No One Wants Out

Pioneers
Let’s mention some of the key deals in the warehouse real estate market with Western investment funds. The pioneer was the British investment fund Raven Russia Limited, which in 2005 became the owner of several projects by the development company Kulon (now known as the Espro Group) – Kulon-Baltiya on Novorizhskoe Shosse, 3km away from the MKAD, and Kulon-Yuzhny on ul. Dorozhnaya. This deal was valued at $18.6 million.
Somewhat later, Raven Russia bought warehouse premises from RosEuroDevelopment of the first phase of the Krekshino logistics park outside Moscow under a forward financing scheme. According to Knight Frank, the deal was worth $110 million.
In spring of 2006, Raven Russia started to realize its first project in St. Petersburg, signing an agreement on creating a joint venture with the Russian investment company Avalon Group. “It also made a supplemental issue of 269.57 million shares and raised 310 million euros ($538 million),” says Heiko Davids, a partner at Knight Frank.
The British fund also established several joint ventures – joint construction project with Aldama Limited for the Vostochny industrial park on a 61.8-ha site in the Noginsky district of Moscow Oblast (MO) (developed by Espro Group), as well as the development of a site located next to St. Petersburg’s international airport.
In 2006, the British investment fund Raven Russia started its first regional project in Russia (having adopted a plan to build warehouse complexes in 14 Russian cities). Together with Avalon, the fund acquired a site in Rostov-on-Don, where it plans on to build a 230,000-sqm warehouse complex. Specialists appraise the cost of the project at $166 million.
Ferit Yildirim, managing director of the company DTZ Zadelhoff Tie Leung, Russia, believes that among the most significant deals on the market in 2006 one should also mention the purchase of the FM Logistic complex (65,000 sqm, Khimki, МО) by AIG European Real Estate Fund, the first investment deal in the warehouse market with a foreign company under the sale and lease back scheme. The loan for acquiring the warehouse complex was granted by Hypo Real Estate Bank. The same bank provided Multinational Logistics Partnership (MLP) with a loan of $300 million to realize two warehouse projects – one in the Moscow region and another in St. Petersburg.
Among the largest deals with completed buildings last year we would highlight the two acquisitions by the English investment fund Fleming Family & Partners. These are a warehouse terminal in Shushari outside St. Petersburg and a warehouse complex on Dmitrovskoe Shosse, 15 km away from the MKAD. “Experts appraised the value of the deal at $14–16 million and $40 million, respectively. Fleming Family & Partners has several warehouse projects in its portfolio, but is so far acting cautiously,” explains Heiko Davids.
Moreover, according to Knight Frank’s valuations, several large investment funds and development companies have already announced plans for developing their own projects, including Europolis, Scan Quinne, and Parkridge Holding.
From the deals listed above, it is evident that the most active player in this field is the British investment fund Raven Russia, created in July 2005 on the initiative of the development company Raven Mount.

Also a choice piece
Many specialists highly appraise the investment attractiveness of warehouse real estate. “This is the youngest segment of the Russian commercial real estate market. It only recently started to develop actively and it has already managed to become one of the most attractive,” believes Mr. Yildirim, “A large number of investment deals, one of the highest return rates and the lack of quality supply stimulate investors’ activity.”
“The warehouse real estate market in Russia offers the possibility for Western investment funds of received high profit in relation to what they would be able to make in Western Europe. This is why companies, such as Fleming Family and AIG, were attracted to Russia. As far as newer investment companies for the Russian market are concerned, they have now realized that Russia is politically stable, has a growing consumer market, and positive financial prospects,” believes David Lane, general manager of Tablogix.
Ivan Potekhin, general manager of Espro Group, is more reserved: “From the profitability perspective, warehouse real estate is less attractive than say an office building or shopping center. Changes in capitalization rates are more or less identical across all sectors of commercial real estate. However, the possibility of increasing profitability by leasing out offices or retail premises is immeasurably higher.”
Despite the certain differences of opinion in relation to the investment attractiveness of warehouse real estate, specialists identify a number of benefits that are specific to precisely this sector. “Long-term rent agreements, the clients’ predictability, the relative ease of management and exploitation, and longer period of the building’s commercial attractiveness are all factors that make investment in warehouse real estate less risky for institutional investors,” explains Ivan Potekhin.
“I would also note the possibility of acquiring the plot of land in ownership,” says Vladimir Avdeev, a partner of S.A.Ricci in association with King Sturge. “This is a particularity of the warehouse market that is very important for many foreign players.” “In the same vein, construction of warehouse buildings from a technical point of view is relatively simple and quick, as is their inspection and appraisal,” adds Sergei Beloshapko, head of industrial real estate at DTZ Zadelhoff Tie Leung, Russia.
In addition, specialists continue to speak of the serious imbalance between demand and supply, which also stimulates Western investors’ interest. “If a warehouse is good quality and is in a good location, there will be no problem with renting it out, given that demand exceeds supply. Everyone understands that warehouses will be needed today and tomorrow,” continues Vladimir Avdeev.
And this is the opinion of Raven Russia experts: “Having studied a number of markets we concluded that Russian real estate is the most attractive for us from a macroeconomic point of view,” says Adrian Baker, managing director of Raven Russia.
Specialists believe that the funds present on the market represent the “first wave” of investors. “These companies have come for the long-term but the main objective of most of them is to resell the buildings in several years time to more conservative investors,” believes Vladimir Avdeev.
“The main strategy of most of the funds here today is not to invest long-term for 20–30 years, but to acquire properties at existing rates (10–12%) for subsequent resale in 5–6 years at a profit of 6–8%. This speculative approach allows funds to make a profit of more than 50% in this time. This is why funds’ strategy is to try and maintain high profits in the near term, so as to manage to buy as many properties as possible with high profit, and then resell them to more conservative investors oriented at Western rates,” one market player explains.
Meanwhile, specialists highlight the fact that not all warehouse complexes are interesting to western investors. Far from all developers can offer a product that is genuinely investment grade.
“Institutional investors interested in long-term investments need properties built to global quality standards,” explains David Lane. “Gradually Russia is beginning to understand the type of development that is called for in a civilized market.”
Mr. Yildirim agrees with this opinion and believes that in Russia a group of reliable developers has already emerged, and they can offer investors high-quality projects.

Biding time
Despite the interest shown by investment funds in warehouse real estate, the intensity of deals in recent times is on the wane. Market experts identify several reasons. “One is the lack of readymade high-quality buildings, able to provide investors with the right amount of income” explains Heiko Davids. “The buildings that meet these requirements have already been sold, namely, the buildings of Kulon, FM-Logistics and such.”
The other reason is waiting for capitalization rates to fall. Owners of warehouse complexes are taking a pause, biding their time in order to sell their property at lower capitalization rates, which will provide them with higher profit. “Many developers either offer their properties for sale at inflated prices, or consider the possibility of selling them in the mid-term,” explains Heiko Davids.
According to Knight Frank, at present capitalization rates in the warehouse real estate market vary between 11 and 12.5%.
Sergei Beloshapko believes that the return on investing in the warehouse real estate market is as follows: investment return – 10–11%, average developer’s profit – 14–15%. Meanwhile, Sergei Beloshapko specifies that this refers to large class A properties.
Andrei Podgorny, executive director of RosEuroIndustrial, believes that in a couple of years the capitalization rates will fall to 9–10%.
It is worth noting that declining capitalization rates is a generalized trend for the commercial real estate market, which is occurring under the influence of several factors. “Russia’s improved macroeconomic indicators, increased investment ratings and expected entry into the WTO are the primary factors. Additionally, capitalization rates fall due to the lack of alternative instruments for investing in Russia. And, finally, it is possible to find another reason – the declining profit from investing in real estate in the countries of Central and Western Europe” says Ivan Potekhin.
“Moreover, each new fund arriving on the Russian market makes it possible to reduce the capitalization rate,” believes Vladimir Avdeev, “In the form of an entrance fee they are willing to accept lower capitaliztion rates, by perhaps 0.15–0.25% less.”
The fact that developers are not rushing to sell is also influenced by the declining return of the development business, yet another trend on the warehouse real estate market. We know that recently the cost of construction has risen sharply. At the same time, the rise in rent rates, in experts’ view, does not compensate for the expense (according to Knight Frank, with a cost of $1050–1,200/sqm the developer’s costs represent $850–900/sqm and above). “Therein lies the reason for falling developers’ returns,” declares Andrei Podgorny. “Considering the rising cost of construction, a rate of 14% is a very good indicator, which is still a struggle to attain, which is why this is not the time to exit a project at current capitalization rates.”
Another factor influencing the intensity of investment deals is the active development of the program for financing construction on the part of Russian and Western banks. Previously, for many companies the certain sale of the property was the only way of ensuring its financing. Now, times are changing. “Having access to cheaper funding, means that it may not make sense to sell a property ahead of time,” believes Andrei Podgorny. “It’s better to build a warehouse complex on borrowed funds, rent it, then refinance it with the bank and only subsequently, sell it. Many developers think this way – I have not heard any information on new deals in the last six months.”
We should not fail to mention investors’ interest in regional projects in the sphere of office and retail real estate. The warehouse sector in this regard is noticeably lagging. One of the reasons is the same lack of quality warehouse properties. “The regional market is not as simple” explains Mr. Podgorny. “Demand for class A warehouse premises has simply not been researched. This is why developers are concerned that regional projects could find themselves without tenants. Everyone is worried about this at present and consequently, is cautious.”
Because construction does not start easily, there are few developers who would be trusted by investors. The funds that concluded the first deals in Moscow and St. Petersburg, for example Raven Russia, are currently prepared to enter the regions. However, new players are afraid.
At Knight Frank, the silence is explained as part of the information strategy of the funds themselves. “Only some investors offer information on their deals to a broad audience, in order to attract potential sellers or partners for creating joint ventures. Meanwhile, most investors, on the contrary, prefer not to advertise their activity, in order to avoid competition on the market. They do not need the information to be disclosed because for realizing certain projects they choose the same partners over and over,” believes Heiko Davids.
Knight Frank is sure that in 2007 the situation will change. “According to our forecasts, the number of investment deals with high-quality warehouse properties on the Russian market will grow,” believes Heiko Davids. “In the near future a whole range of projects that are currently in the final stages of completion will enter the market. Thanks to this, the number of transactions (investment deals) in the warehouse real estate segment will become significantly higher than in the preceding period.”
Sergei Beloshapko believes that the most promising deals in 2007 will be with the participation of MLP (Leningradsky and Podolsk properties) and Capital Partners (Pushkino).”

Investors’ interest
Last year another trend emerged – for funds to participate in the development process. Market specialists unanimously agree that this is a forced measure for funds. “First of all, not all institutional investors are satisfied with declining return rates,” explains Vladimir Avdeev. “Many attracted financing to ensure a particular rate of return, below which they cannot stoop. In addition, there is a serious lack of high-quality properties. For this reason, funds are starting to finance the development process, or – depending on their strategy – to buy a stake in the Russian company.”
For developers a fund’s participation in a project is a double-edged sword. On the one hand, this type of collaboration considerably reduces developers’ risks. “In concluding a deal with a fund nowadays, developers obtain an end-buyer. Moreover, Western investors help the project’s realization, in particular, offering considerable support in the context of the negotiation process, since not everyone is capable of correctly approaching and dealing with potential tenants.”
A disadvantage of such a scheme is that developers’ returns decline. Investment funds will offer a loan at the same percentage at which the building will subsequently be bought, which does not always suit developers. Vladimir Avdeev offers the following example: “If a warehouse is to be sold, at approximately 12%, then the loan will be given at 12%. Meanwhile, some banks could offer better conditions, say 10%. The developer loses the 2% difference. On the other hand, the reduced profit in this case is compensated by the certainty of knowing that the project will be sold.”
“In general, funds are interested not so much in extracting developers’ profit (in the warehouse sector it is insignificant), so much as fixing the future sale price of the property at a beneficial capitalization rate for themselves. This is why they agree to fund the construction of new properties (at the abovementioned 12%), while their main interest lies in their subsequent resale,” explains one market participant.

Investment package
Having analyzed the changes occurring in the warehouse sector under the influence of investment funds, specialists identify several trends. “The improved quality of construction is undoubtedly one of them, but not the main one. The investor’s task in acquiring a property is to minimize any risk related to the loss of revenue flow. This is why the most careful attention is now paid to the quality of rent agreements. In this regard, the market has taken a significant step forward. Long-term (a minimum seven years) rent agreements, Triple Net rent rates, deposits, advance payments, bank guarantees and mandatory insurance (including insurance of the tenant’s goods) – are mechanisms that in future will assure investors a stable income,” says Andrei Podgorny.
“To say that there are any higher demands of a development project’s quality is only relevant insofar as its packaging to investors is improved: the creation of an investment-grade product with carefully designed financial models, a transparent shareholder structure, etc.; that is, the use of internationally accepted mechanisms to provide guarantees and cover risks,” continues Ivan Potekhin. “Where the project concept and supervision of construction is concerned, Russian developers do not lag far behind our Western colleagues.”
On a separate note, many investors, including those coming from England, have understood: certain quality requirements are simply unattainable in Russia. However, thanks to the high capitalization rates they are prepared to soften their demands. “In relation to the particularities of Russian projects, such as the order for obtaining permits or tax regime, Western funds are obliged to adapt to the habits and customs established in Russia,” says Ivan Potekhin.
Market experts believe that in addition to the improved quality of buildings, it is worth mentioning the improved concepts that in the long-term will correspond to what the second wave of investors will want to buy.
Although, according to Heiko Davids, it is still too early to speak of the influence of foreign investment funds on the development of Russia’s warehouse real estate segment. “In future, as the market develops and new large international companies enter the market, demands for the quality of projects will rise,” asserts Mr. Davids. “While the arrival of Western investors has facilitated the boom in warehouse construction, it has also brought about a decline in the profitability of this real estate sector in comparison to the office market, shopping centers, even housing.”
In future, the warehouse property market will be divided between large developers, each of which will be backed by one or two investment funds. Considering all the difficulties in relation to warehouse development, and the fact that profit in this real estate sphere is the lowest in the market, smaller companies will be unable to participate in this segment,” concludes Ivan Potekhin.