Bourgeoisie boom

Russia's expanding middle class is opening up huge opportunities in the retail and office sector. But with investment in Russia still a risky gambit, particularly outside the two main cities, do foreign investors have the stomach for the opportunity? By Dave Keating

The sight of a foreign fund manager eagerly selling their strategy to London financers may not be unusual, but a presentation to London financial media at London's Somerset House last month did have a bit of a quirk. East Capital, a Swedish private equity firm investing in Russia, chose the historic location to present their case to British investors for why Russia presents a huge opportunity.

All along the perimeter the firm had laid out blown-up photographs contrasting scenes from Russia in the mid 1990s with scenes from today. A photo of an empty shop with its shelves bare of food stood next to an image of a bustling modern supermarket. A deserted city center road with ancient-looking vehicles was contrasted with a later photo of a busy highway.

As the assembled journalists were told of Russia's economic resurgence, photographic evidence of that rise surrounded them, which may have helped to quell their natural skepticism. Considering that East Capital has just launched a €200 million ($311 million) Russian property fund that will target exactly the types of assets in the photos, it was probably a smart move.

For all the talk of Russia's buoyant economic resurgence, it's clear there are still many in the West who look at investment in the former superpower with a great deal of skepticism.

Still, the fund faced some sharp questions from the reporters. Can business partners in Russia really be trusted? Is Russia truly isolated from the credit crunch? What does the increasingly authoritarian control of the government mean for business? For all the talk of Russia's buoyant economic resurgence, it's clear there are still many in the West who look at investment in the former superpower with a great deal of skepticism. So who's right?

Rising from the ashes
Winston Churchill once described Russia as a “riddle wrapped in a mystery inside an enigma”. For many in the West this remains an applicable description. Images of Russia tend to focus on the Soviet juggernaut period first, the extravagant Tsarist period second, and the blundering, embarrassing 1990s third. However to Russians, it was the last decade's awkward transition to a market economy, beset with its fair share of humiliations and disasters, that is the most fresh in their minds.

Now that rising oil and natural gas prices are driving the economy to new heights and fostering a burgeoning middle class, Russians are feeling a renewed sense of national pride, an emotion they haven't felt for some time.

GDP is now growing in excess of six percent per annum, which has prompted many multi-nationals to start moving into the country. The economic boom hasn't just been for the few. The wealth that was once enjoyed by just a few powerful oligarchs is now trickling down to a rapidly expanding middle class, and that middle class is starting to demand a higher standard of living in the form of modern housing and Western goods. And Russian president Vladimir Putin's autocratic leadership style, though concerning geopolitically, has delivered a stability that is making Russians feel more confident in their own society.

Tapping into that growing middle class is at the heart of East Capital's plan. At the event in London, the firm explained that its new real estate fund's strategy will revolve around acquiring and refurbishing some of the dilapidated eyesore shopping centers that were built in Moscow and St. Petersburg in the previous decade, bringing them up to Western standards.

“We are looking for properties built during this period that were poorly planned, but are cash-generating and have attractive yield potential,” says Biljana Bozic, head of real estate at East Capital. “By improving commercial concepts, tenant mix, customer flows and efficiency, we can give foreign investors access to these types of properties that they couldn't reach otherwise.”

Retail rush
Before the fall of the Soviet Union there was basically no private retail at all. People tended to live in very tall apartment buildings, and the bottom floors had basic shops. Then in the 1990s came the understanding that people needed a separate facility to go to with many different kinds of outlets in one place. The first attempts at this were clunky and disorganized. Many outdoor markets were hastily thrown together, and shopping centers were built with bizarre design flaws or out of shoddy material. Over the past few years though, project developers have gone outside of Russia to study Western European standards of building. With this knowledge in hand, they now have the capability of building modern, well-organized shopping centers.

East Capital is targeting 15 percent returns from a redevelopment strategy for these eyesore shopping centers. The firm is hardly alone in this strategy. Aberdeen Property Investors, another Sweden-based firm, has also made the acquisition of existing retail assets a cornerstone of its Russia strategy. In September last year, the firm launched the €500 million ($709 million) Aberdeen Property Fund Russia, aiming to deliver 14 to 18 percent annual net IRR. This could involve refurbishing existing 90s-era shopping centers in Moscow and St. Petersburg, or developing new shopping centers in the regions in one of the so-called millionki – the 11 regional cities which have populations of one million or more.

“You won't believe your eyes when you see the working conditions in the Russian market. I believe that office space will double in the next two to three years.”

Charles Voss, general director for Aberdeen Property Investors' new office in St. Petersburg, says the key to grabbing the opportunity presented by the Russian retail sector is to understand what the Russian middle class consumer wants. “Shopping now in Russia is a family activity,” he says. “Something like sixty percent of business is done between six and 10pm. This ‘sport shopping’ makes it very important for retail developments in Russia to have entertainment and food service components.”

At the same time, he says, it's important to keep the geography in mind when building these developments, given that the spending power of the average Russian middle class consumer in the regions is far lower than those in Moscow and St. Petersburg. “Most of the regional cities with populations between 400,000 and 500,000 people don't have any big retail space at all yet, so it's important to build something well thought out,” he says. “At the same time, the pitfall that people don't talk about so much is that people there also have less disposable income, so you need to make sure you don't overprice the facility for the customer base. A Moscow or St. Petersburg plan won't work in the regions.”

Without a doubt, the retail sector is the most intuitive market in Russian real estate at the moment, and to that end the logistics sector, which grows along with increased retail activity, is also attracting increased attention. Voss says that essentially retail and logistics are the only two investable sectors in the regions, and that many firms are keenly looking at logistics hub areas, particularly in Southern Siberia along the trans-Siberian railway route. The city of Novosibirsk, for example, is not only Russia's third largest city and the largest in Siberia, it is also a rapidly growing logistics hub for goods moving from Russia's resource-rich east to the west.

Office opportunities
The other sector getting major attention as a result of Russia's expanding economic activity is office property. Obviously, with all the new multinationals moving to the country and the increased commerce, people need more and better places to work. Speaking at last month's PERE Forum: Europe 2008 in London, Jeppe De Boer, head of real state investment banking for Moscow-based Renaissance Group, imparted his own personal experience with Russia's office market. “We just moved offices, and we wanted more space but just physically couldn't find it,” he told delegates. “You won't believe your eyes when you see the working conditions in the Russian market. I believe that office space will double in the next two to three years.”

There is currently a huge supply and demand imbalance in the office sector in Moscow and St. Petersburg. In Moscow, the new multinational headquarters and the old Russian institutions alike are desperate for Western quality office space, and it can't come fast enough, even though it is already coming quite quickly.

Nick Burnell, a partner with Rutley Capital Partners, which manages both Rutley European Property fund and Rutley Russia fund, says this is the main thing he hears from the Moscow and St. Petersburg markets. “Moscow has close to zero unemployment now,” he says. “Russia-based companies are looking for Western property facilities, and they are being built, so we'll see a continued hardening of yields.”

Obviously, developers have responded to this demand and have started building class A office space. But the government is keen to develop the Moscow region's outer rings, and for this reason they have put a moratorium on new office construction in central Moscow. Aberdeen's Charles Voss says this should help keep Moscow's office build-up relatively stable, but he says that St. Petersburg will see a cyclical pattern coming up. “In St. Petersburg there's a lot of office stock coming online to meet the demand, and there's going to eventually be an oversupply of class A office stock in the next three years,” he says. “In three years that glut will take tenants from current class B and move them up, but since there will then be all this extra space on the market, it will drop prices and people will stop building for a short period. So it will be very boom-bust. Moscow won't see the same pattern.”

Raining on the parade
Despite all of the enthusiasm for property investing in Russia, Western investors are still showing a great deal of hesitancy. Investing in Russia comes with many challenges. Unusual and often opaque tax, legal and regulatory systems can make Russia a difficult place to do business. Corruption is another thorny topic. And, as in most emerging economies, finding the right operating partner is such an important part of the process it can often be intimidating. As Jeppe de Boer told the PERE Forum delegates, “Because it's a young market, there are relatively few construction companies where you can go and be comfortable with the level of expertise.”

PIK Group, which established the $1 billion PIK Capital Partners fund for European investors looking to invest in Russian property in May, has set up its particular vehicle with exactly this hesitancy in mind. The group, which owns $12.3 billion of real estate and is listed on the London Stock Exchange, is stressing its status as a publicly listed company to show investors they can get a higher level of transparency with them than with other Russian property investors. It's also set out a strategy to partner with a select few developers in Moscow and bring them to the regions, thereby eliminating the risk of ending up with dodgy partners.

“The problem we had to answer was, how to bring the expertise in development, financials, etc, into the regions,” says PIK chief operating officer Artem Eyramdzhants. “It's a real problem for most development companies when they expand into regions. We decided we have to take people from Moscow and bring them into the regions.”

PIK is also working with several prefabrication factories in the Moscow region, where developments can be made and brought to the regions. The degree to which the firm can make foreign investors comfortable with this model was demonstrated when in December last year it entered into a $233 million joint venture with GIC Real Estate in which GIC bought a 25 percent stake in a mass market residential project in Mytischi, in the outer Moscow area. “This was a milestone transaction because before this, foreign investors were just looking at class A properties in central Moscow,” Eyramdzhants says.

Still, even with reassurances about partner complications and proper due diligence, Western LPs may be hesitant to invest in a Russia fund because of more general perceptions. “Investors perceptions are slightly skewed,” says Burnell. “There's concerns over transparency, disclosure and the ability to adopt Western business styles. But if you undertake your due diligence correctly and thoroughly this is solvable. And despite concerns over title and planning issues, Russia does operate a relatively standard form of planning and title registration, therefore the risks are less than in other emerging markets.”

Though the expanding middle class does present new opportunities, it's clear that Russia is still not an investment environment for the meek

Generous lending Russia has remained generally isolated from the global credit crunch, which has made obtaining financing for real estate investments easier than in the West. At last month's PERE Forum: Europe 2008 in London, those speaking in the Russian roundtable discussion had positive feelings about how the credit crunch was affecting Russian liquidity. “The financing environment has changed very favorably for us,” Maksim Kunin, managing partner for Investment Management Group, told the crowd. Renaissance Group's Jeppe de Boer agreed. “Financing is still available even on the equity side, and debt financing is still available,” he said. “If you want to raise half a billion dollars for Russian real estate you can. The liquidity is there.” Russia has been much less affected than other countries by the credit crunch because it had little involvement in subprime investments coming from the US. For that reason banks have plenty of cash to fund development projects, which is quite a different story from what one fnds in Western Europe. “The most interesting feature about Russia right now is credit availability, and the impact credit is going to have on development projects,” said Rutley Capital's Nick Burnell. “There's a waning of interest in demand from European banks to pro- vide development finance and development projects may be softening in terms of price because of that, and you'll see yields working out accordingly. But you can still get development finance from Russian banks.” Of course financing in Russia can't remain completely isolated from the lack of credit globally, but it is widely agreed that the Russian banks have the cash and are open to lending for property development. Investors having trouble securing debt for property investments in Western Europe might do well to look east for a better financing environment.