Russian Developers Finding a Cure for STD

With financing virtually impossible and likely to remain tight, developers will face increased costs of financing and insolvency risks. Investors should focus on their ability to cover the short+term maturities from existing cash resources. Otherwise, shareholders face the risk of adverse structural change and dilution.

We expect housing prices in the mass market to go down by 10+15% within the next 12 months, and 15+20% in the more volatile upscale segment. Additionally, we believe that commercial property prices will go down 15+25% y+o+y in the next 12 months on the back of stagnating rental incomes and forced sales.

Unlike on Western markets, short+term liquidity problems rather than any decline in consumer buying power are the main causes of the downturn in Russian real estate. We still believe in the strong upside of the development sector in the longer term, when economic expansion in Russia is set to continue.

We initiate coverage of Russian developers with BUY recommendations for low+risk Open Investments and LSR Group, as well as the more speculative PIK Group, and HOLD recommendations for Sistema+Hals and RTM.

Investment Summary

Market view

Given the post+Soviet vacuum in quality commercial space and huge backlogged demand for housing stock, the development sector in Russia embeds strong upside that has a solid long+term growth outlook. However, in light of the current liquidity crisis, the financing risks are clearly the main short+term driver for the stocks. To help navigate these tricky waters we summarize the main market exposures and key financing risks of the businesses that we cover.

Real Estate market remain promising in long run

In the long term, real estate remains a segment with one of the most promising growth prospects in the Russian economy. Backlogged demand, along with economic growth, suggests that the prime commercial estate market could double by 2015, while the housing market possesses the highest annual volume growth. The building materials and construction market is set to enjoy volume growth of at least a 20% CAGR through 2015 on the back of investments in development and infrastructure.

Liquidity crisis increases shortterm uncertainties...

In the shorter term, we consider demand and supply distortion due to increased uncertainties and vanishing liquidity on the part of both developers and their customers a risk. While the main players in the development market may change dramatically post+crisis, the survivors will definitely come out stronger and ready to execute their postponed pipelines to a market hungry for supply.

Which we expect to trigger price correction across segments

We see the potential for a 10+25% downward correction in real estate prices in the next 12 months, as the more liquidity+squeezed developers opt for price cutting alongside price adjustments, which will cause an increase in capitalization rates. Developers’ margins in the regions will erode faster due to initially lower levels. The falling property prices may also exert downward pressure on construction and building material costs (also driven by falling commodity and energy prices), which is negative for producers of building materials but helpful for developers in general.

Housing market is overpriced

We believe that the residential sector is overpriced, and are wary of higher pricing uncertainty. In our view, mass+market apartment housing carries the lowest pricing risk due to its comparative affordability and larger buyer base. Given that the liquidity crisis is still unfolding, we anticipate housing prices in the mass market falling by 10+15% in the next 12 months, compared with a 15+ 20% decrease in more volatile elite housing segment.

Moscow mass market to be more defensive

However, we expect Moscow’s residential mass market to undergo a smaller y+o+y price correction, helped by state tenders in the Moscow area. The city’s government has already budgeted $2 bln in municipal orders and has indicated plans to consume up to 50% of new housing supplied during 2008. We believe that these state buys will be particularly beneficial to PIK Group, which has a working relationship of supplying social housing to Moscow. We expect every deep+pocketed local Russian government to support developers under various schemes.

Mortgages becoming more expensive, greater deposits required

Importantly, banks are already considering the potential of a correction in housing prices, as they have increased the down payment requirement from 10% to 30% for mortgage financing. Though rates have seen a spectacular 500 bps increase since the start of the credit crunch in July 2007 – to as high as 15% in dollars and 18% in rubles – the main banks still continue mortgage lending, which remains a decisive source of liquidity for the housing market.

Commercial space to suffer from forced sales and stagnating rentals

We expect commercial prices to go down 15+25% y+o+y on the back of stagnating rental incomes and increased refinancing costs. Though the commercial space is priced more adequately, this vulnerable stock makes up a big chunk of the relatively liquid estate pledged at banks, and is becoming more susceptible to abrupt increases in the property offering as forced selling becomes prevalent. However, compared with Western lows, Russian legislation requires significantly longer lead times (six to 12 months) for the banks to sell the pledged property, and we thus believe that the chances of a chain reaction occurring are limited. In our view, the value of unfinished commercial property may fall as much as 50% in a market with many sellers and very few buyers. The St Petersburg administration is prepared to buy out distressed unfinished projects in its area, though we expect this to be at significant discounts to recent high prices.

With the growth here supported by strong underlying fundamentals, we estimate the prime commercial space to be priced adequately in the long term. However, the upside in this sector is bottlenecked by scarce financing and long cash+back periods. Conversely, residential developments are self financing due to presales.

Valuation

In the current environment, the use of NAV as a value indicator becomes complicated due to a few factors caused by increased short+term refinancing risks:

• The value of a developer’s NAV may be undermined by sharply increased restructuring and dilution risks.
• As the cornered developers are ready to pay high premiums, the costs of refinancing short+term debt may become higher than the return on the projects;
• The developers may start monetizing part of their unfinished projects at low prices, which, in conjunction with an expected drop in real estate prices, may cannibalize the future cash flows from the developer’s portfolios.

As the financial risks of individual developers diverge rapidly, so does the quality of their NAVs, and the refinancing risks become central to investment decisions. The more a stock drops, the higher the dilution and refinancing risks become, undermining the perceived upside to NAV, thus favoring those developers with strong internal cash generation capacity and limited refinancing needs.

In t he v iew of NAV u ncertainty, we r egard SO TP DCF a s the most o bjective t ool f or f air value appraisal. We compare results from multi+scenario DCF with ranges calculated from P/NAV and EV/EBITDA multiple analysis of Russian and foreign peers.

We have applied 50+400 bps premiums on the company level over our already conservative base cost of equity in order to quantify the impact of financing risks on execution and the long+term cost of capital. In addition, we applied further discount premiums (300+600 bps) at the project level to reflect the execution risks within individual projects, depending on their status. Thus, each company has a range of discount rates applied to its SOTP. This leaves us with significant room to upgrade our indicative ranges as conditions improve.

LSR Group: Best risk/reward proposition

We initiate coverage of LSR Group with a 12+month target price of $8.00 per GDR and a BUY recommendation. Operating across the full chain of development and building materials businesses, the company has grown quickly to become the market leader in Russia’s Northwest. LSR Group has unique industry exposure and excellent transparency. Ambitious yet prudent regional expansion alongside diversified cash flows offers long+term upside and a cushion against near+term credit risks. Following the correction, the company is now trading at an 87% discount to its NAV, with the rest of businesses effectively being offered for free. We believe that under current market conditions, LSR Group offers the best risk/reward proposition.

PIK group: high upside to sweeten risks

We recommend PIK Group as a speculative play, with a 12+month target price of $11.00 per GDR. The historically strong growth is now ensured by regional diversification, and we believe that the company has significant opportunities to capitalize on adverse market conditions. Through vertical integration of the prefabricated construction division, the developer controls its execution and cost risks, while offering investors additional exposure to the construction business in Russia. However, in light of the liquidity crisis, we remain cautious on the developer’s ability to meet its large short+term debt maturities, but point out that PIK Group’s near+term cash flows can be sufficiently hedged by purchases by the Moscow government. Recalling the developer’s regular 60% premium to its NAV in the past, we believe that the long+term reward outweighs short+term risks.

With their respective foot prints in Moscow and St Petersburg, PIK Group and LSR Group today replicate their business models into faster growth in regional cities, offering investors the best diversified portfolios of mass market residential construction, development pipelines of over seven years and volume growth CAGRs of 20%. Thanks to the short development cycles and apartment presales, the development businesses are cash creative, allowing both developers to consolidate the market, as many other developers decrease the supply of new space due to insufficient project finance.

Open investements: Lowest risk profile

We reinitiate coverage of Open Investments with a target price of $130 per share and a BUY recommendation. Rapidly emerging as one of the main land players in Moscow Region, the company enjoys local lobbying power and defensive positions. The developer‘s asset value may benefit somewhat from decreased supply in the market. We believe that the longer+term expectation of stock recovery creates an interesting risk/reward opportunity on the back of current market weakness together with the low risk of an equity+financed developer.

Thanks to its rich cash reserves, Open Investments is the most expensive Russian developer on P/NAV and EV/EBITDA; however, it has the highest immunity against near+term insolvency risks. In the long term, we remain skeptical about the company’s ability to spread its existing experience over mass market suburban developments with less proximity to Moscow.

RTM: Speculative risk/reward proposition

Reflecting high short+term risks, we reinitiate coverage of RTM with a HOLD recommendation and a 12+month target price of $0.95 per share. RTM has a sensible business model, which together with regional diversification provides the company with strong long+term growth potential, though this is undermined by tightening financial markets and high leverage in the short term. Around three quarters of the developer’s project portfolio is already income generative, which gives it a real NAV. Monetizing RTM’s income+generative retail space and fully paying off its debt would maximize the shareholder value; however, the company is foregoing this option as time passes. RTM is now trading at an 85% discount to its NAV, and considering the dilution and financing risks, we believe that the risk/reward position remains moderate.

Sistemahals: Even more speculative risk/reward proposition

We have a HOLD recommendation on Sistema+Hals, with a target price of $0.90 per GDR. Rather than as a property company, Sistema+Hals emerges as a limited purpose niche+play developer. A lucrative property portfolio, thanks to predominantly Moscow+located development sites in high+ demand areas, provides a solid base for a nice mix of shorter+term high+end residential projects and longer+term commercial projects. However, we remain aware of financing and dilution risks in light of the liquidity crisis and a generally high debt load. With its main cash flows still years ahead and undermined by current high interest payments, the company now trades at a 93% discount to its NAV, which we believe merely addresses the increased risk perceptions in light of the current market weakness.

Financing Risks

Shortterm debt refinancing to become the main value driver

Given the scarce funding, developers’ ability to secure sufficient financing in the near to medium term is currently perceived to be the key risk and the principle driver for stock prices. The inability to meet short+term maturities could escalate value+destructive forced sales, even with generally underleveraged developers. But the alternative – potential equity injections – could increase the risk of minority shareholder dilution in light of weak stocks, with both discounting the upside potential to NAV. The real estate development industry is perhaps the most vulnerable to financing turbulence, which is especially true for Russia, given the prevalence of short+term debt in portfolios and aggressive, last+minute investments.

We believe that during a liquidity crisis, capex+intensive developers face increasing financing risks, which in light of weak stocks, now translates into stronger dilution risks for minority shareholders. It also discounts the shareholder’s ability to realize upside from the price/NAV. Underleveraged Open Investments, PIK Group and LSR Group are at little risk of dilution. However, PIK Group and LSR Group have significant short+term maturities. In the shadow of increased end+user demand risks, both developers still maintain high chances of servicing their debt obligations, and we like LSR Group’s diversified cash flow sources.

Debt restructuring – converting debt into equity – is common practice for increasing the financial health and improving capital structure. This method is good for the company as an operating entity; however, it assumes partial or full dilution for existing shareholders, who are replaced by the former debt holders.

Given that RTM and Sistema Hals have deep pocketed shareholders behind them, equity injections remain a viable option (RTM has its rights issue upcoming) to decrease leverage. Following the strong correction, the market value of developers has sunk well below the value of their debt, which could translate into major dilution risks for minority shareholders.

To quantify the impact of financing risks on execution and the long+term cost of capital, we apply individual risk premiums of 50+400 bps over the base cost of equity in our SOTP DCF models.

A stock correction increases the potential for minority shareholder dilution, even with much safer developers like Open Investments, should the deep+pocketed strategic investors decide to make more aggressive capital investments via equity injections. The minority shareholder would then have either to inject more cash into their pre+emptive rights or see their stake in the company decline.

The increased uncertainty with financing and high stock volatility translates into higher execution risks, as we believe that the developers will have to refinance their debt at premium costs.

PIK group's solvency dependent on operating cash inflows

PIK Group has generally low leverage; however, it faces the threat of large short+term maturities. In order to service $1.3 bln of short+term debt, the developer will have to either refinance its dues in part or fully at a significant (or value+destructive) premium, or redeem the short+term debt from its operating cash flows, potentially cannibalizing its working capital as its pre+sales schedule may be distorted. The developer sources its pre+sales from a single market segment and we do not rule out a situation whereby end+user demand declines sharply in the next few months. We believe that the first difficulties will be evident in the regions, where demand is heavily reliant on now unavailable mortgage financing and slower growth in disposable income. However, we estimate that there will be certain inertia+driven demand, for the next two to three months, as the population still has significant cash on hand budgeted for buying a primary residence (and only part of them will hold onto it for a possible price correction). On the positive side, PIK Group has high flexibility to suspend any project where it does not see sufficient demand. In addition, we believe that the disruptions in the sales schedule will be initially offset by purchases in the public sector, where the Moscow government has committed $2 bln already. We believe that adding 100 bps to 14.4% of base cost of equity addresses those risks on the conservative side.

LSR Group: appears prudent, but still...

We assign an equal 100 bps risk premium to LSR Group’s development segment; however, we apply a different logic. Considering the lower execution risks and independence of the business, we have applied a base cost of equity of 14.4% to LSR Group’s cash flows from non+development business segments). The company also has generally low leverage and 70% lower short+term debt (compared with PIK Group), but still considerable short+term maturities, the refinancing of which will come at significant premium cost. LSR Group plans to redeem about half of its short+term dues from its operating cash flows, and, compared with PIK Group, we see fewer risks in doing this, thanks to the fact that LSR Group has a much more diversified revenue stream and that it was prudent in anticipating the liquidity crisis. A large portion of the company’s operating cash flows is generated by the chain of building materials operations, which will certainly be affected by the development downturn; however, it will provide a solid cash flow cushion thanks to large state+ funded investments in infrastructure development in the Northwest. Residential space form 75% of the company’s real estate portfolio, where the projects are either in the self+financing stage or can be suspended. On the downside, one quarter of LSR Group’s portfolio i s in capital intensive and long+cycle commercial real estate developments. The company was reasonably prudent in postponing construction starts wherever possible; however, it will have to carry forward those already started.

Open investments: Equity financing now turns into a blessing

We assign the lowest risk premium of 50 bps to Open Investments. We believe that the company faces the lowest near+term insolvency risks. The developer has historically been equity financed and entered the liquidity crisis with low leverage and significant headroom between its cash balances and short+term debt maturities. Open Investment’s current residential (outskirt) developments have reached the self financing stage and will provide sufficient cash flows to cover its operating expenses for the foreseeable future. However, the developer attributes roughly one quarter of its portfolio to capital intensive commercial projects. Open Investments remains positive about completing a few large projects, which is long+term value additive, but can meanwhile drain their cash resource, in our view.

Sistemahals: Financing risks high...

Sistema+Hals is generally overleveraged, and in particular faces significant short+term debt maturities during 1H09. Since the company’s operating cash flows are by far insufficient to cover its short+term debt, we believe that Sistema+Hals will face three value+destructive options: refinance the debt at high premium cost; monetize the part of its unfinished portfolio; or raise more equity or restructure debt. The risks of restructuring stay high, as most of the company’s long+term debt is owned by VTB, a single lender that may find legal grounds for requiring premature redemption. Lastly the value of Sistema+Hals is heavily dependant on its commercial real estate projects under construction, which the developer has to either complete or discard at a discount. On the positive side, Sistema+Hals enjoys the support of its sister companies in Sistema; however, the worsening markets undermine the chances that Sistema itself will devote all its resources to bailing out Sistema+Hals. We believe that our 400 bps premium to the cost of equity merely addresses the minority risks in the current environment.

RTM: Options tighten as time passes

Under the same logic as we apply to Sistema+Hals, but considering that RTM’s debt portfolio is more diversified; we assign a 350 bps risk premium to RTM. The company also carries high leverage and faces elevated long and short+term financing risks. Unlike Sistema+Hals, RTM has no strong parent looking over its shoulder. On the positive side, the main part of RTM’s property portfolio is already income generating. Before the liquidity crisis, the company could raise some $700 mln if it decided to exit from its income+generating retail space, and would be net positive after closing all its debt. We believe that RTM still enjoys fair chances of employing the aforementioned strategy and it still could get a healthy price for its space (supported by the sharp drop in retail space completions). Given that RTM’s interest expense exceed its operating cash flows from rental revenues, we believe that the company will only add shareholder value if it monetized its assets and pays off its debt. However, the company has low cash reserves and high immediate maturities, and we view it likely that RTM will either choose to attract equity (from its new deep+pocketed strategic investor), or the company will be forced to restructure its debt or sell its assets; all of which comes at the expense of minority investor value.

Applying risk premiums to valuation methodology

The companies have very different profiles in respect to debt and equity and they all carry very different risk profiles.

We have applied individual risk premiums for base cost of equity in our SOTP DCF models in order to quantify the impact of financing risks on execution and long+term cost of capital. Apart from general market risks, we have distinguished the following factors which we believe are the most decisive for developers’ liquidity risks.

• Leverage
• Short+term maturities
• Flexibility to suspend capex
• Single lender risk

Leverage

We see few long+term financing risks for PIK Group, LSR Group and Open Investments, as all three are underleveraged and enjoy decreasing debt burdens thanks to growing operating cash flows. All three also have indicated their plans to increase long+term borrowings, which in the longer run will both optimize their capital structures and debt portfolios, in our view.

As a result of aggressive borrowing against long+cycle commercial projects, RTM and Sistema+Hals have found themselves in a situation where interest expense grows faster than operating cash flow, leaving no other option but to monetize part of their property or borrow more to service debt. This becomes a value+destructive factor, which along with increasing execution risks and growing interest rates, undermines the value of future cash flows.

We believe that PIK Group has the highest flexibility to suspend its capex thanks to short+cycle projects that are self+financed via pre+sales. All the company has to do is to freeze the build+up of its future pipeline. Open Investments and LSR Group, due to their partial exposure to long+term commercial development, will have limited flexibility to suspend costs in the projects already under construction. However, these two can move around the costs for more remote projects. Also, LSR Group can continue investing the planned $1.2 bln in its building materials equipment only under the condition that long+term and low+cost EU export financing is provided. RTM and Sistema+ Hals appear to be the least flexible due to their much higher exposure to commercial real estate and high interest expense, which leaves them with little time to wait. Thus, RTM and Sistema+Hals would have to aggressively borrow to finish their projects, or monetize those projects rather quickly and at a considerable discount to their fair values, in our view.

Singlelender risk

With $700 mln out of its $900 in long term debt owed to VTB, Sistema+Hals carries significant single+lender risks, should credit conditions suddenly change (we believe that the loan was provided under certain covenants, which may be challenged due to the company’s increasing debt load). As previously mentioned, the developer may be forced by the bank to restructure debt or make premature settlements, which would imply massive dilution for shareholders.

We estimate the developers' ability to meet short+term dues, either from operating cash flows or cash reserves, such as cash on accounts or committed credit lines from the banks.

Wherever possible, we separate short+term debt maturing by end 2008 and by end 1H09. PIK Group has the highest short+term maturities, with around $0.5 bln for each period. We expect the company to collect enough cash to service its dues. However, we remain alert that PIK Group’s cash flows, exposed to a single market (the developer operates in mass market residential segment across Russian cities and we believe that the demand in regions, which was based on high disposable income growth expectations, may be altered), may see interruptions due to lower mortgage finance availability and possible price corrections, and that the developer might not have secured sufficient cash reserves. LSR Group has lower short+term dues and a more diversified cash flow base thanks to its exposure to the building materials business and a diversified development portfolio. Open Investments is, perhaps, the winner in this context due to its rich back+up reserves. Sistema+Hals will be challenged to refinance around $0.25 bln by 1H09, which we believe will be done either through more expensive borrowings or via selling unfinished projects, a value+destructive proposition in both cases. RTM has reliable but insufficient operating cash flows to refinance its near+term maturities, which we estimate at around $40 mln, by year end. However, the company should be covered by the rights issue to commence in October 2008 (87 mln shares or 50% of share capital pre+dilution).

Risk premium methodology

Having looked into four factors, we have applied scoring (0 for no risk, 1 for low risk, 2 for medium risk, and 3 for high risk) for each of these factors, and assigned 50 bps premium for each score in order to come out with individual risk premiums. In order to quantify the impact of financing risks

Cash snapshot: where it stands in the company accounts

For the sake of visual analysis of near+term (by June 30, 2009) positives and negatives of company cash flows, below we have given the snapshots of most important cash sources and expenditure items which could influence the developers’ near+term solvency.

Aggressive investments during 1H08 drained PIK Group’s cash resources. Suddenly caught in the liquidity crisis, the developer now faces challenges to refinance its large short+term dues and has to heavily count on the stability of its rich cash collections.

Thanks to rebalancing its portfolio toward long+term debt, LSR Group will be able to meet its short+ term maturities with minor effort, in our view

Historically an equity f inanced company, Open Investments now enjoys the f ruits of i ts r ich cash reserves and low short+term maturities, which significantly reduce the insolvency risks at the company. Growing operating cash flows comfortably cover the interest expenses

In order to repay its debt maturing during 1H09, the Sistema+Hals will need to monetize a number of its most liquid assets at a significant discount to quoted prices or make an equity injection, we believe.

The rights issue to commencing in October should raise sufficient cash to cover RTM’s near+term dues, we believe, High leverage leaves the developer no choice but to make further equity injections or to monetize the part of its assets

Russia’s Real Estate Market

In the long run, Russian real estate market remains strong. End+user demand, driven by a robust economy, is growing at high rates for retail turnover and real disposable income. In shorter run, we will see both demand and supply falling due to increased uncertainties and vanished liquidity on both supplier and consumer side. We see the potential for 15+25% downward correction within the next 12 months in real estate prices Commercial and residential property values (currently at a high) may decline amid forced selling, rising refinancing rates and stagnating incomes. However, we do not expect a chain reaction, as compared with western lows, Russian legislation requires significantly longer lead times (six to 12 months) for banks to monetize the pledged real estate. The falling property prices may put downward pressure on construction and building material costs (as well driven by falling commodity and energy prices), negative for building materials producers like LSR Group, but helpful for developers in general.

In the long run, we estimate that prime retail and office space are priced adequately. The growth here is supported by strong underlying fundamentals, in our view; however, the upside in this sector is bottlenecked by scarce financing and long cash+back periods. Conversely, residential developments are self+financing due to pre+sales, but we estimate the residential sector to be overpriced and are wary of higher pricing uncertainty. We believe that the mass market apartment housing carries the lowest overpricing risk due to it being more affordable and having a larger buyer base. We find organized suburban developments to be unreasonably overpriced, and therefore doubt that the success of a few high+end developments can spread to other large+scale mass market cottage communities that are two+three hours away from Moscow by car.

Backlogged demand, along with economic growth, suggests that the prime retail real estate market could double by 2015, while the housing market possesses the highest annual volume growth. While office markets largely remain skewed toward metropolitan areas (especially Moscow and, to a lesser extent St Petersburg), the growth in retail and residential real estate is driven increasingly by the regions. The building materials and construction market, on which LSR Group is a leading player, is set to enjoy volume growth of at least 20% (CAGR) through 2015 on the back of investments in development and infrastructure. However, the building materials and construction market may soften in the short term due to imports and a temporary slowdown in construction.

That said, we believe that in longer run PIK Group is the best positioned to tap into market growth thanks to its full exposure to mass market apartment housing and regional expansion. LSR Group, in addition to its balanced development portfolio with increasing exposure to the mass market segment and regional exposure, should also capture the volume and margin growth along the construction chain, thanks to its vertically integrated model. RTM is well diversified to take a share of the increasing regional demand for organized retail space. Sistema+Hals possesses a handful of lucrative Moscow based commercial projects, but the company has no strategy for further initiations. Open Investments is among the strongest brands to drive the value out of suburban land in Moscow area; however, we remain uncertain about the volume growth and price sustainability in this sector.

In light of further tightening on debt markets and falling equity prices, and considering that refinancing costs are objectively expected to be 400+700 bps higher than initially forecast, the ability to complete lucrative projects in the portfolio – the ability to source funds sufficient to realize the projected NPVs in cash – has become the cornerstone of a developer’s value. Among the companies we cover, PIK Group and LSR Group, with negative to zero cash+back periods, may have opportunities of consolidating the market. Meanwhile, overleveraged Sistema+Hals and RTM, which have cash+back periods of five to eight years but have lucrative commercial development portfolios, should pace their growth to survive through hard times.

As smaller developers’ growing insolvency has resulted in a considerable backlog in construction and the supply of new space, we expect an increase in unfinished projects on offer to considerably soften prices. This could downplay the value of unfinished projects, especially for costly and long term commercial ones. The most vulnerable, in our view, is Sistema+Hals, which has the greatest portion of unfinished commercial projects and a limited ability to borrow.

However, the delayed supply of commercial space will boost demand for offices that are already operational or close to completion, which is obviously good for those developers with a large share of office space that is finished or close to completion. RTM tops this list, with over 75% of its portfolio already generating rental income. But the company has exhausted its borrowing capacity and has to think about portfolio refinancing or equity options. On balance, commercial real estate developers have limited capacity for growth due to financing shortfalls.

We favor PIK Group and LSR Group, as they have solid exposure to the mass market residential segment and are capable of financing their growth through pre+sales, thanks to their strong reputation. In the longer run, we like the enormous potential of Russia’s residential market, ensured by huge potential demand and strong growth in disposable income. However, in the shorter term, we are concerned by the continuous appreciation of real estate prices in the country, especially in its central cities. We think that the residential market is overheated and we see higher chances of prices escalating further on the back of limited supply. We keep in mind that liquidity, supply and prices are largely based on the solvency of high+income buyers, who make up 20% of the population. Further, if elite class buyers’ disposable incomes fail to catch up with growing residential prices and mortgage rates, the risk that new buyers could default on mortgage loans increases, which may lead to a significant price correction (yet on a limited scale, as most property is mortgage free).

We see significant risks of developers taking on higher cost in anticipation of price growth and are partial to those that work in the mass market segment. We believe that PIK Group and LSR Group, developers with large residential portfolios and the ability to finance growth through pre+sales, are now the best positioned to consolidate the market, but remain cautious of the risk of them over investing in market consolidation.

Commercial real estate

Recent trends

The completions in commercial real estate will be hit hardest by the liquidity crisis, as this segment requires the highest upfront cash investments with no presales or long+term financing available. In the drive for liquidity we expect the commercial property market to start softening, led by increased offer of unfinished projects (with forced selling prevalent). We believe that rental revenues will stagnate, as the retail and corporate sectors reduce their expenses, while prices for commercial properties may be adjusted downward due to higher refinancing costs (leading to 15+25% price correction). Though the commercial space is priced more adequately, this vulnerable stock makes up a big chunk of the relatively liquid estate pledged at banks, and is becoming more susceptible to abrupt increases in the property offering as forced selling becomes prevalent. While there will be no short+term winners, players like LSR Group and Open Investments who still can finish their prime commercial space developments will still benefit from decreased supplies.

Longerterm view

Unlike the sentiment+driven residential real estate market, commercial real estate in Russia is backed by a strong business rationale that ensures its efficiency.

With real estate prices correcting on Western markets due to weak fundamentals and a high mortgage burden, Russian commercial real estate is enjoying continual growth. This is thanks to strong end+user demand coming on the back of a robust economy, translating into strong growth figures for retail turnover and real disposable income.

The demand for prime office space still remains highly skewed toward Moscow, especially the city’s center, which exerts upward priced pressure due to limited supply. Contrarily, demand for quality retail space is rapidly spreading into the regions, aided by strong consumption growth of late. As regards volume, we see greater opportunities for developers that have diversified regional portfolios of retail space development.

As the supply of commercial space has fallen considerably, halted by the growing insolvency of smaller developers, we expect the increased offer of unfinished projects to soften prices, which could lead to reassessment of the value of unfinished projects in the developers’ portfolios. That said, the delayed supply of commercial real estate will boost demand for already operational space. For this reason, we like developers with large shares of commercial space that is operational or close to completion.

Retail still remains more attractive for investors than the office segment due to relatively easier construction and lower requirements. However, we have witnessed considerable yield compression in recent years in big cities where the market is somewhat saturated. This fact has led the gap between yields in the office and retail sectors to narrow, and we expect the gap to remain very small in the future.

Capitalization rates for office space in Russia, at 8+9%, remain among the highest in the world. We estimate that the tax+adjusted prime rental yields are in equilibrium with capitalization rates. The capitalization rates closely trace the tax+adjusted cost of debt (re)financing, given that completely operational commercial property is fully refinanced either through leaseback or commercial mortgage options. This correlation is provided by the investment efficiency; if one were to debt finance commercial property with the goal of collecting its future rental cash flows, then it should be expected that the rental yield at least returns the cost of financing. Along with decreasing debt financing costs, yields have compressed significantly since 2003 as a function of upward adjusting commercial real estate prices.

Yield compression came to a halt in 2007, as the liquidity crisis pushed up financing costs. Within the next two years, we do not expect any noticeable yield compression as the costs of refinancing may rise even further from their current levels.

Retail market

We view retail property as the most attractive commercial real estate segment, as it is a natural beneficiary of Russia’s buoyant retail market expansion. The country’s retail market has been growing at a CAGR of 32% over 2004+07, and we expect it to climb another 36% y+o+y to $579 bln this year. We forecast an almost doubling of the market to $962 bln by 2012, fueled by growing disposable income, proliferation of consumer lending, a high propensity to spend and changing lifestyles.

We expect disposable income to grow an average of 7.5% in real terms over the next three to five years. Meanwhile, consumer lending should continue soaring, with outstanding private debt tripling in the next three years to $404.6 bln in 2010, which should cause savings to be retained. Currently, savings do not generally exceed 5% of individual incomes, with the largest figures being in the low double+digits.

Besides robust retail growth itself, an important factor underpinning acute demand for modern retail property is the changing structure of the retail market. We expect the growing satisfaction of basic needs to cause the non+food retail market segment to slightly outpace food retail. We forecast the former to grow at a CAGR of 14% over 2008+12, compared with the 13% average expected for food retail, with the key beneficiary being the shopping mall property market.

Another structural change is retail market consolidation. Russia’s retail market is currently very fragmented, as exemplified by food retail, where the top 10 retailers account for roughly 12% of overall market value, compared with 30+50% in Europe. It is estimated that in most other segments of Russia’s retail market, the level of fragmentation is commensurate. The last three years saw the market consolidating rapidly, with the key p layers g rowing 40+50% per year. Once the liquidity crisis is over, we expect this trend to persist in the coming years, with the main retailers expanding 35+40% annually on M&A and aggressive organic openings, which, in our view, should further bolster demand for quality retail property. On the back of increasing competition in the Moscow area and St Petersburg, the growth strategies of most retail majors increasingly targets Russia’s regions, suggesting growing demand for modern retail property in regional cities.

Russia’s retail sector has shown spectacular growth over the last few years, albeit from a low base. This supports the strong demand for modern retail space, translating into high occupancy rates and accurate forecasts of developers’ future cash flows.

We think that the potential demand for quality retail space will continue to grow along with the consumer sector, leading to new construction. When thinking in terms of demand distribution between tenant types, we believe that the biggest share of retail space will be occupied by anchor tenants, followed by average+size retailers.

The shortage and value appreciation of retail space ensures high demand for new floor space, as most anchor tenants view the underlying space as an investment and as a hedge against rental risks.

Along with dynamic growth in the retail real estate sector, Russia remains strongly undersupplied in retail floor space per capita. Retail space in Moscow (331 m2 per capita) and St Petersburg (655 m2) is at the upper end of Western Europe averages, while the Russian regions suffer from severe undersupply. We estimate that it will take an additional 15 mln m2 of new retail space across the country to reach the average European level. Backed by the booming retail sector, and the population’s willingness to pay high prices, Russia is one of the leading countries in Europe in commissioning new retail space.

The pipeline of retail projects in the near future puts Russian in first place both in terms of expected property completions and floor space growth rates. The number of projects in the course of development is double the amount commissioned last year. In addition to new construction, we expect several additions to be built on existing projects.

Russia’s share in the pipeline of retail projects in Europe is the largest, accounting for more than one seventh of the region's total. If all the projects that have been announced on the market are completed, it will bring the total retail stock in Russia close to the level in Germany and a little behind that in France.

Most of the country’s retail space is still concentrated in its “two capitals”, Moscow and St Petersburg. At the same time, the level of project completion in the regions is picking up pace. There is still a gap between Moscow and St Petersburg – which still experience undersupply of quality retail space – on the one side, and the remaining cities – which for the past two to three years have been targeted for regional expansion by federal developers – on the other. This incentivizes many companies to focus on new construction sites on the back of a growing retail market. While the first wave of retail developers has targeted big regional cities with population over 1 mln, the second wave is considering building at the sub+regional level. A growing number of projects are appearing in cities with population under 500,000, and even 300,000. However, regardless of the impressive short+term performance on regional markets (cap rates in the regions began to overpass those in Moscow and St Petersburg as markets in the capital cities saw a large amount of new retail space added over a very short period), medium and long+term operational results on average can be rather modest due to a very young “consumption culture”.

We point out that retail real estate market saturation does not come only from the amount of shopping centers on the market. In Moscow and St. Petersburg, the market is seeing increasing demand for retail space better designed for customer satisfaction. Thus, many earlier developments may experience falling traffic and occupancy as consumer sophistication rises.

Thanks to high demand and limited supply, rental rates for retail space have been growing above ruble PPI inflation throughout the last few years. We believe that retailers will be able to support the average rental rate growth going forward, at least matching ruble PPI, thanks to faster same+store revenue growth on the back of a strong increase in consumer spending.

Office space

Moscow by far outweighs the regional capitals in office supply per capita; this is not a big surprise considering that Moscow still accounts for over 70% of Russian turnover and every single corporation on the federal level tends to have representation in the country’s capital. However, the city remains severely undersupplied when compared with western capitals.

Vacancy rates in Russia are inflated due to high inflow of new office space, which typically has higher vacancy during the initial year of operation. Adjusting for this would bring the country’s rate down by roughly 200 bps. This puts the vacancy rate at a record low, which comes on the back of strong demand and undersupply.

Moscow’s office market has one of the highest rental rates in the prime (class A and B+) segment, but it also has the highest rental yields. Based on average comparisons, it may appear that prime office rentals in the capital are overvalued. However, as we will see on residential markets, the language of averages does not translate to the situation on Moscow real estate market. Prices are driven by supply and demand, and considering that along with the highest rental rates, Moscow has one of the lowest vacancy rates, it is obvious that the market is ready to pay the price.

As previously noted, Moscow accounts for most of Russia’s prime office space, and this contributes to the country’s average rental rates being higher than those in Western countries.

Moscow’s office market has so far demonstrated high growth rates, albeit from low base, thanks to high demand backed by robust economic expansion.

Regular rental contracts with anchor tenants hedge the property owner against sharp fluctuations in the ruble/bi+currency exchange rate. In the medium term, the developer generally has limited ability to increase the anchor’s rent against ruble inflation; however, it can do so by increasing rent for small boutiques.

Moscow by far outstrips regional capitals by the office supply per 1,000 inhabitants. This is not surprising, considering that Moscow still accounts for over 70% of Russia’s turnover and every corporation at the federal level tends to have representation in the country’s capital.

However, Moscow remains severely undersupplied when compared with Western capitals. As all other large cities in Russia significantly lag Moscow in office space supply, the country overall looks rather undersupplied. The superior demand dictates the high rental rates that businesses are prepared to pay for prime locations in Moscow and regional capitals.

The aggregate A and B+class stock in Russia’s main cities (11 cities with population over 1 mln plus Moscow and St Petersburg) is estimated at 8.12 mln m2 of net rentable area.

Though the $800/m2 in annual rent may seem comparatively exaggerated, we argue that the average rent in Russia objectively reflects the picture of supply and demand. Moreover, our calculations show that Russia’s economy, at its current levels, can support over 18 mln m2 of prime office space at an annual rate of $800/m2. We have based these calculations on our estimates that corporations spend an average of up to 5% of their turnover on representation expenses (excluding retail companies, which spend up to 10%). This shows that demand for office space in Russia could support more than twice the existing stock at the aforementioned price.

Residential market

Recent trends

In the residential segment, we expect the weakness to come on the back of higher cost and lower availability of mortgage financing, as well as due to increased disposable income uncertainty. We believe that the regions and remote areas will experience price correction first, as the number of small developers will be willing to cut their prices by 20+30% in order to attract some liquidity. We expect the mass market residential prices in central regions to appear more defensive simply due to limited supply and municipal buys. The transaction volumes in the upper residential segment (including gated communities), where prices went through the roof, were down even before the recent liquidity problems. Here we expect to see either significant price correction, as the holders of business class investment property start releasing their investments, or massive loss of liquidity.

Importantly, the banks are already considering the risks of about 20% y+o+y price correction in the housing segment, as they have increased the down payment requirement from 10% to 30% for mortgage financing. Though the mortgage financing rates have seen spectacular 500 bps increase since the start of credit crunch in July 2007, to as high as 15% in dollars and 18% in rubles per annum, the main banks still continue mortgage lending, which remains a decisive source of liquidity for the housing market. Longerterm View

In the longer run, we like the huge potential of Russia’s residential market, ensured by great potential demand and strong disposable income growth.

However, we are concerned with the continuous appreciation of real estate prices in Russia, especially in central cities. We view real estate in Russia as overpriced on average and believe that high prices are only sustained by the specific demand and supply structure and a very low level of mortgages. As the initial liquidity to the housing market is supplied mainly through mortgages granted to elite buyers (top income quintile), the sensitivity of prices to mortgage rates and the elite class’ standing should rise dramatically within the next few years. So far, rental rates have returned only a fraction of market prices, and demand has been supported by speculative interest in rising prices.

In the best case, we see prices rising at the level of CPI growth and slower than disposable income for a few years, allowing the latter to catch up and the former two to normalize on the back of inflation, growing rental yields and decreasing mortgage rates.

However, it is more likely that prices will escalate further on the back of limited supply, and there is significant risk of developers taking on higher+cost, larger+scale projects in anticipation of price growth. The higher prices grow, the less support and liquidity they find, and the greater the chances that new buyers will default on their mortgages. Moreover, more expensive projects imply a better chance that negative returns will be realized, should prices correct or stagnate.

Russia’s residential real estate market started to emerge in 1992, when the prevailing majority of residents were entitled to privatize their municipal apartments. The apartments in the center of Moscow could then be bought for a price equal to just 1 m2 in today’s prices. With one major drop during the 1998 default, housing prices in Russia have posted spectacular growth since then.

The residential market is very sentiment driven, as the average household views their apartment as holding some fundamental (last resort) value, and hardly anyone considers the apartment from the perspective of opportunity costs/alternative investments. Thus, sales occur only when households are forced to sell; otherwise, the appetite for high prices is insatiable.

Housing stock in Russia currently totals some 3 bln m2. The residential market’s total capitalization in 2007 was $5.4 trln, or quadruple that year’s GDP. Considering how housing prices have risen over 1H08, the current figure has moved closer to $6 trln.

Russia’s residential market is rapidly developing in two main directions, namely traditional multistory apartment buildings in urban areas and suburban townhouses (gated residential communities) within driving distance of major cities. The townhouse concept is rather new to Russia, as Soviet+era dachas are a far cry from this type of housing. Cottage communities in proximity to a city are increasingly being considered an alternative to residing in metropolitan areas.

Apartment buildings

Supply

Unlike the fairly fragmented townhouse market in Russia, the secondary and primary segments of the traditional urban housing market exhibit high price correlation and co+influence, which is understandable in light of the high liquidity in apartment buildings and the ease of matching prices within one neighborhood. In fact, primary market prices regularly reflect the cost of production as a marginal premium over the secondary market, and production costs are set as the long+term pricing bottom. Reciprocally, the secondary market reacts accordingly to cost inflation for primary offerings. Strikingly, Russia, which has the largest territory and one of the lowest population densities in the world, also has one of lowest per capita housing stock figures.

This phenomenon was largely determined by Soviet+era housing standards, which limited the housing stock per person to 15+20 m2 on average, and the post+Soviet decline in housing completions was offset by a shrinking population. Another factor was the high concentration of people around key economic and administrative centers.

The country’s total housing stock is currently on the rise. However, construction activity slowed in 1H08, the level of new housing completions inching up a mere 6% YTD, due to liquidity problems that smaller developers are facing, in our view.

Subject to buying+power sufficiency, we expect housing stock per capita in Russia to gradually close the gap with western averages, supported by the increasing weight of suburban residential developments. Our estimates for potential demand are also supported by forecasts in the “Federal strategy for massive residential construction” project. According to the strategy, the current housing stock is expected to rise by around 2 bln m2 by 2025 to 5 bln m2. This would bring housing stock per capita to the average level of 33+36 m2.

We are currently observing a considerably high level of investment/GDP, which is in line with Western countries. The peculiarity of Russia is that most residential investment is still directed at apartment building construction. Considering the investment backlog during 1991+2000 and the somewhat higher construction costs in Russia, we expect the country’s investment/GDP ratio to exceed that in Western Europe, should Russians’ buying power continue to rise at its current pace.

Demand

On the demand side, we see strong potential for supply trends to be supported. Of the current housing stock, 80% was built during the Soviet era and is becoming increasingly depreciated. We see the potential for housing per capita demand in Russia as much higher than that on developed markets.

Another driver of housing demand is the country’s further urbanization. Of the current population, 75% live in urban areas (excluding suburban townhouses, which are in fact the part of the urban infrastructure). This ratio, high compared with other BRIC countries and the average European level, is similar to that in the US.

The continuous migration from Russian villages will transplant roughly 1% of the population to cities over the next 10 years, we believe. This migration will largely offset the opposite migration to townhouses and the decline in urban population due to the negative birth rate.

Most Russians are likely to expand their residences, and we estimate the minimum potential demand for housing stock for next decade at 1.5 bln m2.

However, at today’s average prices, potential demand translates into over $3 trln in private and budget investments. Meanwhile, with current incomes and mortgage rates, Russian residents can realize only around 30% of the aforementioned demand.

While the Moscow market accounts for over 20% of the anticipated demand in dollar terms, we view the regions as more promising due to the following factors.

• As there is the possibility of imposed constraints for land available for development, the developers may meet only part of the housing stock demand in Moscow, while the remaining supply will have to be provided by the secondary market. The same logic applies to the St Petersburg metropolitan area. Thus, we favor developers with growing exposure to Moscow and Leningrad regions and large Russian cities.
• Disposable income has higher potential for increasing in regions (albeit from a low base), which may effectively translate into stronger demand and a better price environment.

Prices

As prices for upscale and elite housing climbed up to Western levels far ahead of disposable income, Moscow found itself on the top of the list of countries with peaking housing prices/income ratios, and it is still rising. With an average GDP per capita level among BRIC and Western European countries, the Russian capital has some of the highest apartment prices.