The market for retail business in Russia continues to develop rapidly. Indeed, the emerging prospects are lost on neither domestic nor international players, while the competition between retail operators grows each year. With the step-by-step saturation of the Moscow market, ever more chains are turning their gaze to the country’s regions, which look much more fertile compared to the competition on the Moscow market. However, not everything is so simple on the attractive Russian market, and foreign retailers are well aware of this, as several international operators have been probing the unsure ground of the local retail market for several years now.

Retail real estate is the most attractive segment for investment on the contemporary Russian commercial real estate market. Nevertheless, market experts note that institutional deals in this segment remain few in number. Market analysts contribute this to the low number of retail facilities ready for sale and the corresponding requirements on the part of potential investors.

A Russian Babylon
The Russian retail real estate market is actively developing today, which is connected foremost with the general economic situation in the country. Furthermore, the next year to two years will mark a second phase in this development, as a number of new retail center projects have already started or will soon get underway. These projects are interesting to the retailers as well as to investors, inasmuch as the risks of errors on the part of developers are significantly less than with the first facilities, believes Knight Frank.
The Moscow commercial real estate market has high investment appeal, analysts note. According to information provided by GVA Sawyer, the lower limit of IRR (internal rate of return) when investing ones own funds is not less than 15%, and the use of credit resources (financial leverage) allows a developer to receive up to 35% profitability. The increase in confidence in the Moscow commercial real estate market on the part of investors is the reason for the sharp growth in investment activity in the first half of 2006. The overall amount of investment in retail real estate, according to data provided by GVA Sawyer, totals two billion dollars, which should grow to three-and-a-half billion dollars by the end of 2006, experts believe. This figure is comparable to the amount of investment deals for the past three years. “For example, a year ago investors were not keen on considering regional retail faciltities with a capitalization rate of less than 14%,” says Dmitry Zotov, general director at Torgovy Kvartal. “Now deals delivering 11-12% profitability are included.”
Investors understand the market dynamics and are working to out do each other. Following the appearance of venture companies to the market, we are beginning to see of interest from more conservative investors, such as insurance companies and investment funds. Among the more active investors, according to analysts at Cushman & Wakefield Stiles & Riabokobylko, is Meinl European Land (Austria). This year the company, having bought the Park House shopping and entertainment center, has continued its expansion on the Russian real estate market, having purchased Real Mall Galleries in Moscow. The deal is estimated at $400 million. The investor ImmoEast has added to its investment profile by buying the Golden Babylon shopping center in Moscow's Yasenovo district as well as the second shopping center to appear with this name in the city's Otradnoe district. The amount of the deal is estimated at $200 million.
Retail real estate facilities are becoming a significant part of investment portfolios; therefore, the amount of inquiries on the part of interested investors exceeds the amount of quality investment grade buildings. Moreover, as noted by CB Richard Ellis Noble Gibbons, although the sale of shopping centers is not unheard of, these deals take place infrequently.
Indeed, the problem is the lack of a sufficient number of quality facilities ready for sale. Unlike the warehouse and office sectors of real estate, a project's concept is the most important in retail real estate, believes Natalia Korotaeva, commercial director at RosEuroDevelopment. “Furthermore, the location and selection of tenants is very important. Due to the fact that the majority of Russian shopping centers fall short on one or perhaps all of these attributes, retail real estate thus far is not a very popular segment for investment.”
“If a shopping center project is done well, from the point of view of the development, the location, selection of tenants with long-term contracts for leasing, a transparent arrangement of owners and an established structure for the future sale of the facility, and is clean from a legal and tax point of view, it could be no less successful than, say, an office project, and possibly more profitable in the long-term prospect,” says Alexander Nikolaev, managing director at MCT for Moscow and the CIS.
Nevertheless, at this time the retail real estate segment gives falls behind the office market in terms of the number of deals and profitability rate. However, both segments, the retail and office, exceed the warehouse real estate market segment, explains Jeff Kershow, director of the real estate premises department at CB Richard Ellis Noble Gibbons.
Another factor affecting the low level of investment activity in the retail real estate sector of Russia is that owners of shopping centers are unprepared to adhere to an exit strategy, believes Ivan Vashurin, senior consultant in the financial markets and investment department at Knight Frank. “So far, most developers prefer to receive stable income from the functioning of a shopping center and do not sell them,” explains Vashurin. “Nevertheless, we assume that already in the near future, this situation will begin to change, and we will witness an increase in the number of investment deals in the retail real estate sector in both Moscow and the regions.”

Betting on the big cities
When buying a facility, an investor is guided by various financial indicators, of which the capitalization rate is the fundamental indicator. When applying net profit generated by this or that retail real estate facility, the rate allows us to determine its price. Today in Moscow if the talk is about actually high-quality investment retail facilities, the capitalization rates could fluctuate in the range from 10% to 12% (analysts believe this rate varies from 9%-15%). In the regions in cities with populations of a million or more, taking into consideration the administrative risks and modest experience of the developers, the rates are about 13%-14% (several experts cite 11%-25%). Many investors believe the profitability rates in the regional cities could exceed those in Moscow by 100 to 200 basis points depending on many factors. “Until now, we did not see investment deals in the regional cities with populations of less than a million,” notes Kershow. “However, even with quality shopping centers with a good p ool of tenants and long-term contracts on leasing, I do not think we would find profitability rates higher than in the cities with populations of one million or more.”
According to Alexander Nikolaev, the higher rates in regional cities are a result of a whole range of factors, both macro- and microeconomic, and it can mean an additional 1% to 8%. However, Korotaeva believes there are not any particular differences in the profitability rate between the cities with over one million and those with less.

Two ways to buy
At this time on the domestic market there are two fundamental concepts used for investment buying and selling of retail real estate facilities: the purchase of a building (with service structures and infrastructure) or the purchase of assets in a company that is the owner of the facility or chain of facilities, says Vitaly Mozharovsky, a partner with the law firm Pepeliaev, Goltsblat and Partners. “The second option has a number of advantages compared to the first, and this is connected with the relative simple execution (it is not required to register the deal in the Real Estate Registry).” Moreover, clarifies Mozharovsky, the new owner also receives trained personnel, sometimes brand names, clientele, flow of goods and licenses – in other words, a functioning business.
Nevertheless, the drawbacks of this option are reflected in its advantages, given that the investor not only obtains the assets, but also the liabilities: tax issues, labor disputes, unions, obligations on deals, etc. Accordingly, the choice of deal arrangement is dictated by its goal; however, the most popular one is the obtaining of shares in a company owning a specific facility. “Unfortunately, at today’s stage of market development, the direct purchase of assets is practically not used,” confirms Vashurin. “The most popular arrangement is the purchase of assets in a company that owns the asset. This arrangement could be complemented by another link when an offshore company registered in, for example, Cyprus owns a Russian company which has an asset registered to it. In this case the deal occurs abroad, and the investor buys assets in a Cypriot company.”

Parameters for evaluating a facility
There are many parameters for an investor to assess the value of a building prior to making an investment purchase. “The key parameter is the tenants’ list and the long-term nature of the contracts signed with them,” agrees Zotov. This is especially important for Western investors. Korotaeva believes the most important parameter is the investment quality of the project. “Investors first and foremost evaluate the concept, soundness and lifecycle capability of the building. And there are no Russian specifics here. These are specifics only in that the profitability is higher in Russia than in Europe, but the risks are also higher here so far.”
The base principles for successful investment are generally accepted, believes Kershow. “In the ideal situation the shopping center should be a leader in its market and, when possible, isolated from its future competitors,” he believes.
Nevertheless, several experts indicate the presence of Russian specifics in this matter. “All investors, particularly Western investors who are now very actively looking at and already operating on the Russian real estate market, are paying a lot of attention to due diligence. This is a complex review that first and foremost checks the legal and good tax standing of the deal,” says Vashurin. The Russian specifics, he notes, consist in the process sometimes stretching over several months, with the payment for professional legal and tax consultancy possibly costing a substantial amount of money. Indeed, everything is checked, starting with the means for obtaining the premises by the seller and the accuracy in registering the various documents at the very stage of construction, to the existence of contracts with the tenants. Particular attention in paid to the direct structure of the deal. “Namely at this stage this type of review could disclose definite problems, which, if they cannot be rectified, could cause the deal to break,” clarifies Vashurin. “In the West, the legal parameters of the facility are paramount and they are paid careful attention,” explains Zhanna Bulokk, president of RIGroup. “The procedure lasts usually for one to two weeks. The Russian specifics of due diligence are its length and more delays that attend it.”
Additional Russian specifics are the different mentality of the purchaser (Western funds) and the seller (regional Russian entrepreneur), believes Zotov. “Finally, not having any experience working with foreign partners and trying to earn as much as possible could lead to not upholding the generally accepted standards and norms in similar deals,” notes Zotov. “In this case the solution could be seeking the assistance of Russian consultants who would take upon themselves the responsibility of brokering the deal.”

Working to avoid errors
Today, despite the rapid development of the retail sector, the situation on the investment market is characterized by very limited offers. Specifically because of this, if any sort of retail facility of institutional quality is put on sale, the seller often does not even have any significant effort to push the sale. Nevertheless, the situation is changing quickly, and soon the instruments for increasing the investment appeal will indeed be in demand.
It is best to attract qualified foreign consultants to help a shopping center attract a buyer in Russia, notes Kershow. This immediately provides access to the leading investors and allows potential buyers to feel comfortable and calm, if the person representing the seller speaks with the investor in the same language. “I always advise people thinking about building a shopping center anywhere in the world to think about how they are going to exit the project in the future,” says Kershow.
“In principal, it is worth thinking about the investment appeal of a project at the early stages of the project, when a project concept is being developed, architects and legal firms are being chosen, an ownership scheme is being worked out, lease contracts are being developed and the lease rates are being prescribed,” says Bulokk. Because at the selling stage, there will not be any possibility to hide errors in management, use and construction of the shopping center from potential investors. The most common errors are short-term lease contracts, unregistered tenants, operating expenses not 100% compensated, lease payment, partial loans in cash, tax liabilities, etc.
“Together with what our poll has shown, the deciding factor in this situation is not the Western brand, but, rather, actual experience of the company working on the Russian market and its connection with network retailers,” indicates Zotov. “For example, when purchasing our shopping centers – we took on the additional obligations of management, removing the possible risks and providing the new owner the level of income he counted upon when buying the facility.
As a rule, the extent of problems existing prior to the deal and after its completion depends exclusively on the professionalism of the two parties, the seller and the buyer, believes Nikolaev. And if both partners in the deal approach it with the necessary attention to detail as well as the specifics of the exact facility from the position of the interests of both parties, then substantial problems can be avoided. Nevertheless, there are aspects worth careful investigation. “When structuring a deal, it is worth paying attention to the burdens (deposits, lease, servitudes) and limitations on rights to the land plot (protected water zones, lines of communications), the possibility of non-agreement on redesigning/restructuring the building, utilities and infrastructure,” notes Mozharovsky.

Investors are coming to the regions
Commercial real estate market experts believe that today foreign funds and investors are amply represented on the Russian market. Moreover, the fact that the majority of them have still not made any investment deals does not mean they are not ready but rather indicates that supply falls far short of demand.
“I think that in two to three years the market will be similar to the West,” says Zotov. “Ownership of facilities is transferring to secondary owners, to the pension and venture funds and investment companies for whom the professional outer management of the shopping centers is necessary, and the profitability of retail real estate is lowering and stabilizing.”
Furthermore, the trend of foreign investors entering the regions is becoming clearer. “Investors are ready to invest funds in both Moscow-based shopping centers and those in the regions, and they are prepared to take on additional Russia-specific risks. And once enough investment grade offers appear on the market, we are certain to witness sharp growth in the number deals,” says Vashurin.
Nevertheless, not all experts forecast quick changes. “There will be more quality projects appearing, and it is possible to forecast a lowering in the profitability because of the lessening of risks; but these are prospects for the next 10 years,” believes Korotaeva. “Before then I would not forecast a massive entering of foreign investors, given that the investment quality of projects is still not that large here.”
Furthermore, Nikolaev believes that the development of the retail real estate market will depend not only on and how many foreign investment funds enter or exit, inasmuch as their share in the overall amount of projects is still too small. It is better to talk about the forecasts for macroeconomic development in the country as a whole and the activity of the local players: the developers (both Russian and Western), which, in turn, can determine the degree of market saturation. Accordingly, it is important to note that the growth in the share of professional investors in this segment, just as in all the others, should positively reflect on the volume of this market and its transparency in the long-term prospect.