The office real estate market has traditionally been considered one of the most attractive and dynamic commercial property segments. Nevertheless, in terms of investment this market lags slightly behind the retail real estate sector, and this gap is more appreciable beyond the confines of Russia’s business capitals.

In chase of saturation
The headlong development of the office market, especially in the class A segment, is quite striking: even developers specializing in residential properties and high-profile financial-industrial groups of Russia are now announcing their moves to join this rush. And yet demand for quality property exceeds supply. “The market of office real estate is still developing and far from saturation, even though it has changed both qualitatively and quantitatively over the past few years. This situation is already evolving into a trend,” says Olga Baturina, who leads the group of office real estate analysts at Jones Lang LaSalle.
Out of 5.4 million sqm of office space currently available on the Moscow market, class A offices accounts for about 1.5 million sqm, according to Colliers International. While new offers are increasing with each passing year, the growth fails to keep pace with rising demand. Thus 975,000 sqm office space was developed or modernized in 2006, whereas 1.3 million sqm was purchased or rented; preliminary lease and sale transactions accounted for about 43% of the market. In this situation the vacancy rate reached a six-year minimum in late 2006, as reported by Colliers International: 1.2% in class A and 3.5% in class B.
According to CB Richard Ellis Noble Gibbons, around 900,000 sqm of quality office space was developed in last year, with class A not exceeding 14% (or 22% as estimated by Colliers International) of this space. Analysts at Knight Frank estimate the office space commissioned in 2006 at 1.1 million sqm, with class A accounting for 38%. Jones Lang LaSalle forecasts that the vacancy rate will slowly rise, reaching up to 4.0-4.5% in 2007 and perhaps 5% in 2008. This figure is not significant enough to affect lease rates, and so further rise in office space rates should be anticipated. According to Colliers International, throughout 2006 lease rates grew by 15-17% in the class A segment and by 8-12% in class B, depending on location.
According to Olga Baturina, Moscow’s maximal lease rates at the best and priciest office buildings (where large office units from 1,000 sqm are rented) ranged from $900 to $1,200 per square meter at the year’s end. Regular class A office space is leased for $680-750 per square meter a year while in class B rates vary between $525 and $550 per sqm. As reported by Jones Lang LaSalle, the best class A office premises in St. Petersburg are leased at $650-800 per sqm a year while the lease rates in class B office buildings fluctuated between $300 and $500 per sqm.
It should be noted that a new office categorization developed by the Moscow Research Forum has been in use since autumn of 2006. According to this new classification system, outdated class A buildings are downgraded into class B while the latter is subdivided into B+ and B- subclasses. From now on lease rates will partly be established with regard to the new concepts of this classification.
According to Blackwood, the selling prices of Moscow offices were in the range of $4,800–5,600 per sqm for class A business centers and $3,500–4,200 per sqm for class B, as of the end of 2006. As reported by GVA Sawyer, selling prices averaged $7,000 for class A office premises inside the Garden Ring and $5,500 for class B. Some market participants estimate the construction cost of class A and B office buildings at $1,500 to $3,500 per sqm depending on the project’s complexity and location.

Moscow versus the regions
At present office real estate is being most vigorously developed in Moscow and St. Petersburg; Russian regions cannot compete with the two capitals in terms of market volume or the number and quality of office premises. The reason for this is quite simple, says Olga Baturina: international and Moscow-based developers are very poorly represented in the province, because Moscow and St. Petersburg boast a higher demand for office space and higher lease rates. “The situation with the development of office real estate in Russia’s regions is not quite clear yet: quality office space is almost nonexistent; the demand is unclear and so investors have difficulty forecasting returns on their investments in office development,” explains Konstantin Demetriu, director of the investment department for Russia and CIS at Jones Lang LaSalle.
Certain local conditions are also of importance: in Moscow developers generally have good connections with both contractors and the city administration, but it is difficult and time-consuming to establish such ties as a newcomer to regional markets. Experts at Forum Properties say that the factors adversely affecting development of the commercial real estate market are widely known: an unfavourable economic situation, social and political instability, legal problems, substantial of social infrastructure difficulties, such as transportation links, utility access, power shortages, etc.
At present most Moscow-based investors put their money in class A office space, and due to the deficit of such space on the market, office buildings under development are also of interest. Some investors are gradually switching to class B offices. In the foreseeable future they’ll take greater interest both in lower class offices and in regional projects, says Mr. Demetriu. This may happen in three or four years when the Moscow market approaches a point of saturation. Ms. Baturina suggests that developers will move to regions in the long run and then supply will catch up with demand on local markets. But it remains too early to talk about attractiveness of regional markets.
Nevertheless most the dynamically developing regions in terms of office real estate are worth mentioning. The most active development is seen the Urals region, with such cities as Tyumen and Yekaterinburg, as well as Novosibirsk. The total office space of Tyumen comes to about 100,000-120,000 sqm, according to Lex, and the city is seeing a boom in retail and residential real estate. Office properties remain “in the shadow” of more lucrative projects (shopping centers and residential builings); investors and developers don’t take much interest in the office segment. Purchase and sale deals account for about 90% of all transactions on the office real estate market, while the rest is put up for lease. The average office lease rate in Tyumen is $315 per square meter a year, while the average selling price comes to 40,400 rubles per square meter.
Over 1.1 million sqm of office space in business centers and mixed-uses (more than 60 properties) are now at the construction stage in Yekaterinburg, according to analysts at the Ural Chamber of Real Estate. An even greater number of properties are presently at the stage of design and due to hit the market in 2009-12. According to the chamber’s analysts, the changing balance between demand and supply along with redistribution of tenants will cause a quality leap on the Yekaterinburg office market and a qualitatively new supply to emerge within the next 3-5 years. As a result, lease rates will be more differentiated and companies will have more interest in establishing operations in Yekaterinburg. On the whole, these changes can be seen as prerequisites for the city’s transition to a more competitive position on the global labor market and creation of more attractive conditions for Russian and foreign companies.

Players and deals
An increasing number of western developers and investors are entering the Moscow market. Last year alone saw the arrival of such well-known companies as Singapore-based developer CapitaLand, the Irish private investment fund Sean Quinn Group, the Greek holding company Michaniki, one of the biggest UAE developers Tameer Holding and the Swedish developer Northern European Properties Limited, and a number of others announced their plans to invest in Russian commercial property development. Among the most significant deals closed by western companies on the Russian office real estate market in 2006 Knight Frank mentions:

the acquisition of the business center construction project on Ivan Franko St. by the private Irish investment fund Sean Quinn Group;
the purchase of the office center Ducat Place II by British investor London & Regional Properties;
the sale of MacDonald’s office building at Gazetny Lane to Eastern Value Partners Limited (a Russian division of Exelor Limited)

Furthermore the year 2006 was marked by a record-breaking transaction in the history of the Russian commercial property market: Vneshtorgbank acquired (for its own needs) more than 60,000 sqm on 32 floors of the business complex Federation erected by Mirax Group on the territory of MIBC Moscow City.
The projects of office complexes being erected by Russian and foreign developers are notable for their large scale: a project with floor space of 100,000 sqm no longer surprises anybody.
According to CB Richard Ellis Noble Gibbons, investment in office properties amounted to about $500 million, roughly 21% of the total investment in commercial real estate (which reached $2.3 billion in 2006, up 6.5 times over 2005). The office segment is still behind retail properties in terms of investment. Perhaps the reason should partly be sought in the gradual yield compression. Konstantin Demetriu says the highest possible yield from the best Moscow office buildings for investor is now about 8-8.5%. In the regions it is higher by 1.5 percentage points. The yield from office properties is 0.5-1.0 percentage points lower than yields from retail properties and 1.0-1.5 percentage points lower than that of logistics complexes.For the sake of comparison, the minimal yield in the Moscow office segment was 11.5-12% as of the end of 2005 and 12-14% at the end of 2004, according to Jones Lang LaSalle.
Despite the gradual slide in office yields, Russian and foreign investors are taking an ever-increasing interest in acquisition of business centers, especially since the yields have so far been higher in Russia than in Western and Eastern Europe. On the other hand, an almost complete lack of available properties capable of satisfying institutional investors hinders investment. Developers tend to prefer a stable rent income to sale revenues.

Outlook
As noted by experts, the Russian office real estate market is getting hotter with each passing year: the number of new projects and new players is multiplying. This trend stems from an apparent deficit of new supply, and an increasing number of companies are eager to participate in the office market. Non-specialized companies, such as Evrazholding and Bouquet, are demonstrating considerable interest in the commercial real estate. Experienced players of the residential market are keen on trying their hand in the commercial real estate market as well. The influx of significant foreign capital has also given a new impulse to increasing the scale of planned projects.
The market is clearly maturing: Russian developers are rather quick to learn from their mistakes. The increasing quality of office buildings under development will further raise the interest of Western investors in the Russian market of office properties and stimulate more foreign investment.