In 1991, Steve Wayne moved to Moscow, part of a new generation of entrepreneurs looking to make their fortunes in the aftermath of communism's collapse. Yet after a few years in the Russian capital, the former Morgan Stanley real estate pro decided that more lucrative opportunities lay elsewhere. So in the mid-1990s, he moved to St. Petersburg.
His company, Jensen Group, started off small, buying communal apartments in the city's “golden triangle”—the prime neighborhoods along the canal—and leasing them to ex-pats. The Russian debt crisis of the late 1990s was a trying time, according to Wayne, but in the intervening years, his company steadily expanded its presence in St. Petersburg. The firm currently manages a portfolio of eight funds that own 21 apartments and a business center in the heart of the city. Recently, the firm purchased a local retail portfolio as well as a 54-hectare land plot in the nearby town of Lomonosov. Jensen is also in the process of developing a mixed-use project in the suburb of Sestroretsk, converting the city's oldest factory into a complex of residential units, office space and retail shops. And last year, the firm closed a $100 million (€76 million) private equity real estate fund focused exclusively on St. Petersburg.
“There are a lot more people now than a year ago. And a lot more people than five years ago. It's growing, but it's not growing as fast as everyone thinks. we haven't competed against a foreign fund on any deal. There is nowhere near enough capital in the market.”
Despite the firm's recent growth, however, Wayne admits that, in retrospect, he was wrong to leave Moscow in the mid-1990s. Since his departure, property values in the Russian capital have skyrocketed, while in St. Petersburg, the lack of depth and liquidity in the city's real estate market has hampered its growth.
Yet amidst the current craze for Russian property, St. Petersburg is quietly emerging as a viable alternative. While Moscow may be attracting most of the capital—and generating most of the headlines—St. Petersburg is experiencing many of the same fundamentals that have fueled the capital's renaissance: a booming economy, an emerging middle class, an inflow of foreign capital and government-backed investment in infrastructure. According to Jones Lang LaSalle, St. Petersburg's gross regional product tripled between 2000 and 2005; it is expected to double again by 2009. In 2006, average income per capita grew by approximately 16 percent and foreign direct investment nearly doubled. And with a population of approximately 5 million people, St. Petersburg remains the fourth largest metropolis in Europe.
“No question we made a mistake” says Wayne, referring to his company's move to St. Petersburg. “But saying all that, it's a much better time to be here than Moscow. You can buy things much cheaper and I think there's much more upside. I strongly believe I'm in the perfect place now.”
The call of the north
Over the past 12 months, private equity real estate firms and other opportunistic property investors have started to agree, with activity heating up across almost all property sectors. On the residential front, RREEF, the real estate and infrastructure arm of Deutsche Bank, formed a joint venture last year with St. Petersburg-based residential developer RBI; shortly thereafter, Morgan Stanley acquired a 25 percent stake in the company. In the retail sector, JER Partners is looking for assests via its Russian property fund, which closed last month on more than $300 million. In the industrial space, Raven Russia, a property vehicle listed on London's Alternative Investment Market, is in the process of developing three warehouse properties totaling more than 230,000 square meters. And in the hospitality market, UK property firm London & Regional, which purchased a St. Petersburg hotel last year, recently announced a joint venture with Hilton to expand its hospitality presence throughout Russia, including properties in St. Petersburg.
Yet private equity real estate activity—or activity in general—still pales in comparison to Moscow, which has seen a dramatic influx of foreign and domestic capital. But that of course is part of the appeal of St. Petersburg. As in other emerging markets like India and China, where the wall of money is pushing opportunistic investors into second- and third-tier cities, so too is the flow of capital into Moscow increasing the appeal of Russia's second largest city. Last year, David Brush, the former head of RREEF's opportunity fund business, told PERE that St. Petersburg was a much more attractive market than Moscow for that very reason.
Another part of St. Petersburg's appeal, according to property investors, is the city's business climate. In Moscow, most developers have to enter into a contract with the city that gives the government a stake in the project, which is essentially how it gets paid for the land. The problem with that approach, of course, is that every deal has to be negotiated with the local bureaucracy and the size of the government's payout is uncertain at closing. By contrast, in St. Petersburg, most of the land is sold on a free-hold basis and the process is supposedly much more transparent.
“We liked the idea of [investing] in St. Petersburg,” says Pierre Cherki, co-chief executive officer of RREEF Europe, referring to the firm's venture with RBI. “The business environment is more positive. In Moscow, the city takes a very active part in any investment or development—it is very time-consuming and adds another level of uncertainty.”
St. Petersburg is also welcoming in other ways. Given its proximity to Europe, the city is often seen as a gateway to the Russian market, particularly for Scandinavian firms. Just last month, for example, Aberdeen Property Investors, a Stockholm-based real estate investment firm, announced that it was opening an office in St. Petersburg—its first in the country—as part of its push into the Russian property markets.
“In Moscow, you rarely see foreign developers,” says Tomas Dukala, an associate director with Jones Lang LaSalle in Russia. “In St. Petersburg, there are quite a significant number of Scandinavian developers.”
In recent years, the city has also benefited from its connection to Russian president Vladimir Putin, a St. Petersburg native. Not only has Putin directed federal capital towards the development of the city's infrastructure, particularly in advance of its 300th anniversary in 2003, he has also been influential in luring powerful institutions to his hometown. The Constitutional Court of Russia, for example, is scheduled to move to St. Petersburg in 2008. And energy giant Gazprom has plans to develop a huge new business complex on the banks of the Neva River.
“There's massive influence in St. Petersburg just because of Putin,” says Wayne. “And not just on the top level—there is a lot of power in Moscow from people who grew up in St. Petersburg. Maybe I'm biased, but I've got a sense that we've got critical momentum. And it's hard to turn it off now.”
THE OTHER ST. PETERSBURGThough Kaliningrad has none of the appeal of its Baltic sibling St. Petersburg—one reporter described it as “post-apocalyptic”—a new plan to make the Russian state part of the EU could spur foreign investment.
|Kaliningrad could easily be called the land that time forgot. You could be forgiven if you've never heard of the region, which is tucked in between Lithuania and Poland on the Baltic Sea and roughly the size of Northern Ireland. Even Russian president Vladimir Putin had to point to a map when describing the region to Russian journalists during a 2004 press conference.||Many companies initially jumped at the opportunity, but in the end, nine out of ten found the investment climate extraordinarily difficult. Ignored and almost sadistically punished by the Soviet Union for decades, the oblast is a barren no-man's land that was recently described by BBC reporter Steven Poulikas as looking “post-apocalyptic.”|
|Yet even though Kaliningrad has less than a million inhabitants, the location of the oblast–a Russian state–gives it a disproportionate political importance, especially now that it is surrounded by two members of the European Union. Invaded and settled by Teutonic crusader knights in the 13th century, the area was controlled by Germany until the Soviets invaded at the end of World War II. When the Iron Curtain fell, the territory became part of the Russian Federation while the surrounding satellites became independent countries.||However, there is new hope for the oblast's development. There have recently been discussions about making the oblast a “foreign territory” of Russia, enabling it to become part of the European Union, while still being technically part of Russia. And according to a report by the Pan-European Institute, since its neighbors entered the EU in 2004, Kaliningrad's economy has grown faster than the Russian economy as a whole. The report also concludes that the number of Russian tourists visiting the oblast doubled between 1997 and 2004.|
|Given that Kaliningrad is now Russia's only Baltic port that is ice-free year-round, much has been made of its potential for investment. When Russia gave the oblast special economic status, it was thought the region would be transformed into an economic powerhouse, creating a solid trade bridge to Europe and acting as a test case for European investors who wanted to dip their toes into the Russian markets.||Kaliningrad is certainly a much riskier bet than its Baltic sibling St. Petersburg, and foreign real estate investment there has been limited to a handful of Nordic and Baltic firms. Though its location suggests tremendous potential, its low population and awkward political status are holding international investment back. However, if a solid political solution to the Kaliningrad problem can be worked out, the area could see a flood of Western investment.|
The next ten years
Despite the market's growth, however, property investors in St. Petersburg face many of the same challenges that they do in other parts of Russia: relatively opaque legal and regulatory regimes, limited financing options and a dearth of sophisticated operating partners.
“It's still a joke in terms of sophistication,” says one real estate investor active in St. Petersburg. “Information is limited, it's hard to find good asset managers and it's hard to find decent brokers, frankly. And there are not very active and efficient debt markets. We do a lot of our deals with just equity.”
“My biggest concern,” he adds, “is operationally, it's a very, very difficult place. To find people to perform on time and on budget—if you can get everything done, you're going to make some money.”
Another challenge may be competition. As in Moscow, where yields have fallen dramatically over the past two years, returns across all property sectors are declining. Jones Lang LaSalle notes that prime yields for office, retail and warehouse properties are currently at 9.5 percent, 10 percent and 10.5 percent, respectively—and are still declining. While those figures are higher than yields in Moscow, some industry practitioners believe that the differential does not support the additional risks of investing in a less liquid market like St. Petersburg.
Yet investors active in the city obviously believe otherwise. Not only are the city's underlying fundamentals all pointing in the right direction, they argue, but the market itself feels much more stable than Moscow. As of February 2007, for example, average apartment prices in Moscow stood at approximately $4,200 per square meter, according to RREEF, more than double the price three years prior.
“In terms of volatility, St. Petersburg is and will be more stable,” says Cherki. “With the boom that Russia is witnessing right now, most of the money is channeling into Moscow.” St. Petersburg, according to many observers, also has another advantage over Moscow. With its historic palaces, world-class museums and legendary white nights, the city is popular with both foreign and domestic tourists. St. Petersburg attracts over 3 million annual visitors and is the top tourist destination in Russia, drawing 39 percent of all visitors to the country. Yet tourism across Russia currently suffers from the expensive and sometimes onerous process involved in acquiring a visa. Currently, Russia is negotiating with the European Union and other countries to lift these requirements; if successful, St. Petersburg is likely to be the primary beneficiary.
If more tourists stream into the historic city, they're likely to bump into a growing number of foreign real estate investors. As the Russian economy continues its ascension, the opportunities emerging in the country's second largest city are bound to multiply. And with the massive price appreciation seen in Moscow, the eyes of many property investors are turning northward.
“There are a lot more people now [in St. Petersburg] than a year ago,” says Wayne. “And a lot more people than five years ago. It's growing, but it's not growing as fast as everyone thinks. We haven't competed against a foreign fund on any deal. There is nowhere near enough capital in the market.”