% in the firm post-IPO, worth $4.85 billion each, placing them among the 25 richest people in Russia at the time.
Different view
Fast-forward to April this year and the picture for PIK and its main shareholders looks very different. The company’s London-listed shares are down 95% from their high last year, many of its projects have been frozen, and Pisarev and Zhukov have dropped off the list of Russian billionaires. In early April, PIK agreed to sell a 25% blocking stake to billionaire Suleiman Kerimov’s Nafta-Moskva holding company and announced that it had mandated Sberbank Capital, the investment banking unit of Russia’s largest lender, to advise it on restructuring its R45 billion ($1.3 billion) loan portfolio, in a move greeted as a sign that the country’s biggest housebuilder had been crippled by the side effects of the global credit crunch and the associated economic slowdown. In 2008, PIK finished only 813,000 square metres of housing, almost 50% down on the 1.54 million square metres it completed a year earlier.
Commenting on the Moskva Nafta sale and debt restructuring announcement, David Ferguson, real estate analyst at Renaissance Capital, says that with Kerimov holding a 5% share in Sberbank – one of PIK’s principal creditors – PIK is now better positioned to secure favourable restructuring terms and access to new debt to fund its working capital requirements. “Overall, it increasingly looks to us as if PIK will be able to successfully address its liquidity requirements without the need to issue new equity and the subsequent dilution for minority shareholders that this would imply,” Ferguson says. Although the presence of cash-rich Kerimov as a key shareholder should help to ensure PIK’s survival, there’s still precious little enthusiasm about the company’s stock. Thomas Fasbender, a director at ParusKreml, says: “We manage family-firm money from western Europe that wouldn’t want us to play the inter-oligarch investment game.”
Although big developers such as PIK should successfully renegotiate their outstanding debt obligations, securing funds for new projects is likely to remain challenging, say bankers. “On a global level, capital-raising for real estate projects is very difficult right now and capital-raising for Russia is even more difficult,” says De Boer at RenCap. “People are looking to protect their existing investments rather than make new ones.”
According to RenCap research, the combined debt of the Russian real estate/construction sector is in the region of $80 billion, with $6 billion in the form of bonds or credit-linked notes and the balance in loans. “The impression we have is that most developers are already in talks with banks about debt restructurings,” says De Boer. “A lot of developers relied on short-term debt and on their ability to either roll it over or refinance it elsewhere.” An added problem, he says, is that a lot of developers spent their free cash on building up their land banks, while in the residential market a lot of the homebuilders relied on pre-selling apartments to finance their developments.
De Boer says that the ability to negotiate refinancing/restructuring options will depend heavily on how much of a prospect lenders see of actually recovering their investment without the borrower’s continued involvement. “There’s a big difference between foreclosing on a half-finished project and on a completed income-generating project.” In terms of the prospects of a sizeable inflow of foreign funding for the sector, De Boer says: “Right now, rightly or wrongly, there is very little international money pursuing Russian real estate, therefore developers are likely to pursue local solutions to their funding problems.”
Banks offer support
One of the few bright spots on the horizon is that the big state-owned banks in Russia are willing and able to provide funding for the sector. “We’re still ready to provide financing for real estate, especially for residential projects by top-tier developers,” says James Corrigan, global head of real estate, investment banking division, at VTB Capital. He says that as well as providing construction loans, VTB Capital is looking to acquire real estate assets in conjunction with foreign partners.
“We have the local knowledge and experience to manage assets here in Russia,” Corrigan says. Although there has been widespread speculation about the likelihood of real estate funds looking to snap up assets at distressed-type pricing levels, Corrigan concedes that so far at least there’s been little actual activity. “There’s lots of anticipation from potential buyers, but lots of reluctance from potential sellers,” he says. He expects that most of the interest will be focused on flagship assets in Moscow and St Petersburg markets rather than in the regions. “In times of crisis the economic gap between Moscow and St Petersburg becomes more obvious,” he says, adding: “Before the crisis there weren’t assets for sale in Moscow and St Petersburg and so investors were forced to go to the regions. Now that you can do deals in Moscow, why go to the regions?”
Maximizing rental income
Among the real estate funds already active in Russia the focus so far in 2009 has been firmly on the efficient management of existing assets rather than the acquisition of new ones. Ivan Kabulaev, senior associate at Russian investment bank Troika Dialog, who manages the Kommercheskaya Nedvizhimost commercial real estate fund, says that maximizing rental income is the name of the game for his fund. Launched in December 2004, the closed-end mutual fund, which is listed on the Moscow Interbank Currency Exchange (Micex), has seen its net asset valuation grow from just $20 million at launch to $114 million by the end of the first quarter of this year. The fund owns 14 properties in Moscow, Moscow Region, Ekaterinburg, Samara, Ufa, Kazan, Perm and Sochi, ranging from individual shops and restaurants to office blocks and shopping centres.
“We have a very diversified portfolio, both in terms of geography and business segments,” says Kabulaev, adding that after initially focusing on the Moscow market in 2004, the fund gradually expanded its focus to regions outside the capital where there are high GDP/capita levels and demand/supply imbalances. Although the long-term aim of the fund, which is expected to run until December 2019, is to deliver capital appreciation in the present environment, Kabulaev says the focus is on ensuring stable rental income from its tenants.
Kabulaev says that while tenants in its office developments are still faring well and have not requested any reductions in rents, restaurant tenants are suffering from the reduction in consumer spending and are seeking to renegotiate the terms of their leases. “Our main focus right now is on managing our current properties to best effect,” says Kabulaev. “But we would look to buy further properties at the right price.” He adds that although there are plenty of uncompleted projects available at distressed price levels, there are many fewer completed projects for sale that would enable the fund to generate rental income immediately.
Like many of his peers, Kabulaev says that there is still a disconnect between sellers’ and buyers’ expectations. “There are investors with money both inside and outside of Russia that are interested in real estate here but they are still waiting for prices to fall further. As sellers don’t want to sell at current levels there are almost no deals being done right now.” In terms of future prospects he believes that outside of Moscow demand for office space will remain depressed as many businesses are opting to build their own premises rather than buy from developers, while the retail segment will remain under pressure as most Russian retailers cut back rather than expand their networks. Kabulaev says that to date hopes that foreign retailers encouraged by lower rental levels would take up the slack have largely been misplaced.
“We don’t see that much international interest in retail space right now,” he says. Other firms are also looking to keep their powder dry in the expectation of better bargains to come. Fenner at Deutsche UFG Capital Management, which raised $140 million for its second real estate fund in 2008, says that it is adopting a wait-and-see attitude before committing any capital. “Right now the real estate market is absolutely dead – sellers believe that properties are not as cheap as potential buyers believe they are,” he says. “Prices need to adjust to the new economic realities in Russia, and then we will be happy to put money to work.”
Fenner believes that the pressure to sell will increase over the next six months as growing numbers of project and development loans fall due, with little prospect of them being refinanced. “Financing is either not there or only available at Libor plus 7% to 8%-type levels.” The main focus of any new investment will be on commercial real estate, says Fenner. “Russia still has a structural deficit of quality office space,” he says. “For example, Moscow probably only has five truly A-class office developments.”
Although there’s undoubtedly plenty of doom and gloom surrounding the Russian real estate market, there’s also a sense that the sector will learn some useful lessons from the present turmoil. “We will have a cleansing of the market that will be painful but very necessary,” says Fenner.
Sergey Riabokobylko, senior executive director at real estate consultancy Cushman & Wakefield Stiles & Riabokobylko, agrees. “A lot of people who shouldn’t have been involved in real estate won’t be after this year,” he says. “We will see a lot more professionalism in the sector. The Russian real estate market is definitely still a long-term priority for a lot of people – it’s simply too big to ignore.” But learning to recognize the potential risks as well as the rewards of the sector will be key to its future wellbeing, says Kabulaev at Troika Dialog. “I hope that people will become more sophisticated about real estate – using a calculator and not their heart when it comes to valuations.”
