Russia Although economic growth has slowed, investment in the country's 'undervalued' assets is picking up across all sectors

Last year Russia's GOP growth was 3.4%. But this solid growth faltered in the fi rst two months of 2013, slowing to just 0.9%, mainly due to weak external demand.

Slower growth in China coupled with t he recession'prone eurozone and surrounding uncertainty knocked Russia's industrial production back to ' 0.8% at the start of the year, worsening to -2.1% in February.

These were the first steps into negative territory for the country since 2009 but there were some bright spots in t he economy: residential development was up by 9.8% and retail sales rose by 3%.

Nevertheless, growth in consumption dipped by nearly half in the first quarter due to weak growth in income (3.5%) and relatively high inflation at 6.6%, causing the Ministry of Economy to revise its GOP growth forecasts for this year to 4%.

One enviable statistic is Russia's zero budget deficit and little government debt.

Investment activity in the Russian real estate market reached a record level of $3.39bn for the first quarter, according to Cushman & Wakefield. This is almost half of the $8bn total investment volume the fi rm projects for all of 2013 and came primarily from two major $1bn-plus deals.

Although investors continue to focus on more liquid assets, they are beginning to invest in quality properties in relat ively developed regions as well, including assets in the warehouse/industrial sector, traditionally considered more risky.

The office property sector was preferred by investors and was a leader wit h $1.58bn in total investments. Major deals took place in the office and retai l sectors, where records were set in both.

Local lenders dominate Yields in Moscow are 8.5% for offices, 9.25% for retai l, and 11.5% for warehouse and industrial assets. Capit alisation rates in St Petersburg are 50-150 bps higher and 150-300 bps higher in the regions. The main players providing financing to the real estate sector are local - Sberbank, VTB and Alfa-Bank - and they dictate the rules ofthe game, potentially hindering newcomers from participating. Long­established banks such as Austria's Raiffeisen, however, are still active.

Although the lending markets remain challenging, the Cyprus crisis does not appear to have fundamentally altered investor perception of t he Russian market.

Cyprus was widely used to clinch deals in commercial real estate due to its favourable double tax avoidance treaty, English legal system and t he flexible approach of local banks. Existing arrangements will not be affected but the crisis will delay investment deals.

The country's fund management sector recorded a notable, and rare, success when manager Fleming Family & Partners and wealth manager Garber Hannam & Partners recently announced a final distribution to the shareholders of the FF&P Russia Real Estate vehicle.

Although investors continue to focus on more liquid assets, they are beginning to invest in quality properties in relatively developed regions as well, including assets in the warehouse/industrial sector

The payment means that the RREL fund has returned over $213m to shareholders, including international private equity companies and clients of FF&P Asset Management. Quite a few managers had thei r fi ngers burnt after pi ling into Russian property during the bull market of the early and mid-20oos. Those who remained disciplined during that period and ran a conservative investment strategy did a good job for investors.

Local commentators think t hat Russian real estate is undervalued and that comparative yields for Moscow are high compared with similar CEE core markets. But as long as the majority of foreign investors avoid the country's property assets, it will remain t hus.

A hard core of mainly US long-standing outside investors remain, including Hines, Morgan Stanley real estate funds, AIG and Heitman. CaIPERS, the ultra­conservative US pension fund, recently committed equity to a Russia-focused, US managed vehicle.

Some observers t hink it is only a matter of ti me before more of the world's core investors start to consider buying into Russian real estate in a way that would seriously boost t he sector.

EUROPROPERTY 117 JUNE 20 13

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Domestic and US players are pushing up investment volumes, but institutions are waiting

Moscow's market expands as deals, projects and proposals roll in The scene is set for another vintage year for Moscow's investment market. According to Valentin Gavrilov, CBRE's head of research in the city: "So far this year $4bn of deals have taken place and we expect a total of between $5bn to $5.5bn."

Recent transactions include Russian oligarch and Chelsea FC owner Roman Abramovich paying $370m (€282m) for Four Winds Plaza, a new prime office and residential complex on Moscow's Tverskaya Street in February.

The price for Four Winds Plaza, which includes 112 apartments and business tenants Moody's and Morgan Stanley, reflects a keen yield of below 8.5%, according to local sources.

Abramovich made the purchase through his holding company, Millhouse, which already owns class A business centres Balehug Plaza in Moscow and Krilatsky Hills in the Moscow region.

Russian companies AFI Development and joint venture partner Snegiri Development built 28,000 m' Four Winds Plaza.

And a month later, Russian investment company 01 Properties, one of the largest office owners and managers in Moscow, completed its purchase of White Square from a consortium of AIG/Lincoln, VTB Capital and TPG Holdings.

Largest single-asset office deal At a rumoured price of around $1bn (€nm), it is the largest single-asset office real estate investment transaction ever completed in the Russian market.

White Square Office Center consists of three office buildings comprising 76,000 m' of rentable area. Completed In 2009, the complex is the first of two phases co­developed by AIG/Lincoln and Coaleo, a Russian development company. Coaleo sold its holdings in the White Square project to a consortium of major international financial investors led and arranged by VTB Capital and TPG Holdings in May 2011.

The complex, located at Belorusskaya Square and the Church ofSt Nicolas, is leased to tenants including PwC, Deloitte, McKinsey & Co and Microsoft.

Although these two deals involved domestic purchasers, foreign investors

17 JU NE 20131 EUROPROPERTY

are participating almost as actively. US investor Morgan Stanley Real Estate Fund VII bought the 80,000 m' Metropolis shopping centre in Moscow for over $lbn (€n3.4m) from developer Capital Partners earlier this year.

The year before the $4.7bn MSREF VII vehicle bought the 191,000 m' Galleria shopping centre in St Petersburg from Meridian Capital CIS Fund for around $1.1bn, reflecting an 8.7% yield.

And in the same year, US fund manager Heitman bought the 22,495 m' Building 2 at the Metropolis complex. The deal was the first acquisition on behalf of the Heitman Property Partners IV fund in Russia. Local sources put the yield at 9% to 9.5%.

Austrian investors such as Immofinanz are still buying and the talk is that German funds are looking around again, though few think they will make a move yet.

Yields in Moscow are 250 to 300 basis points higher than elsewhere in the CEE

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region. Gavrilov says: "The fundamentals of the property investment market and the economy are much better than the perception among overseas investors. Although Hines, Heitman, Morgan Stanley and US pension fund CalPERS have been investing, we still don't see a large wave of international institutional clients. A negative perception is what scares off buyers, and it is a major problem."

Gavrllov points out that a lot of risk is already priced into deals in Russia through high rents. "Four Winds' rents are $1,500 per m', but for investors it's twice as cheap as London or New York."

The lack of international institutional buyers is universally lamented. Dimitry Mints, chairman of local property company 01 Properties says: "We hope that if more core guys come into the market this might shift liquidity and valuations; we think we have high-quality real estate here that is fundamentally undervalued." He compares

The New Moscow Development area (pink) Is expected to attract $250bn of Investment

prime Moscow yields of 8.5% with those of Warsaw where they are 5.8%.

Mints also says there are too few players in the market. Pension funds and insurance companies, for example, are either unable by law to invest in real estate or their business model doesn't allow for it.

Tom Cashel, head of capital markets at Cushman & Wakefield in Moscow, says the presence of more pension funds in the market would be a "game-changer". Generally, yield opportunities in Russia are "terrific across the sectors. There are still very few places in the world where you can pick these yields up."

"The difference between Russia and Brazil is that here there are long-term dollar-indexed leases: legal and accepted. In Brazil you have to do everything in local currency so to compare the opportunities in the two countries you have to price in currency risk for Brazil."

Cashel says that the relatively high availability of debt from both domestic and foreign banks mean that IRR opportunities in the "high teens or low 20S" are usual.

Although occupier interest is healthy in Moscow, high levels of office construction over the next five years could result in a temporary growth in the vacancy rate in the city's new business district called Moscow-City, says CBRE.

Moscow City, the centrally located former industrial site with a mix of office, residential, retail and hotel space, is the Russian capital's equivalent of London's Canary Wharf. It covers around 200 ha and has 480,000 m' of office space. By 2017 the estimated number of office workers at the complex will be more than 120,000.

CBRE said that over the five years there would be 1.5 times more space delivered than during the previous 10 years of construction. According to the overview, in 2014-16 about 150,000 m' of new office space will be delivered annually.

Delivery of improved transport infrastructure is expected by 2017, when Moscow City will be connected with the dark-blue and yellow metro lines and the Third Interchange Loop. This will stimulate demand for office space and thus contribute to a gradual decrease of vacant space and steady rent increases, said CBRE.

More parking spaces When more buildings are delivered, the number of parking spaces will rise as well, reaching up to six times the current supply.

Moscow is set to double in size as an administrative area, according to a new plan to expand the city limits by having Moscow authorities take over territories

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The state is providing more than €1bn of funding for the Innovation Center at Skolkovo in the Odintsovsky district of Moscow Oblast, 2 km west of the MKAD ring road.

Work is under way on a high technology business area to encourage science and technology companies to locate here. The authorities have granted a variety of tax incentives and special workers' residential permits to build a highly skilled tech employment hub. Roman Abramovich's Millhouse Capital is one of the biggest participants in this regeneration district.

Q1 2011 Q12012 Q12011

Skolkovo to the MKAD and new rail connections are being built to facilitate a 40-minute journey time from central Moscow via Belorussky and Kiyevsky Terminals. A link to Vnukovo International Airport is also planned.

The main elements of the center are a university and a technopark but it will also feature a congress centre, offices, laboratories, and retail provision.

A new highway has opened connecting

In all the Skolkovo project will cover roughly 400 ha and have a permanent population of 21,000. Employees, including commuters from Moscow and surrounding regions, will comprise about 31,000 people.

totalling 1,400 km' from Moscow Region (see map, opposite). The New Moscow Development plan was recently published, taking in the Sherbinka, Troitsk, Leninskiy, NaroFominsky and Podolsk districts south west of existing city borders.

The enlargement is expected to attract some $250bn (€187bn) of investment. Two international architectural practices have been engaged: Antoine Grumbach et Associes for the development of the Moscow agglomeration and city; and Urban Design Associates for the construction of a new $15bn centre for the federal government totalling 4.5m m' in the Kommunarka area.

Presently, only 250,000 people live on the territories that have been newly included into the New Moscow Development Plan, but around 2.5m Muscovites are expected to relocate there

in a planned 100m m' of new housing. In addition, there will be up to 10m m' of offices and up 102m m' of shopping.

Moscow city authorities are bringing in additional planning powers. For example, they have put up for discussion a proposal to reduce the notice period of compulsory land purchases for government use within New Moscow from 12 months to five months.

Denis Sokolov, head of research at Cushman & Wakefield: "The city has to address big changes. Everyone treats Moscow as a cash cow and all administrative efforts are focused on the city.

"It's a very rich city and rents for offices in prime locations are around $1,000 per m', reaching $1,100 m' in some cases. Business development has been so chaotic and so no obvious office clusters have developed. New development will be planned more rigorously now."

EUROPROPERTY 117 JUNE 2013

SURVEY

As Moscow rents stabilise, occupiers are becoming confident about taking more space, and retail developers that had frozen projects because of the recession have now dusted off their plans

Weight of tenant demand powers building boom across all sectors Occupier demand for Moscow offices remains high and, for the past nine quarters, this stability has led to rising rents.

According to Maria Sergienko, acting director, commercial property at one of Russia's biggest developers, Capital Group: "Now tenants are becoming braver because previously they didn't understand what their rents would be because of the uncertainty in the office market.

"Now there is stability. But I think rents will not grow as fast as they did pre-crisis."

Capital Group has built extensively in Moscow-City, the new business district taking shape in the capital, and the company's latest project there is the OKO project. US-based Morgans Hotel Group is placing its newest Delano hotel in the scheme.

OKO has been designed by US architectural practice SOM and, besides an 8s-storey mixed-use skyscraper, it will also include a 49-storey office tower.

Like all new areas, it has had teething troubles, and problems remain in transportation and parking. Tom Cashel, head of capital markets at Cushman & Wakefield says: "Landlords have dealt with some issues: the district has changed a lot in the past 18 to 24 months and the amenities are terrific, with great places for shopping, lunch and coffee.

"Transport is being addressed and new metro lines will be coming in. Parking for tenants and residents has also been increased."

Meanwhile, Cushman & Wakefield estimates the volume of new office construction across the whole of Moscow

this year will be 700,000 m', up from its earlier predictions of 520,000 m'.

Already in the first quarter this year 14 office buildings were delivered to the market totalling almost 260,000 m'; 84% of this remains for lease. White Gardens (64,000 m') was one new property opened in Q1, while the largest class B building to come on stream was a phase in Navigator ofS2,000m'.

According to Cushman & Wakefield, the average vacancy rate during the three­month period was stable at an average of just over 12%; class A was 16.6%, and class B, 11%. Take-up in the quarter was 450,833 m' and the firm says that "demand is steady as tenants look to consolidate or renegotiate leases".

Average class A rents have grown to $850 per m' a year from an average of $790

Retailers are keen to take space In new schemes such as Capital Group's Metropolis Center. The group Is also building the massive mixed-use OKO project In Moscow-City

17 JUNE 2013 1 EUROPROPERTY

per m' in 2012; the very top space - with internal modifications - can command up to $1,500 per m', while trophy buildings rent at $1,200 per m'. Levels for class B space are firm at $490 per m'.

Moscow's retail market Retail real estate suffered greatly during the crisis and a number of large schemes were frozen. Valentin Gavrilov, CBRE's head of research in the city, said: "Next year we expect to see some landmark schemes being delivered as developers have become less afraid of starting very big projects."

Fashion and sport retailers predominate among new retailers planning to enter the market in the near future. Around 80% of them come from Europe, although some US companies will also arrive. Most new brands prefer to open in Moscow or St Petersburg first.

C&W puts the vacancy rate for quality shopping centres in Moscow at a low 1.2%. The firm says that this year will see 90 retail centres with a total area of 2.87m m' being delivered to the market in 49 Russian cities. Five have already come to market in Volgograd, St Petersburg, Belgorod, Orel and Murmansk.

Moscow retail gallery rents are around $500-$4,000 per m' depending on the size of unit and type of retailer; the firm puts potential rental growth this year as high as 5%. In cities other than Moscow rates are typically 30% to 60% lower than in Moscow.

Logistics demand at an all-time high Demand for modern logistics property in the Moscow region is at an all-time high, according to CBRE.

The property consultant predicts that this year up to half of all warehouse deals will be build-to-suit purchases.

Retail chains are the most active warehouse occupiers and normally absorb 20-30% of annual warehouse new supply. These companies consume about 17% of the total warehouse stock on the market.

The main warehouse areas are in the south, east and south-east of the city.

Online retail is a new demand driver, said CBRE, with this segment absorbing about 10,*, of new supply last year; its accumulated share is around 6% of the total stock.

Lance Pilant, director of warehouse and industrial at CBRE in Russia, said: "This year, like last, is marked by an interesting change in both the demand profile of occupiers as well as the structure ofthe transactions that they are concluding with developers of class A logistics space in the

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Fund manager Fleming Family & Partners and wealth manager Garber Hannam & Partners (GHP) last month announced a final distribution to the shareholders of FF&P Russia Real Estate.

The payment means that the RREL vehicle has returned over $213m to shareholders. including International private equity companies and clients of FF&P Asset Management. UK investors achieved a 2.1X return on their initial investment.

RREL was launched by FF&P In 2003 as the first institutional fund focused on Russian commercial real estate investments. RREL acquired various commercial real estate assets in Moscow including the Gogolevsky " and Lesnaya 3 office centres. and warehouse assets at Sholokhovo and Tomlllno. These were sold to international and domestic buyers including Hines Global REIT and Raven Russia.

Moscow region. "Retailers, including both chain

operators and online trading companies, logistics companies and FMCG companies have increased their share of the total demand for modern warehouses to nearly 75%.

"Production companies occupy less than 20% ofthe space around Moscow, owing to less production activity in the region, and a higher concentration of retail development, driven by the high concentration of consumers In the Russian capital," said Pilant.

FF&P sold Its Russian business. including the real estate management team which advised RREL, to GHP in 2012.

Oleg Myshkln. managing partner at GHP Real Estate. says that RREL is one of the very few vehicles in the Russian property market to have completed the full investment cycle and returned significant profits to its shareholders.

GHP Real Estate continues to manage the development vehicle RRED. which was launched by FF&P in 2007 with $1S3m of capital.

RRED has acquired two A-class development projects in St Petersburg, namely the Electro office centre and the Trinity mixed-use complex. both of which are fully financed and under construction, as well as a warehouse project in Tomilino. close to Moscow.

Myshkin says he is thinking about launching another fund of $100m focusing on core Moscow and the Moscow region.

The structure of the transactions with these occupiers and the developers who build their units is also changing, with the build-to-suitlpurchase model now becoming much more common, versus traditional long-term leasing model.

Some developers are now planning their projects to be more flexible and competitive by offering both the BTS/ purchase model and the long-term leasing model as options. Developers such as Radius Group and PNK Group are prime examples of this flexibility, offering both models.

EUROPROPERTY 117 JUNE 2013