Simple arithmetic: one ruble buys one sq.m

By results of the first auction held on April 25, the following objects found their tenants: Mansion House of the Morozovs; Residential House of N.P. Baulin (Irbis LLC); Mansion House (Stary Kvartal LLC).

While this material is being written, they are discussing the possibility of holding a second leasing auction, which is going to feature the following objects: Mansion House of the merchant M.N. Gusev (Building 3, 65/74 Bolshaya Polyanka Street); Residential House, also known as “The House with Caryatides” (7 Pechatnikov Lane); Mansion House of V.F. Kolesnikov-Sarginyh – M.E. Shapatina, the main house with trading premises (88 Taganskaya Square). We should mention that this mansion was confiscated from an unscrupulous owner, who disfigured the fasade of the building.

Initiators of the program seem upbeat about their plans: Nikolay Pereslegin, advisor to the Head of the Department of Cultural Heritage of Moscow, believes the bidding was successful because a huge number of bids were received, and the price for which the buildings were finally leased was considerably higher than the starting price. “We have heard the response from the business community, and we can see clearly that the business is interested in this program. The fact that this system is working properly suggests that this scheme can be both effective and mutually profitable. It is notable that there were more than 60 bidders competing for the first three buildings. This is a very important fact,” emphasized Nikolay Pereslegin. However, Elena Malinovskaya, deputy chief of office real estate at Cushman & Wakefield, corrected Mr Pereslegin, claiming that there were about 20 investors competing for the three mansions offered at the auction. Yet she does agree with the positive evaluation of this initiative. She says, “First results are now seen only as the interest shown to such an auction. By the end of the event, the price of the leases increased threefold and even fourfold, and this clearly shows that interest is high. I suppose that next lots may excite as much agitation.”
We should note that Russia is not a pioneer, but only a follower in this case. It was no mere chance that Dutch experts were invited to develop this program. Dmitry Onofrey, project manager of consulting and appraisals at Praedium Oncor International, notes that countries with numerous historical and architectural monuments “have experience in specific tax regulations, when the real estate tax rate may change considerably depending on the state and the present-day use of a property. This mechanism is adjusted in such a way that the owner of such a property is forced to repair and renovate his objects.” Elena Malinovskaya adds, “In most European countries, the company performing repairs of a cultural object enjoys tax benefits. For example, in Denmark, Austria, and Great Britain, the company pays a reduced VAT for carrying out repair works.” Tatiana Tikova, director of appraisals and consulting at Сolliers International, emphasizes, “There is a practice of giving old objects, which are dear to the city, for reconstruction to developers on favorable terms. Moreover, such format of cooperation as PPP (public-private partnership), is very well developed in the West. In fact, it is only one form of cooperation.”
In other words, similar European experience seems to be a plus, but experts are still in doubt, as they see too many hidden obstacles in the path of this program’s implementation.

The stumbling stones

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Denis Kolokolnikov, chairman of the board of directors at the RRG Group of Companies, says that the program itself is a way out of a situation, when a monument has to be “saved” and attracting investors is almost impossible. Such monuments are ramshackle buildings which have to be not only restored (observing numerous conditions and technologies that make the process considerably costlier) but also used later – with a number of limitations. As a result, such project is hardly attractive from the economic point of view. That is why the state has to either perform restoration works at the expense of treasury funds or offer some preferences to investors. Denis Kolokolnikov finds the preferences offered by the present program to be reasonable and promising. The prospect of getting a mansion with a most favorable location and a flavor of history at just “one ruble per meter” rate may attract either professional investors or companies willing to create a representative office to their own taste. Still the calculations provided by the expert leave much to think about. He says, “It is necessary to take into account that the rate of one ruble per one sqm will take effect after the restoration, and the auction is held for the rate which is going to be in effect before the restoration. Thus, the starting rate of 5,000 rubles per sqm per year may grow to 10,000 or 15,000 rubles per sqm per year during the auction. In addition, one has to calculate the cost of the lease during the period of restoration. Let us suppose, an investor won the auction and began paying the leasing rate of 10,000 rubles per sqm per year. He will pay such leasing rate during the first year while all necessary matters are settled and the project is prepared, and also during two or three of the following years, while restoration works are underway. We should also add to that the cost of restoration – at least $2,500 – $3,000 per sqm. Therefore, by the time when the proverbial rate of one ruble per sqm per year takes effect, the investor is going to have spent about $4,000 per sqm in each of the previous four years, with the prospect of returning this sum within 5 to 6 years through the leasing of premises. Finally, the recoupment period of the project will be at least 9 to 10 years. In fact, this is not too profitable, with account of the fact that he is still the tenant of this object.” Sergey Matiukhin, general director of KR-Properties, added that this program has many hidden obstacles for developers. In particular, this is the need to negotiate the process of restoration in the smallest details, which means spending much time and working with a very limited number of specialists who can perform high quality restoration works. “The program ‘one ruble per meter’ may be interesting for companies that are looking for a premises for their own needs or for small companies that do not have current projects. Large developers engaged in serious projects in the city will not be interested,” concludes Sergey Matiukhin.

First vice president of the Capital Group Valentina Stanovova draws attention to the program’s peculiarity. “Transferring objects of historical heritage to developers should include a complete set of documents, including the performance and restoration work assignment, to enable more precise calculation of a project’s budget. Meanwhile, developers do not receive such a document today. It means they cannot perform a previous and detailed evaluation to see the amount of expenses they will incur in restoring an object. The documents for every lot also lacked information on the status of every object in terms of land laws.” In addition to that, Valentina Stanovova believes that the process of decision making - providing a company, restoring an object, with favorable leasing conditions - still lacks transparency. Today the procedure is as follows: at the auction, a company purchases the right to reconstruct a historical object; then it develops a reconstruction/restoration project and submits it for approval; after that, it performs all works in accordance with the project and receives the final agreement on the restored or reconstructed project from the City of Moscow Cultural Heritage Committee. For development market players, who always evaluate a project from the viewpoint of planned expenses and profits, entering a project on the above-mentioned conditions is quite risky.

Tatiana Tikova has pointed out an interesting aspect, “In my opinion, the defect of this scheme is the uniform approach to the terms of restoration applied to all objects. Everyone understands that a large number of ramshackle buildings are found in places which are difficult in terms of further development – in the yards of other residential buildings, or very close to other buildings so that there is no room for construction equipment to operate on, and so on. That is why even five years may be too small a period to set the reconstruction activities in motion. Sure enough, I still believe this is an exception rather than a rule.” The expert believes that the new program is primarily interesting for old school companies that possess the advantages of administrative offices and probably have their own design bureaus. In addition, a part of buildings involved in this program have already been cut off from the city’s utility lines, so it will take knowledge, skills, and resources to negotiate the necessary utilities to be built anew. This task is much easier for a company with a long history in this market and good knowledge of all procedures. Dmitry Onofrey is apprehensive that this leasing program may become another variant of the McDonald’s story; at the beginning of its work in the Russian market, it was offered a rate of one ruble per sq.m per year, soon followed by charges claiming that the leasing conditions were at non-market rates. “We can only hope that legal arrangements will be fulfilled in a more fair way in the future,” comments Dmitry Onofrey.

The most skeptical respondent is Yulia Nikulicheva, head of strategic consulting at Jones Lang LaSalle, who believes the current scheme is too risky for investors. “The mansions are mostly situated in the center of Moscow, in attractive locations which are nice areas for developers. This land is very expensive – in the capital, the cost of land makes up 30% of the total investments into a development project, so companies will compete for the mansions in spite of their sorry state. However, in accordance with the scheme on offer, the winner of the auction will experience the heaviest cost loading in the period of project approval and its realization, which is a hard time by itself for the developer. On the one hand, city authorities are offering the object at the auction trying to maximize their profits, and actually receive all the possible income – the investor will only pay small amounts later. On the other hand, investors are in doubt as to whether it is worth to compete for such an object, so cheap in the long-term perspective, while its current price is rather high, and its reconstruction requires great investments.”

Legal "hitch"

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Lawyers have their own view on the program. They look not so much on its investment and development appeal, but on legal literacy and transparency of its construction, and they see a problem here – and not just one. Maxim Kuznechenkov, partner of the Baker & McKenzie CIS Law Firm, sees at least three: First, this cannot be considered a perfect design, where a tenant doing restoration work is considered as enjoying the benefits of the leased property according to its designation, and must pay rent for such use. We can only guess, according to Maxim Kuznechenkov, what the designation of the object can be here. In fact, the use of any object, being in an unsatisfactory condition, is highly problematic, so extracting any useful benefits from such objects is impossible. Establishing a leasing rate here – is simply an artificial construct. Such use is no different from hiring a contractor to work on a construction site and on the renovation of a capital construction object, with the only difference being that the contractor is forced to pay rent for his presence at the facilities under construction. Obviously, this design is a compromise between the requirements of receiving revenues and regulatory constraints.

Second, according to Maxim Kuznechenkov, there are difficulties in defining the subject of lease. Parties need to negotiate "now" a lease of an object, whose characteristics will be known only after the restoration is complete. This problem is a version of the classic problem of uncertainty, when one leases an object which has not been constructed yet. However in this case the problem becomes more complicated, because entering changes to a leasing agreement after the completion of restoration and matching the characteristics of the leased object with the provisions of the leasing agreement, is not so simple. The provisions of the tender and clarifications of FAS concerning changing a leasing agreement for state and municipal properties, signed after an auction, do not allow for the possibility of increasing the area of the leased property under such a lease. Thus, the description of the object in the lease and the actual characteristics of the final object will be different. This can lead to uncertainty regarding the rights and obligations of the parties.

Finally, the third problem, which is seen by Max Kuznechenkov, is the specific risks that arise in cases where restoration requires serious changes to, or reconstruction of an object. Neither the legislation nor judicial practice has fully resolved how to handle the issue of significant changes in the leased property during the leasing term. It is believed that the reconstruction of the leased property may result in the termination of the leasing agreement, as the original object of lease, the ownership and use to which the parties have agreed upon, in effect ceases to exist. Although there is an opposite opinion, which I support: the uncertainties, and therefore the risks to both parties, remain.

Assistant attorney at the Yukov, Khrenov and Partners Law Firm, Olesya Salayeva, also believes that the tenants may be faced with some difficulties and limitations. For example, historic buildings and historic homes often cannot meet such requirements as the availability of parking spaces, a professional management company, vertical communications, etc. However, from the point of view of the consumer and the engineering quality of premises, they can meet the highest requirements for modern office buildings. Also, in accordance with the Federal Law “On Cultural Heritage (Historical and Cultural Monuments) of the Peoples of the Russian Federation” № 73-FZ as of June 25, 2002, the leasing agreement for a cultural heritage object should contain a list of characteristics that must be preserved, and that these requirements for preserving the cultural heritage must be fulfilled, regardless of the type of ownership.

Thus, Olesya Salayeva, says that during the conclusion of a lease, the tenant should be made fully aware that the object of cultural heritage can be used at their discretion, but is subject to the following conditions, namely: Usage of the objects should not impair their condition; Usage of an object should not harm the historical and cultural environment; Use of an object should not infringe on the rights and lawful interests of other persons; Use must be in compliance with the legislation on the protection of cultural heritage.

In addition, according to the lawyer, while determining the nature of a cultural heritage the following basic requirements must be kept in mind:
1) To ensure constancy of shape and the interior of the object of cultural heritage in accordance with its characteristics; 2) Approval for the design and work on the preservation of the monument or ensemble and (or) their territories, design and implementation of land management, construction, land reclamation, industrial and other activities in the places of interest, as well as in areas of cultural heritage sites, must be obtained from:
- Ministry of Culture - on cultural heritage objects of federal importance;
- Territorial authorities of the Ministry of Culture - for cultural heritage sites of regional significance and cultural heritage of local (municipal) significance, being identified as places of cultural heritage;
3) Ensuring that the regime for lands of historical and cultural significance, established by the Land Code, under which the lands of historical and cultural significance are used strictly in accordance with their intended purpose, is always observed. Changing the designation of lands of historical and cultural significance into designations not appropriate for their intended purpose or activities is not permitted. In some lands of historical and cultural significance, including lands of cultural heritage sites that are to be studied or preserved, all forms of economic activity may be forbidden; 4) Rules of access to an object of cultural heritage shall be set by the owner of the object of cultural heritage in coordination with the Ministry of Culture and its territorial bodies.

It is clear that all of the above-stated raises questions – five years from now, will this program not lead to a mass termination of contracts by the tenant companies, which have not been able to fulfill their obligations? “We hope that this will not happen,” says Elena Malinovskaya. “However the risk will not last only five years, and it will always be with us. Reconstruction is a very troublesome and expensive affair. In addition, there may be delays in getting approvals from Mosgornaslediye." Dmitry Onofrey feels confident that, "Once a company has been paying rent at market prices for 5 years, and even if it could not proceed to the repairs, to terminate such a contract would mean the recording of serious losses. Rather, by analogy with the leasing of municipal facilities, a secondary market may be born, where legal entities with such favorable contracts will be bought and sold." By the way, to optimize the program, the expert says that the city authorities should understand more the needs of investors and not to severely limit the future use of the premises (provided that all technical requirements for restoration are met). “The contract will contain a clearly prescribed timetable for the restoration, and in the event of a breach, the contract will be terminated. Thus, if the company fails to meet its obligations, this will become clear in the early stages. So at the same time, the mass termination of contracts five years from now will not happen. So we do not expect a whole bunch of unscrupulous investors to appear, those who originally planned not to restore the building, but simply "borrow" it for five years at a reduced rate, and just hastily "renewed" the walls and floors. If under any violation of the restoration schedule contracts are immediately rescinded, it's very unlikely that such "investors" will participate in the auction sales," Denis Kolokolnikov recapitulates.