Real Estate in Russia
By Norman Miller |
Editor's Note: In 2004,
of the University of Cincinnati's Real Estate Center and CCIM
Institute's education consultant, gave a day-long series of four
. Following are some of his observations about
's commercial real estate market and the changes that have occurred since his last visit in 1998.
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
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.
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.
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.
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
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.
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
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.
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.
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.
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.
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.
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.
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
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.
Net rental range in dollars per year per square foot
Class A office
Class B office
Class A shopping malls
$10-$46 for anchors; $25-$250 for specialty goods