Foreign Developers in Russia

Together with the locals Russia’s development business was for the most part created by local players. “No radical changes have happened on the development market landscape over the past 3-5 years. Like before, we mostly see Russian developers. With exception of Enka and IKEA, who have been long present on the market and have large property portfolios, only a handful of foreign developers managed to finish their projects,” says Vladimir Pinaev, Jones Lang LaSalle. Foreign capital was present mostly in the form of joint ventures. As a rule, professional foreign investors looking to enter the market first sought out local developers, and then organized partnerships with them. The local developers helped solve issues relating to securing land plots, receiving project approval, and hooking up utilities. “You need a local partner in order to work successfully in Russia. In other countries, we do not always have a need for this kind of partner. In Russia there is no way to manage projects without a local company-partner. Having well established local connections here is a vital necessity,” argues Rachel Lavin, General Director at Atrium. “The work model – when the Russian company acts as land developer, providing the plot with utilities and regulating legal issues, while the Western company handles development, answering for the concept, construction, financing and rent – is optimal for both sides,” says Christopher S. Van Riet, Managing Director, Giffels Management Russia. Office days – gray and cheap The absolute leader in the highclass office segment is the Turkish developer Enka. As a full-cycle developer, Enka has its own drafters and conducts its own building and property management. Enka frequently acts as general contractor for other developers, including work on infrastructure projects (a new terminal at Moscow’s Sheremetyevo Airport, a Toyota car factory in St. Petersburg, and oil field infrastructure on Sakhalin Island in Russia). In the early 1990s, Enka affirmed its willingness to establish long-term relations in Russia and founded two joint stock companies, Mosenka and Moskva Krasnye Holmy, to develop and manage office and residential buildings in Moscow. Enka currently owns and manages 318,500 sq m of office space providing local headquarters and facilities to a variety of global firms in Russia. To date Enka has completed more than 130 projects in Russia and CIS, ranging from buildings, hospitals and industrial plants to oil and gas projects.

In recent years, the bulk of Enka’s building activity has been at the Moscow International Business Center Moscow-City, a business district set up outside of the historic center of the Russian capital.

The company acted as developer at the Naberezhnaya Tower project, a combination of three class A office buildings: a 17-story building (opened in late 2004) and a 27-story building (late 2005) in the first phase, and a 57-story skyscraper in the second phase (late 2007). Rentable area at the complex totals 150,000 sq m. However, the third skyscraper still has some vacant spaces, about 30 thousand sq m in total. As the property manager at all of its business centers, Enka has to deal with many of the challenges inherent in the office segment.

One problem has to do with payments arrears, which impact cash flow and building profitability. Some renters stop fulfilling their contractual obligations, failing to make rental payments on time. For example, in late 2008 Enka filed three suits in a Moscow Appeals Court against Sibir JSC (S7 Airlines) for six months of back rent ($1.52 million) on a lease agreement for almost two full floors at the Paveletskaya Tower Business Center.

However, this is by no means the only problem facing developers in the office real estate segment. “Today, the office rentals market is experiencing a correction, which on average amounts to 30% of rent. Of course, everything depends upon the previous level of rental payments. On some properties, the drop can reach 50%, while at others – 5 or 10%. It should be noted that business centers considered ‘class A’ in Russia do not fully correspond with counterparts on developed markets. Furthermore, the cost per square meter in Russia can reach $2,200-2,300 annually. Obviously, these are overheated rates,” explains Heiko Davids, Partner, Russia & CIS, Knight Frank.

Rate adjustments also have to do with lower profits in the businesses of most tenants. According to Heiko Davids, many tenants are not only negotiating rate adjustments, but also vacating or subletting parts of rented out space. This has to do with significant reductions in personnel. For the first time in the history of the market, the amount of space available for sublet is equal to the amount of available new space. Furthermore, demand has plummeted to new lows. Tenants who need new offices have taken a wait-and-see approach.

Turnover tumbling down

In the high-class retail real estate segment, the undisputed leader is the Swedish developer IKEA. At present, 11 IKEA stores and MEGA family shopping centers are successfully up and running in Russia’s biggest cities. In 2009, openings are planned for MEGA family shopping centers in Samara and Omsk, with one more set for completion the following year in Ufa. Work on these projects has not been frozen. “IKEA still considers the Russian market highly promising. We stayed in Russia in 1998, and today we still believe in a bright future for this country. Even though many of the major developers are currently freezing their projects, IKEA does not intend to change its long-term plans and plans to develop all of its business lines in Russia: IKEA stores, MEGA family shopping centers, manufacturing, purchasing, and supplying,” says Hokan Person, Deputy General Director and Director of Real Estate Development at IKEA. According to Mr. Person, “IKEA is not listed on the stock exchange, and our investment policy is founded on long-term, highly responsible planning. The crisis is opening up even more opportunities on the commercial real estate market, since prices are decreasing, as well as the number of players, and a wide, intriguing selection of land plots is becoming available.”

In coming years, the company hopes to implement new projects in Russia, primarily in Saratov, Voronezh, and the Moscow region. Negotiations for partnerships are under way in several regions in Russia, including Volgograd, Tomsk, Tyumen, Barnaul, and Kostroma.

Atrium European Real Estate is another active foreign player on the Russian market (belonging to GazitGlobe and the Citigroup fund). The company entered the Russian market when it purchased assets from the Austrian fund Meinl European Land (the Park House malls), a specialist in real estate investments. Atrium European Real Estate Limited (Atrium) operates in 11 countries in Central and Eastern Europe, South-Eastern Europe and Russia. As of February 6, 2009, the company’s capitalization totaled 600 million euro. The company has seven operating properties in its Russian portfolio, spread among St. Petersburg (Northern Mall), Kazan, Volgograd, Yekaterinburg, Toliatti (Park House), and Moscow (Mall Gallery).

In February 2008, the Group completed the first stage of a development project in St. Petersburg on a 50-hectare plot. The first phase is a shopping mall with rentable space totaling about 27,000 sq m. In the next stage, the Group plans to construct single-box units for large retailers (such as consumer electronics, DIY, etc.) on the site.

According to Rachel Lavin, General Director at Atrium, “At about 700 million euro, our Russian properties comprise a significant part of our portfolio. This is because we still believe in Russia’s future as a long-term market. We have 17 development projects in Russia, each one close to 60 thousand sq m. All of them are at different stages of development, and I am quite optimistic on each one.” However, Ms. Lavin argues that today it is better to focus on managing existing projects. “Like other countries, Russia was hit by the wave of global crisis. Therefore, the main thing to concentrate on right now is recovering as much as possible from the existing project portfolio. The main issue right now for companies is how to generate a profit. Therefore, a lot of difficult work must be done, so as not only to increase return, but to sustain what you already have,” says Rachel Lavin. The Hungarian TriGranit Development Corporation, one of the biggest investors and developers in Eastern Europe, entered the Russian market in 2007. TriGranit’s flagship project in Russia is in the first place Mozaica REC in Moscow on the Third Transport Ring (134, 000 sq m of GBA and 68, 000 sq m of rentable area). In partnership with GazprombankInvest TriGranit is also working on a new urban development in Krasnodar (132 hectare land site). The developer has not abandoned any of its projects in Russia.“Russia retains for TriGranit its very strong appeal for straightforwardly objective reasons: huge market size and relatively untapped current status. Russia is still an emerging markets and can support premium development yields (still doubledigit) outrunning Central and Eastern Europe, let alone the five developed countries of Western Europe,” says Marianna Romanowska, Junior Development Director, TriGranit Development Corporation.

According to Marianna Romanowska, Russian real estate market (both residential and commercial) still has a long way to go: shopping centers (malls) first came to Moscow early this century after several decades of triumphant march across the U.S. Private homes market started even later after it has become an unquestionable norm and style of life in Europe and the USA. Thus, TriGranit definitely and absolutely sees Russia as its strategic target for further development expansions.

“However, in the new economic environment geography and structure of our investment priorities have to change. We see that Moscow is likely to be the least effected by the crisis due to high concentration of capital functions, and obviously predominant role in the center-periphery economic and demographic structure of the national economy. Coupled with substantial input from the Moscow government these allow to project highest per capita incomes and lowest unemployment levels, which in their turn will further attract foreign investments into real estate with first priority to mid-market retail schemes,” explains Marianna Romanowska.

In what way has the crisis impacted the retail real estate market? “Rental rates in retail directly correspond with the operator’s merchandise turnover. In Russia, rates remain fixed, and do not depend upon turnover. However, it should be pointed out that the retailer can pay rent under the stipulation that his or her business remains profitable. This percentage depends upon the kind of retail: a supermarket with a high turnover but a low profit margin, or a luxury retailer with a low turnover but a high margin. On average, the retailer pays 10-12% of turnover as rent. Today, we see that sales at many retailers are on the decline. Purchasing power is dropping; one reason for this is the significant drop in the national currency,” Heiko Davids explains.

The future of warehouses

Among the foreign developers on the Russian warehouse market, the Megalogix project clearly stands alone. In June 2006, the British fund Raven Russia created a joint venture with the Avalon Group to build the Megalogix chain of logistics complexes.

The original plan was to build a chain of class A warehouses in 20 largest cities in Russia and the CIS. The total investment to create the said logistics parks were slated to top $2 billion. Raven Russia, a subsidiary of UK’s Raven Group, was created in 2005 for investments into Russian real estate. In 2005, the fund raised $266 million via an IPO. Raven Russia has nine projects in Russia topping 1 million sq m, not including the Megalogix projects. The Avalon Group is a Russian investment group with a diversified scope of activity, including real estate development, contract logistics, consumer goods distribution, brand management, and industrial manufacturing. The company has an extensive network of branches and divisions spanning more than 35 cities in Russia and the CIS. In February 2009, the Megalogix-Novosibirsk class A logistics park opened in Novosibirsk, with an area of 121,000 sq m intended for logistics operators, storage and processing of goods, retail networks, and manufacturers. In addition, two phases are completed at the Megalogix St. Petersburg complex (101,000 sq m) as well as the first phase of the Megalogix-RostovonDon logistics park in Aksaisky District (100,000 sq m). In the remaining regions, including Nizhny Novgorod, Chelyabinsk, Saratov, Khabarovsk, Omsk, Ufa, and Minsk, building sites have been selected, and steps to get construction permits are under way. The fate of these sites is unknown for now. Representatives of Raven Russia and the Avalon Group declined to comment on the situation until the end of March.

Still one more frequently mentioned foreign player on the Russian market is Giffels Management Russia. This company is an alliance between entrepreneur Christopher Van Riet and his partner David Simons, Grove International Partners Investment Company, and Giffels, a Canadian developer. According to Christopher S. Van Riet, Managing Director, Giffels Management Russia, the company right now is continuing work on its main project in Russia, Giffels SouthGate Industrial Park. “Giffels SouthGate” is a 530,000 sq m master-planned warehouse and industrial park on a 104 hectare plot that we are developing in an arrangement with Coalco Developments. The total investment for the first phase includes the land purchase, all utilities and the first phase of buildings at a total investment of over $150 million. The monies are being funded by equity from our shareholders and over $60 million of debt from our Western lending partners. The bank loan was signed at the beginning of February 2009. The project was implemented pre-crisis and completion of the first phase of 70, 000 sq m will be in June 2009. The company has not frozen or put on sale any of its properties, and they still consider Russia to be one of the most intriguing markets.

However, as Christopher S. Van Riet says, “There are many projects in the market for sale.

Development costs are going down in general from the perspective of a $US investor. The cost of raw land (meaning land without utilities and service connections) has fallen dramatically and will continue to fall more. The cost of servicing the land with all utilities has stayed broadly the same and the cost of construction materials has fallen to a certain extent.” The British developer Parkridge – who entered the Russian market over two years ago – is a world leader in the construction of logistics and retail complexes, as well as residences. In Russia, the company had intended to invest more than $1 billion into new warehouses.

The company acquired its first site in the Moscow region, and then acquired a land plot close to Krasnodar. The company also considered sites in Yekaterinburg and St. Petersburg, but decided to abstain because of the crisis, choosing instead to concentrate on current projects.

There are still other foreign developers on the warehouse market, for example – the Belgian developer Ghelamco. In the North of Moscow, the company is developing a warehouse complex with a total area of 220 thousand sq m. However, the company’s press service declined to comment on the current state of the project. Beyond any doubt, the crisis has led to corrections on the warehouse real estate market. “On the warehouse market, we see a minimal correction toward lower rental rates. This correction amounts to about 10%. On the other hand, rates in the warehouse segment never reached the kind of maximum that occurred in the office and retail segments. However, it should be noted that even before the crisis the future of class A complexes in the regions didn’t inspire optimism. Demand was clearly overestimated. High-class complexes are needed in Moscow and St. Petersburg – and possibly in Novosibirsk. In other cities, there were problems with demand, even before the crisis,” Heiko Davids argues.

Multiple samples

Among foreign developers on the Russian market, there are some who occupy several segments at once, for example – Israel’s AFI Development, a full-cycle development company founded in 2001. The company realizes commercial and residential properties, including offices, shopping centers, hotels, mixed-use and residential projects on real estate markets of Russia, Ukraine, and other countries in the CIS. The company’s strategy is to sell off residential properties and keep for itself commercial real estate projects, except for some cases of lucrative sales. An example of this policy is the sale of the Aquamarine II office complex in May of last year at a capitalization rate of 6.8%. Right now, considering the current market situation, the company made the decision to review its operating policy for the immediate term and near future until stabilization settles on the market.

“We reviewed our portfolio, splitting it between three main categories: 1) projects already generating profits and properties under construction, 2) projects in the pre-building phase; and 3) projects in the early phase of development.

A separate strategy will be applied to each of the above categories, to optimize resources and create long-term prospects for projects. The company’s short- and mid-term plans are to concentrate on three key properties currently under construction – the Tverskaya Zastava shopping center, the Mall of Russia and a project on Ozerkovskaya Naberezhnaya (Phase II and III), with financing for all three provided by both the company and borrowed funds.

As for the second category (such as Odintsovo and Serebriakova), where construction has not yet started, the anticipated yield of these projects will be re-estimated to account for the new market realities. One pre-condition to the continuation of these projects will be the possibility for any given project to generate financing during the early stages of development by means of renting out apartments (for residential projects), and for bringing in either outside financing under acceptable conditions or a co-investor on top of company investments (for commercial projects). The decision to continue building will be deliberated case by case for each project.

We will continue work on projects located in the drafting phase (such as Kuntsevo) as is, continuing to seek the appropriate signatures and consolidating land plots,” explains Evgenia Akimova, General Director at AFI RUS. Such developers as Capital Partners – a development company formed in Kazakhstan in 1996 – also work in various market segments in Russia. Its main projects include the Ritz Carlton Hotel, the Pushkino logistics terminal of 212,000 sq m (sold to Deutsche Bank and AIG Global Real Estate) In late January of this year, the company opened the Metropolis mixed-use complex, with an area of more than 241,000 sq m. The company does not disclose shareholder and financial data.

Mirland Development is a company based in Cyprus that was founded in 2004 for investing into Russian real estate. Jerusalem Economic Corporation and Industrial Buildings Corporation own 40% in the company, while 20% belongs to Darban Investments. All three enter into the Fishman Group.

The company planned to build by 2014 about 2 million sq m of residential and commercial real estate in Moscow, St. Petersburg, Yaroslavl, Nizhny Novgorod, Kazan, and Saratov. Mirland raised its startup funds through an IPO on the London Stock Exchange. Investors paid a total of $282.7 million for 30% of the company’s shares.

According to analysts at the Renaissance Capital Group, Mirland Development has decided to concentrate on completing projects currently under construction, and to put off for some time those projects still at an early phase of development.

The rest

Borrowed financing is definitely the number-one problem today for foreign developers and local players alike. “The majority of company-developers made active use of borrowed financing and the ratio of borrowed capital to company funds in many cases reached 60-80%. This kind of capital structure had its right to exist in the area of cheap credit lines and stable growth in all types of real estate, but it became totally inefficient in the crisis time,” says Oleg Mikhailovsky, Manager, Mergers and Acquisitions Oversight Group, PricewaterhouseCoopers in Russia. “Today, both local and foreign developers have halted their projects in an early phase of development. The reason is project financing. Foreign banks have cut off financing for projects in Russia. A lot of German banks used to work here, but right now even these banks are located under government patronage. They are cutting back on all programs that were considered risky and do not relate to their core needs. Of course, they will fulfill all current obligations. However, everything relating to new projects is not even under consideration,” Heiko Davids says. “Alternative sources of project financing include bringing in partners or funds. Of course, those companies that managed to realize a greater portion of their projects before the crisis are more favorably positioned; in this case it makes sense to finish work on the project. Construction on our current projects is 100% financed by Sberbank and VTB, in addition to company own funds. We plan to preserve our financial model for investing in projects: investing company funds in 30% of project construction and raising the remaining 70%. We are also considering the possibility of bringing in partners to our projects,” explains Evgenia Akimova, General Director at AFI RUS.

However, financing projects is not the only problem facing the Russian market. Yield on projects is causing reasonable skepticism with many. “We believe that international investors’ interest today will be concentrated on their traditional markets, and not developing ones. The Russian market was appealing primarily because of much higher yield it offered. Given increased yields those investors can get in their home markets and current risk profile of the emerging economies, it will take some time for international capital to return to Russian real estate,” argues Vladimir Pinaev, Jones Lang LaSalle.

The Russian market is losing its attractiveness for new players, not least of all because of political risks. “The war with Georgia, gas wars – create a negative image for the country in general. The mega-profits that investors and developers were able to obtain on the Russian market before the crisis are no more. In a yield-risk comparison, Russia loses out to the traditional markets,” Heiko Davids argues. In any case, players that operate on the Russian market are not afraid. “I don’t think that the Western players will leave the Russian market. Companies with healthy finances will continue to work here, but, of course, growth trends will reduce significantly,” says Alexei Novikov, Head of the Moscow office, Parkridge. Selling incomplete construction projects is one of the options developers have for optimizing business. However, this kind of sale today entails several problems. First and most obvious, not a single significant deal has been completed on the Russian market since the start of the year, although, according to brokers, many incomplete properties have been put on sale. The problem is a lack of buyers. More precisely, non-specialty companies are showing interest in development projects, but they are waiting for a more significant drop in prices; they are not happy with today’s discount.

“Right now, many players with private capital are taking a wait-it-out approach; this is especially true with financial investors – they need to understand how the cost of many companies will change, how much cheaper they will become, and then they will select and acquire the most attractive assets – the ones the investors used to line up for. High activity on the part of financial and strategic players should start up as soon as company valuations hit some kind of bottom, which might be in 2Q 2009, according to market participants,” Oleg Mikhailovsky argues.

On the other hand, some developers, including some foreign developers, whose assets include promising projects, are not prepared to offer discounts due to the general crisis. Another reason for the lack of deals could be the difficulties in determining prices on properties. The comparative method, which appraisers have used up until now, is inapplicable today due to a lack of similar deals. The cost-based method of calculating property value is complicated by opaque business practices with the bulk of developers, first and foremost – opaque expenditures relating to land costs and utilities connections.

How will the crisis end for foreign developers working in Russia? Experts think that it will only strengthen their positions. “Projects by foreign developers always stood out for quality, which was expressed in effective concepts and quality building. However, on a growing market, where demand exceeds supply many times over, the demand was similar for these projects as for all the others. In a crisis period, tenants will definitely give their preference to quality properties,” says Vladimir Pinaev, Jones Lang LaSalle.

According to Marianna Romanowska, “The crisis presents new opportunities specifically for intensive rather than extensive development path. In a period of market boom and escalating demand, there was a way to grow by simply adding new projects and increasing their individual sizes. Now is the time for intensive development, when a company can and must focus on structural optimization, resource re-allignment and concentration on the most effective areas/submarkets, and risk free secured projects. This basically means thinking long-term”.