Siberia may be the last place you would expect to find a $500 million (€385 million) project. Yet in a town outside of Novosibirsk, RosEuro Development is planning what it bills as the country's largest multi-purpose development. According to the company, the project, known as “Technopark,” will provide up to 6.5 million square feet of new commercial, residential and laboratory space by 2015.
RosEuro, a Moscow-based developer, is only two years old—it was formed in 2004 via the merger of dacha-style holiday home developer Novoye Vremya Development and logistics park developer NLK-development—but it has quickly become a major force in the Russian property markets. In addition to Technopark, RosEuro is developing at least ten large-scale projects throughout the country, including a $400 million, 3.5-million-square-foot logistics park in Krekshino and a $150 million, 1.4-million-square-foot shopping center in Krasnoyarsk.
“There are a lot of developers controlling projects, but they are not experienced and not good quality. They are only in because the market is constantly going up and up. As soon as the markets stop going up, the companies that are not professional will be the ones suffering.”
Last year, the company took an even greater step forward in its evolution. In what is shaping up as a mini-theme in the country's real estate market, RosEuro sold a minority stake in its business to two foreign investors. First, US investment firm Moore Capital Management acquired a 20 percent interest, followed by Morgan Stanley Real Estate, which acquired 10 percent of the company.
Buying a stake in a company is a classic private equity move—and it is becoming particularly popular in Russia. Morgan Stanley's special situations fund, which pursues this strategy around the world, followed the RosEuro investment with two more minority stake deals in Russia. Last October, it acquired a 15 percent stake in Moscow residential and retail developer RGI International, which has seven projects under construction worth almost $1 billion. And in March, the investment bank acquired a 25 percent stake in St. Petersburg-based residential developer RBI Holdings.
Morgan Stanley may be in a unique position, given its size, geographic breadth and investment banking capabilities, to pursue this type of strategy, but many other foreign investors are following similar themes. Whether they are buying out a development team from a large conglomerate, forming a multi-million-dollar joint venture with an existing company or rolling up a series of smaller properties around the country, firms are looking for more than just one-off opportunities or asset sales in the Russian real estate market. Instead, they are looking to build up long-term, large-scale investment platforms.
Maksim Kunin, a director at Morgan Stanley who recently left the firm, says the bank's strategy of buying into development companies gives it access to people who can locate good acquisition proposals. “We have a strategic goal to access the market,” he says. “The strategy of acquiring stakes in partners means the strategy is finding the right partners who can generate deals. It is a rare combination.”
A slice of the pie
RREEF, JER Partners and Raven Russia, for example, also have blind pool fund vehicles that are building development platforms. Last year, before Morgan Stanley acquired its stake in RBI, RREEF's global opportunity fund entered the Russian market by investing in a joint venture with the St. Petersburg-based firm. The two partners are focusing on high-end residential and mixed-use developments with a total pipeline projected at $500 million over the next two years.
Raven Russia, a Guernsey-registered company with an office in Moscow, recently formed a €750 million joint venture with Russian logistics provider Avalon Group, which allows Raven to buy the venture's completed projects. Meanwhile, US-based fund sponsor JER is scouting joint venture partnerships through its Marbleton Property Fund, which is co-managed with Russia investment firm Alfa Capital Partners. One of the strategies that JER is pursuing is buying up small retail assets across the country in order to build a consolidated, large-scale retail platform.
There is little wonder why Western firms are looking to build up quality property platforms in the former Soviet Union. With a vast amount of foreign and domestic capital competing for real estate in Russia today, prices are increasing rapidly. At the same time, there are few high-quality assets for investors to buy and a limited number of large portfolios. By purchasing a minority stake in a developer, Morgan Stanley's strategy, not only does a firm gain access to the company's existing property holdings, but also to its development pipeline and land bank. Though firms such as JER and RREEF are pursuing different investment strategies, they are also creating a critical mass of assets, which generates option value and a potential exit route. Already, Morgan Stanley has taken advantage: A month after investing in RGI, the investment bank took the company public on London's Alternative Investment Market.
Morgan Stanley, which was the bookrunner for the December IPO, took the opportunity to reduce its stake from 15 percent to 9 percent; the company itself raised a total of $251 million. The proceeds have been used to buy two new Moscow projects, the Chelsea Development and the Victory Park Development, as well as to provide working capital for future acquisitions.
Another Wall Street bank is pursuing a similar strategy. The firm's real estate principal investment group is rumored to be buying out the development team from Moscow conglomerate United Industrial Corporation, which manages an array of assets and subsidiary companies, including Russia's largest shipbuilding enterprise and the world's largest coke coal deposit. The company has an impressive deal pipeline in its real estate arm, including: the “Kremlin Project,” the renovation and development of a historic building on Red Square; the Pleshcheyevo development, a large-scale, elite residential compound 20 kilometers to the west of Moscow; and a series of smaller projects, four of which are located in the Russian resort city of Sochi on the Black Sea.
According to those familiar with the situation, the investment bank plans to raise a real estate fund that will effectively own the development platform. The bank will co-invest in that fund alongside third-party investors. In due course, the development company could be floated either on a stock exchange in Europe or New York, depending on market conditions.
Of course, there are plenty of challenges to building a development platform. For one thing, in the current economic climate, there are not that many development companies in Russia that need or want foreign private equity capital. Earlier this summer, for example, the Russian developer PIK went public on the Moscow and London stock exchanges. Its price may have been at the low end of its $25 to $31 expected price range, but it did manage to raise $1.9 billion via the IPO, making it the largest public offering in Russian real estate history. “IPOs are really the preferred route for the local developer,” says Elena Yassik, senior executive of real estate finance at Ernst & Young.
In addition to equity capital, developers are also finding new debt financing options. Domestic and foreign banks are expanding into the market, with the European Bank for Reconstruction and Development, Euro-Hypo and Hypo Real Estate all actively providing loans. Though the country's debt markets are still evolving, they have rapidly grown in recent years and local firms have broader access to Western-style financing options. Taking on construction debt is oftentimes more appealing to a Russian company than inviting a foreign partner to buy a share in the company.
There are also relatively few companies that a foreign institutional investor would want to own. Many local developers may not have the stringent transparency and accounting requirements demanded by foreign capital providers. Corruption is also an issue—investors must get comfortable with the background of their operating partners and understand how their existing assets and land parcels came into the company's ownership. Kunin, for example, says that Morgan Stanley is only interested in a handful of developers. There are relatively few companies that meet foreign investors' hurdles when it comes to track record, quality of development, existing pipeline and the ability to source fresh deals.
Whether they are buying out a development team from a large conglomerate, forming a multi-million-dollar joint venture with an existing company or rolling up a series of smaller properties around the country, firms are looking for more than just one-off opportunities or asset sales in the Russian real estate market. Instead, they are looking to build up long-term, large-scale investment platforms.
Given the activity in the Russian real estate market, the best developers are also attracting premium prices and more than one suitor. RosEuro actually attracted two investors, as did RBI. The mere fact that foreign investors are gravitating to a handful of firms underlines the lack of depth in the market.
Foreign investors must also be willing to undergo a time consuming and costly due diligence process—in the case of RosEuro, one investor took three months to complete their due diligence, while another took six months. The hunt is made even more difficult because new developers are springing up almost every other day, says Kunin. These new entrants can be of varying quality. Natasha Pirogova, head of real estate at Fleming Family and Partners says that a developer might really be an expert in gaining relevant building permits rather than developing product of any real quality.
Though many opportunistic investors view platform-building strategies as the best way to enter the Russian market, others are not so sure. Pirogova points out that taking a minority stake can be riskier than direct development because the investor is giving decision-making power to the company. At the same time, buying a minority stake in a company opens up some exit routes—such as going public—but it also eliminates others. If the market turns sour, for example, it may be difficult to unload such a position. And by building a large platform, investors are making a big bet on the future of the real estate market.
Russia still represents one of the riskiest places in the world to invest—and the possibility of an overheated market is just one of the issues. As witnessed in the Russian casino industry last December, the government can suddenly step in to clamp down on development if it feels an industry needs to be better regulated.
One US investor, who has recently acquired state-owned assets, says he would be wary of investment without majority control. “There is no tradition and limited practice of fiduciary duty among company management, let alone when management are the original shareholders,” he says.
However, many investors are happy to take that risk. Though issues of control and governance are present, firms such as Morgan Stanley believe that the potential returns are worth the risk. And though the consensus seems to be that the Russian market will keep on rising, investing in a reputable company also offers some insulation against the vagaries of a volatile market.
Kunin says that should the market reverse, investors in the good companies will fair better than the rest. “There are a lot of developers controlling projects, but they are not experienced and not good quality,” he says. “They are only in because the market is constantly going up and up. As soon as the markets stop going up, the companies that are not professional will be the ones suffering.”