Entering the Market: Now or never?

A booming market?
Recently, there has been much discussion of the attractiveness of investing in commercial, and particularly retail real estate, and likewise of the favorable conditions created by the authorities for investing in Moscow and beyond. But the main fact that has encouraged the growth of retail in our country is the rising income level per capita, especially in Moscow. Thus, since 2002 the average annual income per capita has almost doubled representing about $10,000, and retail turnover in just the first half of 2005 was $26.6 billion. Since about 2001, Moscow has overtaken Budapest and Prague in terms of income levels. It was precisely this fact that led major retailers such as Auchan, Metro AG and IKEA in 1999 to decide to invest in the Russian market. The decision was well-founded: Russia is not only the largest country in the world – it has more cities with populations of over one million that the whole of Western Europe.
The number of foreign developers in the country has grown. According to Alexei Mogila, head of commercial real estate at Penny Lane Realty, this includes companies such as Ramenka or the South Korean retailer Lotte. The list can be extended to companies such as Mosenka, OBI, Martkauf, Castorama, Centrum Group, Leroy Merlin, Rewe and others. By the end of the year, the total retail space in the capital is estimated to reach 3.4 million sqm. Based on appraisals by ACNielsen, the number of civilized chain retail outlets in Moscow and St. Petersburg has finally risen above 50%. Currently, the capital’s Central District has even overtaken European and American megacities in terms of the number of built shopping premises.
It is not surprising that both Russian and foreign developers see the prospects for the Russian retail real estate market in bright lights. It is estimated that of all investment into commercial real estate since the beginning of 2006, the greater share has been allocated to retail. The reason is the relatively higher rate of return than in other European countries: on average from 12 to 30%. Abroad, the rate is 4-8%. Consequently, the return period for shopping complexes here is shorter than in Europe – about 3-5 years.
Without question, the largest representative of foreign capital in the country (in terms of shopping real estate development) is the company IKEA, which recently announced plans to invest an additional $2.5-3 billion into building IKEA and Mega shopping centers throughout Russia. In the next 5 years, IKEA intends to build its outlets and shopping and entertainment centers in 12 of the country’s largest cities, including Kazan, Samara, Nizhny Novgorod, Rostov-on-Don, Voronezh, Saratov, Volgograd and Novosibirsk. The French Auchan Group intends to open its new format Atac supermarkets in Moscow with areas of up to 5,000 sqm and Elea with areas of 1,000-1,500 sqm. In 2006, there are plans to open domestic appliance stores of the Media Market chain, which belongs to Metro AG. Turkish Ramenka intends to invest about $150 million in the Ramstore chain, and by the end of 2006 there will already be 52 “Ramstores” in Russia.
Among developers conducting business in duo with Russian partners, we would highlight the German retail group Rewe together with the Russian holding Marta, which have opened the Billa retail chain in Moscow. The volume of investment in developing this chain is supposed to reach $500 million. This year, the holding bought the Torgovy Kvartal Na Svobodnom shopping and entertainment center in Krasnoyarsk.
In the next 10 years, the British chain Castorama and St. Petersburg chain O’Kei intend to build 50 hypermarkets in Russia (Moscow, St. Petersburg and Rostov-on-Don). According to representatives of both companies made back in 2004, investment in this project will be $600 million. At present, there is already a Castorama brand shopping center in Samara.
Nonetheless, demand for quality shopping premises in both Russian capitals remains unsatisfied: AC Nielsen estimates that Moscow alone requires 200 hypermarkets, 500 supermarkets and no less than 1,000 mini-markets with areas of up to 400 sqm. In the Russian market, there are 94 hypermarkets, meaning that market saturation is barely 10%. Thus, beyond Moscow the situation concerning the supply of shopping centers is not encouraging.

Looking for reasons
Alexei Mogila says that the low pace at which foreign developers enter our market is reasonably simple to explain: “The formation of the retail market is in full swing; however, large chains are not able to react to this process speedily and to take decisions quickly when it comes to entering our country.” At Penny Lane Realty, the view is that nationality plays a noticeable role: “For some reasons it appears that Turkish and German investors adapt faster to our environment. Obvious examples are companies like Ramenka, OBI, Martkauf, but Americans and French, as well as Italians find it harder.” Alexei Mogila notes that Auchan is not expanding too quickly, and it has stuck to the more convenient format of hypermarkets rather than shops of up to 1,000 sqm, since in this case too much time would have to be spent negotiating with owners of small outlets.
According to Vladimir Perezhogin, head of property management at the Property Owners Association TEN Group, there are a number of factors that dampen foreign developer’s interest: “Firstly, at present the market has already formed its own pool of main players, in other words, the market is already divided; secondly, the Russian market is very specific. The process for obtaining authorizing documentation is still incomprehensible for foreign developers. Additionally, in large Russian cities there is a lack of physical space. There is nowhere to build,” concludes the expert.
Ivan Vashurin, senior consultant of financial markets and investment at Knight Frank, believes that foreign developers have found that in Russia there are almost no readymade assets on sale, which means that it is necessary to find a Russian partner that either owns land or the resources with which to do so, as well as a knowledge of the Russian market in the pre-development phase. “Foreigners know how to build themselves, but cannot overcome the administrative barrier, like, in fact, many national developers. The result is that a Western player entering our market is practically unable to start realizing a project alone,” comments Vashurin.
For example, in the Urals region, Alexei Ananiev, financial director of Olips confirms that foreign developers find it difficult to fathom the specifics of the local real estate market. “Generally, difficulties arise in managing projects, especially when it comes to relations with regional authorities as well as municipal bodies,” says Ananiev. “So, companies are unable to find suitable sites and projects become stalled for several years.” Foreign developers find it hardest to comprehend the situation and choose the most effective partners, project designers, etc, which also delays schedules and increases budgets.
Another factor that contributes to successful work is the rapid availability of full project financing. However, according to Alexei Ananiev, classical western sources of financing, which can be used in projects abroad, are not always accessible in Russia. “Many institutes do not have risk in Russia. But even if there is sufficient documentation to arrange local financing, this does not mean access to western borrowings is possible,” explains the financial director of Olips.

A view from the side
Foreign experts working in Russia agree with the reasons listed above. Particularly, notes Jeff Kershaw, head of shopping real estate at CB Richard Ellis Noble Gibbons, many western companies are put off by the Russian Land Code, in the context of which it is fairly complex to work without local connections. Another reason that hinders players is the lack of private ownership of land. “I have discussed local market conditions with many foreign developers,” explains Jeff Kershaw, “and several admitted that they would like to enter the Russian market in future: they believe Russia has great prospects. However, at present they are put off by obstacles such as obtaining visas, registration for foreign citizens, language barriers, etc.”
Gerald Gaige, partner at Ernst & Young and head of real estate, hotel and construction services, made a whole list of problems that stop a greater number of foreign developers arriving on Russian shores. In addition to the concerns mentioned earlier, he brought up the large amounts required to invest in construction, the non-transparent and lengthy process for acquiring authorizing documentation, the need to find orientation in the market of local specialists, and also the difficulty of competing with already operating Russian developers, which have access to different resources, including land resources. Another problem raised by Ernst & Young is the lack of modern infrastructure at available sites or premises (communications, drainage, electricity and water supplies) combined with the overcrowding of streets and the transport system. Developers are further hampered by the rapidly changing market, which can suddenly reduce demand for a project. “Of course, it is possible to acquire all the knowledge needed for the job, but this is a very long and expensive process,” notes Gerald Gaige. In his view, because of the short history of the Russian retail market, few foreign developers are willing to decide on a risky investment. The most renowned and frequently mentioned are the companies ENKA and Hines.
In fact, it is no secret that both ENKA and IKEA are clear evident examples of collaboration between a foreign developer and a Russian partner, or in these cases directly with the administrative resources. Usually, if developers deal with the authorities directly, without intermediaries, civil servants become participants in the company created for the project. Thus, IKEA, which occasionally experienced difficulties in realizing its projects, according to Ivan Vashurin, appealed for help to the government of Moscow region. At present, one of the partners for IKEA’s latest project, the new Mega shopping and entertainment complex on the south-east of Moscow, is the agricultural firm Belaya Dacha, whose chairman is the former minister of agriculture and now Duma deputy Viktor Semenov, a clear example of engaging the aforementioned administrative resource. The Turkish company ENKA, in turn, is building real estate throughout Russian with the participation of Moscow city government, which owns 20% of the company Mosenka, created specially for this purpose.
However, it is not unusual, according to Maxim Gasiev, head of retail real estate at Colliers International, for foreign developers and local partners to face the issue of mutual trust. “This problem arises when the foreign player acts under the so-called fee-development scheme, whereby a developer is paid to be part of the project. The outcome is usually that the foreign developer simply buys a readymade or almost-completed shopping center,” says Gasiev. Not surprisingly, recently the number of investors buying assets in the Russian real estate market is rising. Generally, it is investors and not developers: for the development side they rely on the local partners. Thus, in 2004, Eastern Property Holdings together with the Swiss company ENR Russia Invest acquired 10% of shares in the Moscow Mosmart chain. In 2005, EPH acquired 26% of shares of the new company Hypercenter Investment SA registered in Luxembourg, whose shareholders are Jelmoli Holding AG (49%), and Mosmart’s controlling shareholders took 25% plus one share. Hypercenter’s charter capital is $150 million (resources of EPH and Jelmoli), which was mostly invested in Mosmart sites - four in Moscow and two in St. Petersburg, as well as four in large cities of Central Russia. The Mosmart hypermarket will be the anchor tenant in each of the shopping centers.
In 2004, the deal between the Austrian fund Meinl European Land (MEL) and Samara developer Vremya was concluded, whereby the Park House shopping and entertainment complex in Volgograd was acquired. In 2005, MEL became investor in the project for building the Park House mall in Yekaterinburg. The relationship between MEL and Vremya is one of strategic partnership: in the next two years MEL will finance the initial phase of the program for building Park House malls in Kazan, Nizhny Novgorod, Ufa, and Rostov-on-Don, and Vremya will be responsible for the development and management of the buildings.
Meinl European Land showed an interest in Moscow retail and in particular in two Golden Babylon shopping centers in Otradnoe and Yasenevo. However, these two buildings recently went to a separate Austrian fund – Immoeast – which has a shareholding in the Fleming Family & Partners fund operating in Russia. The approximate value of this deal is estimated at $200 million.
There are many reasons to suggest that these large deals will not be the last this market sees. In the opinion of Alexei Ananiev, foreign developers will increase their share of the Russian real estate market but not on account of realizing their own projects, rather through cooperation with Russian developers. “The same will happen as in the banking sector more or less,” suggests Ananiev. “Nowadays, there are not many subsidiaries of foreign banks, unlike Russian banks, whose controlling shares belong to foreign financial institutes.” Olips believe that the same will occur with the real estate market: by appraising the synergy effect and joining efforts, foreign developers will enter the Russian market through the process of mergers and acquisitions.