August 2007 VOL. 2

Editor's Note: This story is the second in a two-part series about the top markets in Eastern Europe. The first story, which covered Istanbul, Turkey, was published in the July issue of the Global Real Estate Monitor.

Russia Rewards

Risk tolerant investors embrace Moscow

Despite its history of political instability and corruption, Russia has emerged as one of the top real estate markets in Eastern Europe. The risks of this emerging market cannot overshadow its booming economy and growing household wealth, experts note. 

As Russia becomes more transparent, international developers and investors are heading to Moscow, the country’s largest city. "The yields are higher," says Chris Zeuner, head of business development for Central and Eastern Europe for GE Real Estate. "And, it's very important to note that the legal system is clearer today than it has ever been and international banks are now willing to provide loans in Russia.”

Experts estimate that real estate property returns in Moscow range from 9 percent for office assets to 12 percent for warehouse buildings. Development returns are considerably higher, says Stephen Collins, managing director of Jones Lang LaSalle's International Capital Group, but the intense competition for land and the increased cost of construction is pushing down all returns.

Active investment market

Since 2004, Russia has ranked as the fastest growing investment market in Europe. It recorded a total of €238 million ($324 million) in commercial real estate transactions during the first quarter 2007, establishing itself as one of the most active markets for investment sales across Continental Europe, according to Jones Lang LaSalle. This year, the country is on track to eclipse its all time record investment activity in 2006, which reached €3.4 billion ($4.2 billion).

The 2006 investment volume was nearly nine times more than 2005's activity, but it still ranked below Poland's €5 billion, and well behind Western European markets such as Germany (with €50 billion) or the UK (with €80 billion). To many industry experts, this suggests that there's room for significant growth in Russia for years to come.

Although Russia is traditionally compared to other emerging markets in Central and Eastern Europe, it has become clear that the country is different in a very fundamental way – it boasts a very active domestic investor pool. "In Russia, there are a lot of very wealthy private investors that have the capability to invest $1 billion into a project without securing third party debt," Zeuner notes. 

In 2006, for example, local investors accounted for at least 44 percent of investment transactions. Similar figures for Poland, the Czech Republic and Hungary were a meager 2 percent, 6 percent and 8 percent, respectively.

Additionally, many international players have entered the Russian real estate market, with interest from Austria, Germany, the UK, the U.S., and Scandinavia.  Some players, like Houston-based Hines, have been active in Russia for the past three years. Others, such as the European Bank for Reconstruction and Development and Investkredit Bank have recently partnered to invest €300 million ($405 million) in Russia and the Ukraine. RREFF, which already has a JV with St. Petersburg developer RBI Holdings, also announced a $100 million to $150 million investment, while Ireland-based Quinn Group is shifting its focus from Western Europe to Eastern Europe, specifically Russia.

"All commercial real estate sectors – office, warehouse and retail – are vastly undersupplied," says Tim Millard, partner & head of advisory and research with Cushman & Wakefield Stiles & Riabokobylko in Moscow. "The Russian real estate market has only been open to outside developers and investors for about 10 years and most of the existing stock is obsolete."

Culture of spending

Demand for commercial real estate is driven by Russia's booming economy. Largely propelled by global oil prices, the country is expected to post GDP growth of about 6 percent this year. In 2006, the country's GDP expanded 6.7 percent and in 2005 it grew 6.4 percent.

"The oil and gas sector is the largest piece of the Russian economy, and there are a lot of international companies that are expanding rapidly, leasing more space and hiring more people – at very nice salaries," Millard says.

Russians, and in particular those living and working in Moscow, have seen their annual incomes increase substantially as the economy expands. "Moscow is not only the capital of Russia but also a political, economic and financial center of the country," points out Olga Yasko, head of research for Colliers International's Moscow office.

Similar in size to New York or London, Moscow has a population of roughly 12 million. A total of 18 million people live in the greater Moscow region, and most of them have more disposable income today than they ever have, Millard says. He attributes the increase to the Russian mortgage market, which is just now finding its legs. Russian homeowners are pulling equity from their homes by obtaining mortgages for the first time, and all of this money is being poured into the local economy.

"In Russia, you have a culture of spending rather than saving because there have been points in history where people have lost their savings," Millard explains. "Russians are spending 95 percent of their income." Plus, consumer credit in Russia is only now being established, so Russians will likely spend even more in the coming years.

Retail rush

Developers and investors, eager to tap into the increasing personal incomes and culture of spending, are focusing on Russia's retail sector. In fact, Moscow ranked as the most attractive place in all of Europe for retail real estate investment according to a survey conducted by Urban Land Institute and PricewaterhouseCoopers as part of the Emerging Trends in Real Estate Europe 2007 report. Nearly 72 percent of survey respondents recommended investing in retail, which boast yields ranging from 9.5 percent to 12 percent.

Retail assets accounted for 40 percent of the total investment activity in Russia in 2006. Rodamco Europe N.V., Europe's largest retail property investment and management company, entered Russia in late 2006, acquiring 50 percent of Metropolis shopping center in Moscow from Capital Partners for about $200 million. The center, which is currently under construction, will open in 2008 and will offer a total of 112,000 square meters geared toward the upscale shopper. 

Additionally, Immoeast investment fund acquired the 44,000-square-meter 5th Avenue Shopping Center for an estimated $140 million and two Golden Babylon shopping centers for $170 million.  The new owner will achieve yields of 10.5 percent or 10.6 percent, according to Colliers International's Yasko.

Russia was, by far, the most active retail development market in Europe in 2006, and as a result, Moscow has seen a huge increase in supply. In 2006, more than 1.4 million square meters of new retail space was added to the Russian market, according to Jones Lang LaSalle. Today, Moscow has 149 square meters of retail space for every 1,000 people. But that number is still anemic compared to other European cities where the average is 373 square meters per 1,000 people.

Moscow has been the main focus for shopping center development and international retailer expansion. IKEA, for example, opened an 115,000-square-meter store in Moscow last year, while electronics chain MediaMarkt and department store Debenhams also entered the market.

Retail demand and investor interest in the sector isn't expected to wane anytime soon. The country has the largest development pipeline in Europe with about 4 million square meters slated for completion over the next 18 months. And, Moscow's high-quality shopping centers are expected to experience rental growth of more than 7 percent in 2007.

"Foreign players are becoming increasingly comfortable with development projects and have a better understanding of land issues in Russia, as evidenced by the growing number of forward-funding deals, development joint ventures and outright acquisitions of land, financed by international investors," Yasko says.