In 2006 the total volume of investment in Russian real estate was estimated at over 3 billion euros while relatively recently the same figure stood at under a quarter of a billion. Last year Russia was ranked seventh in Europe in terms of overall investment. At the end of the year the main investment trend in the Russian commercial estate market was for substantial growth in investment from Russian and foreign investors.

Market experts differ when it comes to the share of Russian and foreign capital in the real estate market. “In 2006 foreign investment stood at about 60%,” says Christopher Peters, head of the research department at Cushman & Wakefield Stiles & Riabokobylko. Heiko Davids, a partner at Knight Frank, agrees with this estimate, “In 2006 for the first time, the volume of foreign investment in the Russian real estate market exceeded Russian investment. These figures indicate a significant reassessment by foreign investors of the political and economic risks in Russia.” Konstantin Demetriu, director of the investment department for Russia and the CIS at Jones Lang LaSalle, expresses a different viewpoint: “I find it rather difficult to estimate the proportions of foreign and Russian investment since they involve foreign firms with Russian capital and vice versa. I believe that the majority of deals are closed by Russian investors, but foreign investors are increasing the scale of their investment. Today their share is less than half but over the next couple of years we anticipate a serious increase in the level of foreign investment,” he comments.

Rates are plummeting, ladies and gentlemen!
The advantage of the Russian commercial real estate market is clear – high yields in comparison with the markets of Central Europe. “In Russia yields are higher; depending on the segment and location yields are 9-11% while even Eastern Europe has only about 6% to offer,” comments Konstantin.
The main difficulty is that the Russian market remains less liquid and less advanced than in some other developing countries. For this reason many investors estimate the risks as high. However, according to Christopher Peters, “Market players’ perception is that risk levels have reduced considerably.” He goes on to qualify that this is occurring against a background of increased competition among investors. In turn, growth in investment from Russian and Western firms is increasing competition for the most promising projects and encouraging the gradual reduction of yield rates.
“The most important trend is for lowering yields – from 12% in 2005 to 8.75% and lower in 2006. Over the next few years this trend is expected to continue,” says Christopher.
Reduced yields are also increasing competition among Russian investors, who are showing greater willingness to invest in commercial real estate. In addition to foreign funds that, one would think, would be willing to pay top dollar, a whole galaxy of much more competitive Russian investors have appeared. Why has this occurred? Dmitry Zotov, general director of Torgovy Kvartal points to several reasons for this apparent change: “The reason behind this new-found Russian competitiveness is their ability to make quicker decisions, which is important in an increasingly competitive market. They do not require lengthy due diligence procedures and possess sources of cheap financing within Russia or from abroad. These types of Russian firms make more attractive offers to sellers. Another important element is the differing mentality between the buyer, a Western fund, and the seller – a regional Russian entrepreneur with no experience in dealing with a foreign partner who perhaps does not adhere to generally accepted rules and standards in order to maximize profits.”

Expanding the limits
An important market trend is the geographical broadening of investment. While previously investors showed the most interest in the two capitals, Moscow and St. Petersburg, 2006 saw a number of significant transactions in other large Russian cities. Growing interest from foreign investors in Russian real estate projects is testimony to their increased potential.
According to Knight Frank in March 2006, the US investment fund Moore Capital acquired a 20% stake in RosEuroDevelopment. Market experts comment that this is the first example of direct investment by a Western fund in a Russian development firm. In August of the same year Morgan Stanley acquired a 10% stake in RosEuroDevelopment. The Irish private investment fund Sean Quinn Group acquired a project to build a business center in the Southwest of Moscow. Over the next five years the Quinn Group plans to invest $5 billion in real estate in Russian cities with populations over a million. The largest development firm in Southeast Asia, CapitaLand, has announced plans to invest in the construction of shopping and office centers in Russia.
Investors already involved in the Russian market are stepping up their activity. In March 2006 the Austrian firm Meinl European Land acquired two completed Mall Gallery shopping centers in Moscow and two construction lots for 400 million euro. The British fund Raven Russia announced a joint enterprise with the Russian logistics firm Avalon and plans, over the next 6 years, to develop about 1 million square meters of warehouse areas. The American firm AIG/Lincoln acquired one of Hines’ most successful projects – the Pokrovsky Hills luxury townhouse development – which is leased to the US Embassy and the senior management of foreign firms.
It is becoming easier for Russian real estate firms to obtain loans from foreign partners. The German bank Hypo Real Estate International provided Multinational Logistics Partnership with a loan of $450 million for the realization of three warehouse projects. This is the largest loan to date provided by a Western bank for the financing or refinancing of commercial real estate in Russia. At the start of 2006, AFK Sistema, Renova and the Whitehall Street Real Estate Funds signed an agreement on the creation of a $300-million direct investment fund for Russian real estate and in the future this amount may increase to $1 billion. The Finnish firm Evli has launched the Evli Property Investment (EPI) Russia fund aimed at acquisition and development of commercial real estate in Moscow and St. Petersburg regions.
“Today one of the most important development trends in the Russian commercial real estate market is a revolution in the perception of Russia by Western investment firms and funds – they no longer see just Moscow and St. Petersburg but are looking at other large Russian cities. Last year the volume of foreign capital in regional projects increased several times over. It should be noted that because of a reduction in capitalization rates during appraisals the price of acquired real estate grew by 20-30% in one year. We can track these changes based on our own experience. In 2006, Torgovy Kvartal made strong inroads into the Russian real estate sales market. At the start of the year we concluded negotiations regarding the sale of the Krasnoyarsk Torgovy Kvartal na Svobodnom shopping center. In the middle of the year we took part in the sale of the Shokolad shopping and entertainment center in Nizhny Novgorod and today we are closing a deal for the Torgovy Kvartal center in Naberezhnye Chelny,” says Dmitry.
Foreigners are increasingly investing in development as well as completed real estate because of a shortage in high-quality completed projects. The first reaction of a foreign investor in Russia is to look at completed sites. However investment-grade sites are relatively few and far between and yield rates are lower. So the next step is looking at development projects – in particular, those at early stages in their realization,” says Konstantin. This opinion is shared by Vadim Ulchenko, head of the Russian division of Eurohypo. “The main problem facing investors is that relatively little Russian real estate is put on the market. When owners can hang on to real estate they do so for as long as possible. Since yields are falling, the longer owners keep their buildings the more they can hope to obtain from a future sale. When buildings do go on the market they immediately spark strong competition from a large number of Russian and foreign buyers. The development of the investment market is also being hindered by a lack of transparency for available real estate.”

In quest of super-profits
Experts believe that all segments of the Russian commercial property market are of interest to investors; however, office and retail properties remain especially attractive.
“Investors are most confident in Moscow office properties that yield 8.5-10%. Demand is much higher than supply on the office real estate market and will remain high at least till 2010-11,” comments Christopher Peters. Overall, around 1.3-billion-worth transactions were completed on the office real estate market in 2006, according to Cushman & Wakefield Stiles & Riabokobylko. “Retail properties are as attractive to Russian and overseas investors as office properties as these segments are more civilized, stable and transparent than logistic properties, for example,” continues Mr. Peters. In the opinion of Knight Frank’s experts, the acquisition of the business center project now under construction on Ivan Franko Street by the Irish investment fund Sean Quinn Group, acquisition of Ducat Place II office center by UK-based London & Regional Properties from Hines and the sale of McDonald’s office building at Gazetny Lane to Eastern Value Partners Limited (a Russian division of Exelor Limited) are landmark deals with the involvement of Western companies.
However, according to experts at Cushman & Wakefield Stiles & Riabokobylko, the retail segment seems most attractive to investors. Demand clearly exceeds supply and this situation will continue for a number of years. According to C&W S&R, roughly $1.8 billion was invested in Russian retail properties in the year 2006. This market segment is rapidly developing not only in Moscow and St. Petersburg but also in other big cities of Russia. “A year ago investors were reluctant to consider regional retail properties with capitalization rates below 14%, but now they close deals yielding only 11-12%. Investors realize the market dynamics and try to stay step ahead of each other,” Dmitry Zotov asserts.
The Russian market of logistic properties did not see many transactions in 2006, as compared to the retail and office segments, which is an evidence of a certain lag and the shortage of high-quality warehouse complexes, interesting to investors. This has lead the major players to focus on development projects in the vicinity of both capitals and on a number of big regional centers.
Perhaps only two acquisitions of the British investment company Fleming Family & Partners — a warehouse terminal in Shushary near St. Petersburg and a logistic complex on Dmitrovskoe shosse, 15 km past the MKAD — are noteworthy among the last year’s deals. The net initial yield from quality warehouse complexes is presently estimated at 10.5-13%, which is somewhat higher compared to office and retail properties,” says Mr. Davids. As reported by Cushman & Wakefield Stiles & Riaboko-bylko, acquisitions in the logistics sector amounted to about $370 million in 2006.
As far as the hotel market is concerned, 2006 witnessed an increase in competition and growing professionalism among market participants. The year also marked the arrival of a number of transnational operators that are new to the Moscow market, growing influence and expansion of existing chains and the appearance of major foreign investors. Even though the hospitality sector cannot be described as a hot investment market, its outlook is bright.

Russia’s regions
Significant economic growth has stimulated development in regional cities which are now becoming attractive not just for Russian but also for foreign investors. Areas, currently receiving greatest interest from investors, include: St. Petersburg, Kazan, Novosibirsk, Chelyabinsk, Yekaterinburg, Ufa, Samara, Volgograd, Rostov-on-Don, Nizhny Novgorod, Krasnoyarsk and Kaliningrad. The driving force behind the development of regional real estate has been the retail segment.
The regional warehouse real estate market is developing rapidly while the office segment is showing moderate growth.
Investment yields from regional projects are currently several percentage points higher than for Moscow and St. Petersburg, which stems from the higher risk levels. It can be difficult for a foreign firm to enter the regional real estate market. Russia known as a place where “administrative resources” are of particular importance, so foreign investors in the regions need to locate a reliable Russian partner. Also, the regions are suffering from a severe shortage of highly qualified specialists; this plight makes project implementation even more difficult, although the capacity of the regional market is far larger than that of the Moscow and St. Petersburg markets.