The Russian bear catches a cold

On August 8, Russian tanks rumbled into neighboring Georgia's South Ossetia in support of the breakaway region. The military intervention, though short lived, drew open threats from the West and counter threats from the Kremlin. Five weeks on, the conflict was still making headlines. Alaskan governor and Republican vice presidential candidate Sarah Palin told ABC World News the US had to “keep an eye” on Russia. She was just one of a number of high-profile politicians to express their concern at Russia's actions.

International property investors have certainly been keeping watch over the events. According to Maksim Kunin, managing partner of Moscow-based Investment Management Group, people who were planning on coming to Russia have been postponing trips by a month or two.

But the fact that Moscow-based real estate funds might be held up in their efforts to raise capital is not the most interesting aspect of what is happening inside Russia right now.

Instead, it is the entrance of “distress” that is fascinating. Kunin says that until now Russia had experienced distressed assets. But now, “we are coming into a situation where people have difficulties financing their projects. They cannot complete them.”

Over the past few years, Russia has been viewed as one of the world's most attractive emerging markets. As the “R” in BRIC, the real estate pitch goes something like this: there is plenty of energy-related money here, it is a big market opening up to foreign capital but the country is woefully under-supplied in terms of Class A offices, retail, residential and industrial warehouses.

Though the above-mentioned thesis generally still holds true today, there is another dimension that has slowly crept in that alters the situation significantly. Oil prices that have been the engine room of growth in Russia have been coming down of late (they were around $100-a-barrel at the time of press) and reflecting this, the Moscow stock market has fallen sharply. Some say that, economically speaking, the clock has been turned back in Russia by around two years.

More relevant to real estate investors though, Russian property companies that raised capital via IPOs on the London Stock Exchange are trading at huge discounts to net asset values, in the range of 40 percent to 80 percent.

There is a bigger issue too, which doesn't involve public property companies. For a while, local private property companies have been springing up with alacrity in Moscow, St. Petersburg and elsewhere to plug the shortage in quality property provision. Russian entrepreneurs have used their local contacts well and though some have used foreign consultants to help with construction and project management, what they haven't needed is foreign capital. Except now some of them do.

Renaissance Capital's head of real estate investment banking, Jeppe De Boer, says the underlying market is healthy and large Russian banks such as Sberbank and VTB are still prepared to provide construction financing to good quality developers, but he adds: “It is true that developers find it harder to find equity financing. This puts providers of equity financing in a relatively attractive position.”

Distress in Russia's real estate market has suddenly arrived because private property companies are experiencing difficulties financing their projects. The projects cannot be completed without fresh cash, and this presents an opportunity for funds willing to underwrite the project at hand. The situation is a boon for real estate funds and also provides some comfort as well. In talks with limited partners, Moscow GPs have been asked: why invest in Russia when there are distressed opportunities to buy in established and transparent Western markets? Now, the Moscow fund managers can counter: “But hold, on, there are distressed opportunities here and there is still an undersupply of good real estate.”

We will have to wait to see whether fundraising for Russia-targeted vehicles will tail off. However there is a good chance that private equity real estate firms with capital to draw down will be able to invest in development projects on attractive terms if the credit crunch persists.

And here's a thought: this kind of investment will become more prevalent in the other BRICs. In China, it is known that Morgan Stanley's special situations fund sees opportunity out of the estimated 14 or so property companies that have gone public or are set to go public that are hung in terms of taking their business plans forward owing to a lack of debt. Brazil is perhaps furthest away from this kind of distress, but given the way no market seems immune from the credit crunch and a global slowdown, it cannot be ruled out.