Russia: Bulls roam free in buoyant market

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By:
Guy Norton
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The doom and gloom in the US is in stark contrast to the joy and boom in Russia, where there’s an overwhelmingly bullish tone across all segments of the real estate market. Guy Norton looks at the formula for success employed by two leading Russian developers.

Amid the lamentations and gnashing of teeth in the US in the wake of sub-prime mortgage market tribulations and the associated housing slump and credit crunch, it would be easy to forget that there are plenty of countries where a housing boom is only just beginning. Not least in Russia, where an economy turbocharged by oil prices around the $100 a barrel mark is helping to ensure that property developers and investors are feeling more than happy about the prospects for the coming years.

Across the country’s real estate market there’s a feel-good factor, which stands in stark contrast to the US. Thanks to a confluence of positive factors there’s a whirlwind of activity in the residential and commercial real estate sectors, with construction companies and developers overwhelmingly bullish.

Certainly at the top end of Moscow’s property market there’s little concern about recent events in the US. "In Moscow, nobody really cares about the US sub-prime mortgage problems and the credit crunch," says Emanuel Kuzinetz, director at RGI International, a property development and management company focused on high-end prime location office, retail and residential properties, in central Moscow and the surrounding areas. "Market conditions in Moscow and Russia in general are more driven by the price of oil and metals than by events in the US." Furthermore, Kuzinetz remains sanguine about the prospect of a sudden reversal in the price of commodities. "When the oil price was $50 a barrel people used to ask us, ‘What would happen if it went down to $20 a barrel.’ Now it’s at $100 a barrel." Given that, on the residential side, RGI caters to the growing legions of super-rich Russians, Kuzinetz is confident that the company would still thrive in the face of lower oil prices. "Our clients would still want somewhere nice to live," he says.

Ultra-high end

Even with town houses in the central Moscow district of Ostozhenka at $37 million apiece, there’s no shortage of takers. "The ultra-high end of the market has no connectivity to the credit crunch whatsoever," Kuzinetz says. "We’re talking very wealthy individuals – cash buyers who want to enjoy the same standard of accommodation in Moscow that they see when they travel to the likes of Paris, London or New York."

It’s not just somewhere nice to live – Russia’s new elite also wants to have upscale places to work and shop. RGI’s portfolio therefore includes such projects as the Tsvetnoy 15 retail centre, which is forecast to be worth $285 million at completion in 2010 and the Media City office development in Ostankino, which is set to be valued at much the same level when it is finished at the end of next year. It’s in the commercial real estate segment of its business where RGI has seen the most dramatic changes in ownership since the company was founded in 1991.

"In the 1990s, 100% of our clients were international companies but now it’s 60% Russian and 40% international," says Kuzinetz, adding that although in the immediate wake of the break-up of the Soviet Union the company fought shy of having untested Russian companies as tenants, 16 years later there are many local firms with long operational track records and strong financial profiles that are prime candidates to lease office space too.

Together with the ever-growing number of international firms that are setting up shop in the Russian capital, this local demand means that Moscow is now the most expensive destination in central and eastern Europe when it comes to rental levels on commercial real estate. Gunther Artner, co-head of central and eastern European equity research at Erste Bank in Vienna, says: "Moscow, with its exceptional economic position and overall low office stock, continues to see solid rent growth, in spite of the already high nominal levels compared with other cities." At around €650 per square metre per year, rent levels for prime class A office space are more than double the €250 average in such cities as Budapest, Prague and Warsaw. Only Kiev, which suffers from a similar lack of supply as Moscow, comes close, at €500.

Despite high prices there is no shortage of clients, says Artner. "We cannot seriously talk about any vacancy in Moscow, where A-class offices in good locations are usually fully let prior to completion and only class-B offices have some vacant space." Given the favourable demand/supply imbalance and high rent levels it’s no surprise that Moscow tops the league table for prime office yields at 9.5% – roughly 300 basis points more than the average in central and eastern Europe and almost double the level in western European capitals such as Vienna and Madrid. What’s more the yield spread on prime office space investments is more than 350bp over 10-year Russian government bonds, compared with a premium of 70bp in the Czech Republic and a discount of around 80bp in France.

Raging retail sector

There’s a similarly upbeat tone in the retail segment of the Russian market, where the move from small grocery shops to western-style shopping is still largely yet to happen. Although shopping centre rents in Moscow are relatively high – at around €75 per square metre for a 100 square metre unit they are more than 50% higher than in the rest of central and eastern Europe – they still lag well behind the €160 to €170 levels in such cities as Frankfurt and Paris. Furthermore, Artner at Erste Bank believes that there is still scope for rents to grow further as there is still a supply/demand imbalance in spite of the forecast 50% rise in retail stock in Moscow over the 2006-08 period. Given that rents will account for only 2% to 3% of forecast retail sales in 2008, Artner says: "As a rule of thumb we can say that there is big room for rents to increase or for building additional shopping malls in Russia in the mid term." Despite recent new developments, retail stock per capita in Russia is still forecast to be 0.05 square metres compared with 0.25 in Poland or 0.3 in the Czech Republic, where penetration levels are now close to western European norms. Once again given a positive backdrop the yields on retail property at 10% in Moscow are far higher than the roughly 6.5% average in central and eastern Europe and the 4.5% level common in western Europe.

Office yield spread over 10-Year government bonds

Source: Erste Bank estimates, mid August 07


It is these positive dynamics that have enabled even relatively small niche operators such as RGI to access the international equity capital markets over the past year and attract global institutional investors as shareholders. Since its initial public offering on London’s Alternative Investment Market in December, RGI’s market capitalization has soared from $610 million to $1.3 billion. At the same time it has attracted blue chip investors such as Henderson Global Investors, Kensington Gore and Lansdowne Partners International.

Kuzinetz says that post-IPO, RGI, with more than $1 billion in equity, is able to take on bigger, more lucrative projects and can increasingly look at projects at a post-predevelopment stage — where land has already been rezoned for development purposes, enabling the company to realize projects faster and so accelerate the returns it is able to deliver to investors. "We’re making more than a 100% return on each project."

With a successful equity offering already behind RGI, Kuzinetz says that the company’s primary financial focus is on raising debt capital to help fund its project pipeline, which for the period 2007-12 includes a portfolio of residential, commercial and retail properties worth about $8.6 billion at completion. Of the roughly $4 billion needed to complete its current portfolio projects, some $2.5 billion will be funded by pre-sales of its residential properties, with the balance to come through a variety of debt transactions. It has already secured a private placement through Morgan Stanley Real Estate, whose global co-head, John Carrafiel, says: "RGI is a fast-growing and entrepreneurial company, with an outstanding track record of organic growth. We are excited at the prospect of contributing to its future success through this capital injection, which will be used to invest in several attractive projects in Moscow."

Kuzinetz says that ultimately RGI is considering a variety of debt instruments encompassing traditional construction loans, syndicated loans and Eurobonds. "We like to have different funding options and so we are looking at where we can get the best rates and what are the best options for gaining further access to capital," he says. He says that there hasn’t been any dramatic increase in the rates on construction loans levied by Russian banks or any reduction in their availability. "The Moscow market has barely been affected by the credit crunch in the US," he says. "Local bank rates are pretty much the same as they were before the summer; the banks are liquid and willing and able to lend to developers like us."

Thirty years of work

RGI will continue to concentrate on the high and ultra-high end of the market and intends to maintain its Moscow-centric focus. "We’re very happy to concentrate on Moscow – it’s a huge market with a lack of luxury residential, retail and commercial property," says Kuzinetz. "Moscow alone can provide us with work for at least the next 30 years." He rejects the view that the Moscow market might be heading for a downturn, noting: "Land prices are still relatively low compared with the final sale price of properties, so it still makes sense to buy land in Moscow."

The types of properties developed by RGI are way beyond the means of most ordinary Russian citizens and companies, but developers such as PIK Group are catering to the more affordable end of the market, not just in Moscow but increasingly on a national scale. Founded in 1994 with an initial geographical focus on Moscow and the Moscow region, PIK has gone on to become one of the leading residential developers in Russia, with a rapidly increasing regional presence. At the end of May, the company hit the headlines when it launched a $1.93 billion initial public offering in Moscow and London, the largest ever European real estate IPO and the largest global non-Reit real estate IPO. Artem Eyramdzhants, PIK’s chief operating officer, says that the proceeds of the IPO, which valued the company at $12.3 billion, will enable the company to expand its land bank further and help accelerate its expansion in the Russian regions and fund acquisitions.

The rationale for regional expansion is based on the simple premise that house prices in the regions will ultimately converge towards those in Moscow, enabling the company to continue to enjoy its traditionally high levels of profitability. At present, prefabricated panel housing in Moscow retails at $3,500 per square metre compared with an average of just $1,000 to $1,500 in the regions. Initial costs are also much lower.

"The price of land in the regions is still very cheap versus Moscow and so by using part of the proceeds of the IPO to expand our land bank in the regions we can maintain our high profit margins," says Eyramdzhants. As an example of the opportunities available outside Moscow, he cites the acquisition of regional developer Stroyinvest Region, which PIK bought for $40 million in 2006 and whose land bank, which gave the company a presence in 10 new regions, was valued just 12 months later at about $1 billion.

He adds: "The regional real estate market is still very fragmented and so there’s a lot of scope for consolidation. In the regions we’re now looking to buy up experienced construction and development firms which have good land banks we can develop further." Given PIK’s focus on mass housing projects, which will help replace low-quality Communist-era stock, Eyramdzhants says that the company has been well received by the local administrations in the regions where it has expanded. "Regional governments want developers to develop mass housing projects and we can help them with the master planning of new townships on a mid-term to long-term basis. They appreciate a developer like PIK which has a good financial standing, a good brand and the ability to execute large-scale projects," he says.

First-half 2007 prime office and retail yields

Source: CBRE, JLS, Erste Bank estimates


The company is active in more than 12 cities in the western, central and southern regions of Russia and plans further expansion into the Urals and Siberian regions further east in the near future. Eyramdzhants says: "We concentrate on cities with positive migration flows, with inhabitants that earn higher than the national average income and which have efficient construction companies – the ability to execute projects is very important and so we need to be able to outsource construction at times." PIK’s experience since it started its regional expansion in 2003 has been overwhelmingly positive, says Eyramdzhants. "In terms of the infrastructure, economy, legislation and the availability of information the regions are every bit as easy, if not easier, to operate in as Moscow. Thanks to a federal government agency based on the Fannie Mae model in the US, there is increasing availability of mortgage finance in the regions, which is helping to turn the dream of home ownership for PIK’s target audience of young professionals with one or two children a reality."

Mortgage market growth

Thanks to strong relationships with mortgage providers such as Sberbank, VTB 24, Rosbank and Raiffeisenbank alongside sister company Housing Finance Bank, Eyramdzhants says that buyers enjoy enhanced access to funding. "We don’t finance customers, but we do help them to secure mortgages through our good strategic links to banks." With about 20% of purchases funded through mortgages – twice the average for most developers – PIK is naturally more exposed to any potential slowdown in mortgage lending. So far at least there’s no sign of that happening in the wake of the credit crunch in the US, with mortgage volumes up 190% in the first half of 2007. "We’ve seen rates increase here, but not enough to impact overall mortgage volumes," says Eyramdzhants, adding: "The long-term macroeconomic factors here in Russia are more important than any short-term fallout from the sub-prime problems in the US." What’s more, compared with their central and eastern counterparts and those in western Europe, Russians are far less indebted.

According to the World Mortgage Association, residential debt as a percentage of GDP is just 2%, compared with 8% in central and eastern Europe and 28% in western Europe. Furthermore, with the recent acquisition of commercial real estate developer Storm Properties, PIK is seeking to diversify its activities and mitigate any over-reliance on purely residential developments. "We are ultimately looking to have 15% of our assets in commercial real estate," says Eyramdzhants, adding that while Storm has traditionally focused on Moscow and the Moscow region, PIK will look to expand its activities into the regions once it has built up the necessary expertise.

On the financial side of the business, Eyramdzhants says that PIK has repaid almost $400 million of its most expensive loans, thus cutting its average cost of debt by 1% to 9.4%. He adds that while the company is looking to secure international credit ratings in the coming months, it is in no hurry to borrow funds. "We are looking at the possibility of issuing Eurobonds but not in the current volatile market conditions," he says. PIK will review its funding opportunities in the first half of 2008. "We’re underleveraged right now and so we will look at optimizing our capital structure by raising debt to fund further land and developer acquisitions," says Eyramdzhants.