Foreign Investment

Real Estate in Russia

Editor's Note: In 2004, Norman Miller , director of the University of Cincinnati's Real Estate Center and CCIM Institute's education consultant, gave a day-long series of four lectures in Moscow . Following are some of his observations about Russia 's commercial real estate market and the changes that have occurred since his last visit in 1998.

Today, Moscow 's mood is one of pure jubilation, and the air is filled with dreams of new opportunities. The quality of life in the city is far better than in the rest the county as young, successful professionals infuse their wealth and knowledge into the business culture. Yet, similar to all world-class cities, corruption, entrepreneurship, and capitalism all coexist. These factors each play a role in livelihood of Moscow's real estate markets.

Real Estate Reality Check

Many of the typical U.S. industry safeguards are nonexistent in Russia. For instance, when I inspected an old factory building undergoing renovation, no hard hat was required; if you slipped into an open hole, shame on you for not watching your step.

Environmental concerns also are nonexistent. No Phase 1 inspections are required on urban development. One of our excursions included a four-story descent in a completely dark stairway in a building undergoing rehabilitation. The foreman explained that other stairways were better lit but they were not as safe.

On the investment side, Moscow yields remain well above most international cities for all types of real estate. Capitalization rates for class A office space run about 13 percent to 15 percent and class B space, 16 percent to 18 percent. These rates come down by 100 to 200 basis points per year as capital flows into the market.

The market is difficult to enter without local partners, although U.S. companies such as Hines and Enka, a Turkish firm, have successfully entered the market. Design review, permits, and land-use regulation is inconsistent, bureaucratic, and requires "gifts" for quicker action.

Second, there are severe supply constraints on new development including a city share tax known as dolya goroda. The tax can run as high as 50 percent of the value of the new construction. This share tax can be bought out upfront or paid as a partnership with the city government.

The share tax does not apply to existing space, so renovating factories into offices or retail space and rehabbing old residential space are the preferred paths for new development. Also, tearing down existing buildings and replacing them with the same amount of gross space does not trigger the share tax, while net new space does invoke the tax. As a result, few new developments occur; although several are planned simply as a result of strong demand.

In addition, debt financing remains expensive and the increased use of equity requires higher overall returns to provide sufficient lower leveraged equity returns. Russian interest rates can run 12 percent to 18 percent and external financing from outside Russia remains difficult.

Development Obstacles

Determining the potential value of a finished new project can include many variables not present in the West. All real estate became private in 1989, so there numerous owner-occupants. For example, rehabbing a housing project means the developer must buy out all the existing owners. But it is not enough to simply find a price at which they will sell; the developer must find them places to live and register them at new addresses before they can close on their units. In turn, the developer must find housing for the people being displaced by the first move. This domino theory of replacement housing can require closing on 250 or more unit transactions in order to buy 100 units in a single building. Managing such multiple closings is daunting but necessary when working in the housing market.

Developing class B office product is similarly challenging. The typical process starts with finding a factory teetering on bankruptcy from antiquated production methods. Factory workers, who own the business, must be persuaded to sell their shares for cash. Once a majority of the shares are bought, the factory is closed and a new owner takes over the building.

One requirement of the factory purchase is to find new jobs for the bought-out workers. Every spec investment development company has a staff of employment agents that place as many of the workers as possible.

Most of these factories would not survive in a globally competitive world. There is little value in the companies except for the real estate. Such factories are located near enough to the central city that they make ideal class A or B office space. These sometimes-hostile takeovers started in 1997 and the inventory of well-located old factories will probably run out by the end of 2006. After that, new development will be needed.

Supply and Demand

Labor is cheap enough and rents high enough on new class A office space, retail space, and some new housing that new development still is financially feasible, despite the city share tax. Land often is leased on a very long-term basis, creating a spread between cost and value that can reach close to 50 percent. Moscow probably is at the peak of this spread and in a few years the city will need to lower the share tax to allow new development.

Demand for retail, office, and quality housing space continues to exceed supply yet there are pockets where over development is possible in the coming years. For example, in the first half of 2004 the class A office absorption ran 405,700 square meters (more than 4.3 million square feet) while only 258,500 sm of net new space was added — putting continual pressure on rents according to Jones Lang LaSalle. Only 140,300 sm of A and B space was available (about 1.5 million square feet), which is not that much for a rapidly growing economy that can absorb several million square feet per year. Incomes are growing by nearly 15 percent per year in nominal terms although inflation continues to run close to 10 percent.

In addition to rents (see chart), operating expenses run another $9.30 per square foot for office space, slightly less for warehousing and more for retail, plus 18 percent value-added tax on the net lease payment. In total, occupancy can run $70 to $90 psf per year for class A office space, making it one of the more expensive markets in Europe. Yet international companies, once hesitant to enter the market or having entered it too early, now are returning.

Housing Market

The typical Muscovite household often includes three generations or more living in 800 to 900-sf apartments. These units are twice the size of the typical pre-1989 units and larger than is typical in the rest of Russia . Newer units are larger and of better quality; some new professionals choose to live on the city's outskirts in U.S.-sized homes. Older Russians use dachas or country homes to escape the city apartments. Dachas range from primitive cabins to modern homes and most upper class escape the city on weekends.

Along with rehabbed buildings, new housing developments also exist. One project includes high quality condominium units of 1,100 to 4,400 sf. It will be the tallest housing building in Europe and one of the largest. It may be more than the market can swallow and larger than the market can afford, as it nears completion at the end the year.

New Construction

Moscow City, a new large-scale mixed-use development will result in more than a million sf of class A office space coming on the market each year for several years. Moscow 's mayor wanted the development and waived the normal city share tax. As a result, some developers feel that this new development has an unfair advantage in terms of the cost structure. The mayor also made sure that the subway line would be extended to the site, almost assuring the project's success, since the vast majority of the market depends on public transportation.

Access remains a critical factor in this city: The typical office project provides about one car space per 1,000 sf of office space. Slightly higher ratios are used for class A retail but not class B.

For now the real estate market continues to prosper and players who know the rules and play the game well are creating enormous wealth. Will the oversupply observed in Asian markets occur in Moscow? Probably not, as the city share tax constrains new development for now. Exchange rate risks also are not that high, as the Russian inflation rate has moderated and the ruble has strengthened relative to the dollar in recent years.

While direct ownership by foreign firms is possible, a better strategy would be to provide participating debt to trusted local partners, avoiding the difficulties of foreign ownership and receiving preferred returns that likely will exceed direct U.S. equity investment returns by a significant margin.

Moscow Real Estate

Product type

Net rental range in dollars per year per square foot

Class A office

$53-$56

Class B office

$43-$46

Prime-street retail

$200-$325

Class A shopping malls

$10-$46 for anchors; $25-$250 for specialty goods

International-quality warehouse

$12.50-$14.50

Norman Miller

Norman Miller is director of the University of Cincinnati \'s Real Estate Center and was a 2003-2004 DePaul University visiting professor. He also serves as the CCIM Institute\'s education consultant and is author of Real Estate Principles for the New Economy. Contact him at (513) 556-7088 or normmiller@fuse.net . Hungry for Knowledge The audience for my lectures included local commercial real estate professionals from companies such as Jones Lang LaSalle, Colliers, and Knight Frank, as well as from my host, Horus Capital. Many attendees had MBAs from Moscow State University and U.S. schools. Russia has no formal real estate programs. Most real estate professionals are self-taught and peer-taught. Many had read Commercial Real Estate Analysis and Investment, which I wrote with David Geltner. The popularity of this graduate-level book illustrates how determined Russia\'s real estate professionals are to learn state-of-the-art decision tools. My lectures covered the connection between the space and capital markets using a rather complicated four-quadrant model, land residual theory and option values, and front door/back door feasibility analysis. Most followed these complex and mathematically intensive discussions with the assistance of headphones and simultaneous translation. While in Moscow for a lecture series, the author (left) visited a construction site and found that Russian construction regulations are very different than in America.

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