Opportunities and Obstacles for US Investors in Moscow;
Office Market Comparative Return Study
By
Alexander V. Stolyarik
Submitted to the Department of Urban Studies and Planning in partial fulfillment of the
requirements for the degree of
Master of Science in Real Estate Development
at the
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
September 2003
0 2003 Alexander V. Stolyarik. All Rights Reserved.
The author hereby grants MIT permission to reproduce and distribute publicly paper and
electronic copies of this thesis document in whole or in part.
Signature of Author:
Alexander V. Stolyarik
Department of Urban Studies and Planning
August 4, 2003
Accepted by:
(J
John T. Riordan
Chairman MIT Center for Real Estate
Thesis Advisor
Certified by:
David M. Geltner
Chairman, Interdepartmental Degree
Program in Real Estate Development
MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
AUG 2 9 2003
LIBRARIES
Opportunities and Obstacles for US Investors in Moscow;
Office Market Comparative Return Study
By
Alexander V. Stolyarik
Submitted to the Department of Urban Studies and Planning on August 04, 2003 in partial
fulfillment of the requirements for the degree of Master of Science in Real Estate
Development.
ABSTRACT
Moscow in recent years has seen significant changes in the amount of investment
grade office space. In the period before the financial crisis of 1998, in which Russia
defaulted on its debt and the ruble was drastically devalued, many foreign investors saw
great opportunity in the Moscow office market. What attracted foreigners then was the
scarcity of suitable space for many foreign companies looking for offices in Moscow and
the changes taking place in Russian law concerning ownership of land and real property.
With the advent of the 1998 crisis the interest of foreigners waned, but that of cash-rich
Russian companies and individuals, principally from the natural resources sector, grew in
intensity. Since then and for myriad reasons that I shall examine in this study, Russian
investors appear to have successfully held the foreigners at bay.
Just what advantages do the Russians continue to have over foreigners other than
their opportunistic entry post 1998? How are these advantages measured in risk-adjusted
terms? What is the source of these advantages? Are they likely to be sustained to the point
that foreign investors will be reluctant to compete in Moscow's real estate market?
Using US investors as an example, this study seeks to find answers to these
questions and, to a modest extent, forecast near-term returns while describing risks
involved in the emerging Russian economy.
Thesis Supervisor:
Title:
John T. Riordan
Chairman MIT Center for Real Estate
Table of Contents
Page
CHAPTER ONE: INTRODUCTION.....................................................................
8
Hypothesis..............--------------------------------------------.....................................................
8
M ethodology................................................................................................................
9
In tro ductio n..................................................................................................................
10
CHAPTER TWO: SYSTEMATIC RISK & RETURN IN THE MOSCOW
OFFICE MARKET---------............---------..--............................................................
A C ase for M oscow ....................................................................................................
12
12
* Land Use Segmentation in Moscow................................................................
17
* Today's Product and Investment Markets in Moscow.....................................
18
* Eastern-European Space Market Comparison.................................................
19
* Eastern-European Asset Market Comparison................................................
22
Systematic Risk and Return Analyses.......................................................................
24
P erio d ic R eturn s...........................................................................................................
27
Risk A nalyses...............................................................................................................
33
CHAPTER THREE: NON-SYSTEMATIC RISKS & THE REGULATORY
ENVIRONMENT...----------------------.
.------..................................................
In tro duction ..................................................................................................................
37
37
Devaluation and Default of 1998
38
* The Anatomy of the Crisis..............................................................................
39
+ Entrance and Exit of the Westerners...............................................................
41
* Another Turn-Around.....................................................................................
43
* The Real Estate Industry in Russia Before and After 1998............................
44
The History of Economic Reforms and the Current Situation....................................
46
* P rivatization .............................................................................................
.....
47
* Post-1998 Economic Recovery.......................................................................
48
Oil and the Russian Economy Today..........................................................................
50
L egisativ e Issu es............................................
........
................................................
.
52
Presidential and Parlam entary Elections.....................................................................
52
D ebt M arkets................................................................................................................
54
* D om estic Governm ent D ebt............................................................................
54
* Corporate
55
................................................................................................
Banking Sector.............................................................................................................
57
Real Estate Lending.....................................................................................................
58
H ernando de Soto on Land as the Source of Capital...................................................
60
Land Ow nership Rights & D evelopm ent in M oscow .................................................
61
* Land lease Rights Acquisition and Approval Risks.....................
63
Construction.........................................---.--..................................................................
67
Legal Issues and Taxation...........................................................................................
68
Structuring Foreign Investm ent in Russian Real Estate..............................................
69
Corruption and Self D ealing........................................................................................
71
CH A PTER FO U R: FO RECA STIN G .....................................................................
72
M arket Forecast...........................................................................................................
72
* R ent Only M ultivariate....................................................................................
73
+ R ent and V acancy M ultivariate.......................................................................
76
Forecasting Cap Rates................................................................................................
85
IRR com parison...........................................................................................................
90
CH A PTER FIVE : C O N CLU SIO N S.......................................................................
91
An Overview of the U S M arket Participants..............................................................
91
Conclusions..................................................................................................................
93
Bibliography................................................................................................................
94
List of Tables and Figures
Pa2e
TABLES
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
2.12
2.13
2.14
2.15
2.16
2.17
2.18
2.19
2.20
2.21
3.1
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
Moscow City employment indicators
Moscow City selected revenues
Federal vs. Municipal tax collection distribution
Moscow City property related tax revenue
Moscow City balance sheet
Microeconomic indicators for CEE countries and Russia
Moscow City office market supply side data
Moscow City demand side data
Nominal periodic return for US investors
Real periodic return for US investors
Risk and return for US investors
Nominal periodic return for Russian investors
Inflation adjusted nominal rent for Russian investors
Real periodic return for Russian investors
Risk and return for Russian investors
Russian vs. US investor real returns
Standardized mean deviation returns for US and Russian investors
Global investment return benchmark
Standardized mean deviation returns for Global benchma rk
Global risk-free rate
Beta/ Traynor ratio analyses
Country indicators for permanent debt placement
Russian macroeconomic indicators
Independent variables significance for rent
Independent variables significance for supply
Regression table set-up for rent
Regression table set-up for supply
Regresion results for rent
Regression results for supply
Rent only multivariate forecast
Independent variables significance for rent
Independent variables significance for supply
Independent variables significance for occupied stock
Regression table set-up for rent
13
14
15
15
16
19
25
25
27
28
28
29
30
30
31
32
33
33
33
35
35
59
72
73
73
74
74
75
75
76
76
76
77
78
4.13
4.14
4.15
4.16
4.17
4.18
4.19
4.20
4.21
4.22
4.23
4.24
4.25
4.26
Regression table set-up for supply
Regression table set-up for occupied stock
Regression results for rent
Regression results for supply
Regression results for occupied stock
Rent and vacancy multivariate forecast
Rent only and rent and vacancy multivariate comparison
Forecasting results from the rent & vacancy model:
Market Dynamic / Percent Change:
Cap rate regression output
Cap rate forecast
Real returns forecast for US investors
Real returns forecast for Russian investors
Historic and forecasted IRR's for US and Russian investors
78
79
79
80
80
81
81
82
83
86
86
87
87
90
FIGURES
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
3.1
3.2
3.3
4.1
4.2
4.3
4.4
4.5
4.6
Moscow City debt structure
GDP growth comparison
Rental Trends for CEE capital cities and Moscow
Office space market indicators for ECC capital cities and Moscow
Moscow City Supply and Absorption
Real periodic return for US investors
Nominal periodic return for Russian investors
Real vs. Nominal periodic returns for Russian investors
Russian vs. US investors real periodic returns
Risk adjusted US and Russian return comparison to a global benchmark
Exchange rate volatility
World oil prices
Gross Russian corporate bond placement
Market Dynamic / Percent Change:
Moscow office market real estate indicators growth rates (2001-2007)
US vs. Russian investors real periodic returns forecast (1997-2007)
US vs. Russian investors real periodic returns forecast (2000-2007)
Supply and absorptio forecast
Stock vs. cumulative absorbtion
16
19
20
21
26
28
29
31
32
36
41
50
56
84
85
88
88
89
90
Acknowledgements
I would like to express my gratitude to all those who supported this research;
especially: Eugene Golub from the GE Golub, Ludmila Goncharenko and Anna Danshina
from the Plechanov Russian Academy of Economy (Department of Investment Policy),
Jack Kelleher from the Noble Gibbons, Maksim Kunin from the FF&P, Veta Riabtseva
from the Jones Lang LaSalle, Ilya Metelkin and Mikhail Yakoubov from the Institute for
Urban Economics.
CHAPTER ONE: INTRODUCTION
Hypothesis
There are many US investors/ developers that have tried to enter the Moscow real
estate market, but few have succeeded to date. Despite the rapid recovery of the Russian
economy and improved investment climate there are few US players in Moscow's real
estate market. I believe that after the devaluation of the ruble and default on debt in 1998,
the composition of the Russian market changed in favor of domestic capital. The balance
of economic power was repositioned and the new Russian conglomerates emerged in the
aftermath of the crisis. Rich with money from the exploitation of natural resources, new
Russian capital found its way into real estate. The proportion of the capital is now in favor
of Russian investors who are crowding out US entrants.
Besides hefty risk adjusted returns achieved by Russian developers, the complex
regulatory environment is another advantage that Russians have in the competition for real
estate investments. Without a solid partnership with Russian companies it is almost
impossible for foreigners to get approvals for real estate development.
In this thesis I propose that the reasons for the failure of the Americans to enter the
Russian real estate market at large are the superior returns achieved by the Russian
competition. If the results of the analyses are negative or inconclusive, then the Russian
regulatory system is the main factor blocking foreign investment into real estate.
Methodology
Because rent in Russia is denominated in US dollars there are several factors that
play a role in returns for Russian investors. Mainly, Russian inflation and exchange rate
volatility are important when rent and reversion gains are converted into rubles and
reinvested back into the domestic economy. (I will omit the cases where the rent is kept in
dollars and invested abroad or domestically) For the US investors it is the US inflation and
domestic benchmarks that matter in the game.
First I will assess US investor real returns and analyze the systematic risk involved
in the investment in Russian real estate. Then I will analyze Russian investor risk and
return, and compare the two by way of Traynor Ratios (measures the performance with
adjustment to risk in the investment). If the risk-adjusted return achieved by Russian
investors is superior, then the crowding-out effect is justified. If the return rate is inferior
or comparable, then my further analyses and assessment of the risk for Americans in
dealing with the Russian regulatory system will explain their weak presence in the market.
Using Wheaton's forecasting model, I will project rent and returns for both types
of investors and make recommendations for investments and improvements in the Russian
permitting process.
Torto-Wheaton Research econometric forecasting
Introduction
Over the past decade many investors developed a so-called "love-hate" relationship
with Russia. At various times all were tempted by the enormous potential and flourishing
possibilities of the country. Starting from Robert Nobel in 1873, Rothschild in 1880 and
Rockefeller in 1891 (whose investments were wiped out by the Socialistic Revolution of
1917), to the recent Multinationals and Investment Funds who abandoned the country after
the devaluation of 1998; all learned the price of the unexpected. But in 2003, not even a
full five years after the last crises, Moscow hotels are again are full of Western investors
scouting for opportunities. It seems that this time Russia is determined to become a part of
the World Trade Organization, and prove to be a worthwhile investment. One of the
biggest steps toward the goals of liberalization became a new land code which allowed for
the direct foreign ownership of the land. That, together with the government surplus,
increased transparency, stable political situation, and GDP growth of 4+%, was sufficient
enough to raise some interest among European and US investors. Magnified by the current
recession and uncertainty in all areas of the capital markets in the US and Europe,
investments in emerging markets became more and more attractive. It would seem that it is
a match once again: steady demand for foreign direct investment is met with the need to
deploy capital and demonstrate performance by earning decent risk-adjusted returns with
Western "know-how". However intriguing the situation might seem, the majority of US
investors remain skeptical even with the recent upgrade of county's credit rating.
What seems to be different about Russia in the beginning of twenty first century is
that it is characterized by privately-owned firms who are taking advantage of their excess
capital developed from the oil and gas trade. In the aftermath of liberalization and after the
early privatization programs of the 90's, as many as seven wealthy conglomerates
emerged. Much like the Rockefellers' and Rothschilds', Russian "oligarchs" are now
investing cash in all sectors of the economy including real estate projects in Moscow and
St. Petersburg. Accepted by the Kremlin administration, new businessmen are controlling
"the other half' of the economy. In order to compete on the world markets new Russian
money is reinvent itself with the inflow of foreign management practices and increased
transparency. Many are listed on the NYSE and are trading at 15-20 P/E ratios.
However attractive real estate investments might look for both domestic and
foreign players, there is an apparent shortage in the availability of investment grade real
estate in Moscow and St. Petersburg. "Moscow developers have simply not been building
with the idea of selling later and reinvesting the proceeds," - says Cameron Sawyer, the
president of GVA Sawyer property advisors. Thus development of class "A" properties is
the answer to the current booming demand in space and asset markets. Moscow developers
are still building predominantly with equity capital and are holding their properties in order
to reap cash flow. The return of the invested equity is so fast (5-6 years on average) that
many simply do not care if the building burns down in year seven. Thus, the chief obstacle
for investment is the lack of product on the asset market itself. Development is the answer
to this problem.
But the risks involved in Moscow development are so high that few can afford to
compete in this arena. The winners in development are still Russian developers and a few
joint ventures between Russian companies and the Western real estate giants. The latter are
difficult to establish because Russians see little need for partnership. Rich in oil money and
with foreign advisory services widely available, many Russian developers see the only
reason for a partnership to be a cheaper foreign capital in the form of debt or equity
investment. However, foreign money doesn't come cheap since Westerners see much risk
in the investment. Another issue is that Russians don't want to be dominated by a foreign
entity that needs control for either public reporting or internal qualifications purposes. By
the time Americans are through with the joint-venture agreements many opportunities are
simply gone from the market.
However hard it might be for foreigners to enter, it is obvious that they are not
loosing interest and are eager to evaluate any offer with the potential returns of 30-35%
from this immature and highly competitive market.
CHAPTER TWO: SYSTEMATIC RISK & RETURN IN THE MOSCOW OFFICE
MARKET
A Case for Moscow
2
The reason to analyze Moscow's real estate is its superior economic performance
and political significance in Russia. Despite the fact that Moscow still doesn't have direct
land ownership rights (leasehold only), real estate has for a number of years been a number
one investment choice for foreign capital. The main reins of power are concentrated in
Moscow, and most regulatory reforms are first tested in this city.
The constitution of the Russian Federation divides Russia into 89 'subjects' or
regions. The regions vary enormously in geographic size and economic importance. Two
of the 89 subjects (Moscow and St. Petersburg) are defined as 'cities of Federal importance'
and, although they are only cities, they enjoy the same powers as the other 87 regions. The
administrative system of Moscow is set down in the City Charter, adopted in June 1995.
The executive branch is headed by the Mayor, currently Yuri Luzhkov, who was elected on
19 December 1999 for his third four-year term. Judging by the popularity of Mr. Luzhkov,
he will be reelected this year for his fifth term in office. The Mayor has the right to appoint
senior officials to head the main administrative branches of the city; these officials
constitute the City Government and are directly responsible to the Mayor. The City Duma
is the legislative arm of the administration and is composed of 35 directly elected deputies,
each representing a specific area of Moscow.
Moscow is economically the largest and best performing of all Russia's 89 regions.
With just 6% of Russia's population, the city of Moscow accounts for 15% of Russia's
GDP and provides approximately one-third of the entire revenues of the Federal budget.
GDP per capita is over twice the Russian average and average incomes are four times the
Russian average. The 1998 devaluation caused the City revenues to contract in dollar terms
from US $5.Obn in 1998 to US $4.3bn in 1999. Revenue levels bounced back in 2000 to
US $6.9bn and US $6.8bn in 2001. Although debt service on its foreign currency debts
increased in ruble terms after the 1998 devaluation, the City met all obligations fully and
2
The data for this section was gathered from Moscomstat, IngBarings, and Federal Ministry of Finance
on time. Even though refinancing was not available, the City repaid US $1.4bn of foreign
credits plus interest over two and a half years.
In terms of employment, Moscow has a higher percentage of the workforce in
registered employment than the overall average of the Russian Federation, and also a
higher percentage employed in the private sector. The gap between public and private
sector employment is widening rapidly throughout Russia, though the trend is more
marked in Moscow due to the strength of the city's growing private sector.
Table 2.13 (in millions)
Moscow City employment indicators
Year
Econom. Active
Employed
Unemployed
%
1996
4,100
3,900
200
1997
4,000
3,800
200
1998
4,000
3,800
200
1999
4,200
4,000
200
2000
4,200
4,100
100
2001
4,300
4,200
100
5%
5%
5%
5%
2%
2%
Moscow's economy is strongly service-oriented, as one would expect for a major
capital city. In 1998 services accounted for 66.5% of Gross City Product (GCP), against
less than 50% for the Russian Federation as a whole. The decline in manufacturing is much
in line with the experience of the whole of the former Soviet Union, as previously
inefficient enterprises have been either restructured or closed. The drawback is that after
closing they are left in the center of the city as abandoned ruins (see Chapter x).
An important feature of the City of Moscow's economy is that the city is
headquarters to a large number of Russian companies, the bulk of whose activities are
situated outside the city. This includes a very large proportion of Russia's sizeable oil and
gas sector. Many of these companies have their exporting and financial subsidiaries
situated in Moscow, and these are not included for reporting purposes in GCP. In 1999,
Moscow was headquarters to 14 companies that accounted for 58% of the total sales of
Russia's top 200 companies, and one of these - Gazprom - provided 23% of the city's total
tax revenues.
In evaluating Gross City Product it is interesting to note the decreasing role of
revenue collected from the industry and the increasing role of the revenue collected from
real estate services in the city:
3Moscomstat
Table 2.2
Moscow City selected revenues
Total Rev. from Industry
Total Rev. from Services
Rev. fromReal Estate
1996
1997
1998
1999
26.4%
59.2%
0.9%
22.9%
64.1%
2.6%
22.1%
66.5%
2.6%
19.0%
67.2%
3.8%
The City Government's main areas of responsibility and activity are:
+ Moscow's economy and infrastructure, including public transport, utilities and
communications and engineering infrastructure.
+ The provision and supervision of social services, such as public health, education,
cultural activities and social assistance for targeted groups.
+ The development, management and sale of the city's property and other assets.
+ Construction activities.
Each of these areas is headed by an official, appointed by and directly responsible to
Mayor Luzhkov. The City Administration consists of approximately 14,000 employees.
The largest unit is the Social Services department with 7,500 employees. Within Moscow,
the City Administration is the largest single employer.
Tax revenues are by far the largest component of the city's budget, averaging over
68% of total revenues over the past few years. Direct taxes - corporate income tax and
personal income tax - are the most important taxes, which comprised about 56-60% of
total tax revenues up until 2000. From 2001 on, the proportion increased because 15% of
the VAT tax retained by Moscow is no longer available and was directly transferred to
Federal jurisdiction. Additionally, Moscow instituted its own 5% sales tax to partially
compensate for the loss. Corporate profit tax is the largest single source of revenue for
Moscow. Federal law requires 11% be paid to the Federal budget with the balance of taxes
paid accruing to the city. Moscow clearly benefits from being the financial and political
center of the Russian Federation.
The distribution of tax collection is as follows:
Table 2.3
Federalvs. Municipal tax collection distribution
--31%
100%
City
100%
50%
100%
100%
100%
69%
---
Water tax
---
100%
Land tax
15%
85%
Taxes and Fees
Excises on ethyl alcohol (spirit)
Excises on alcohol (vodka, wine etc.)
Excises on jewelry
Personal Income tax
Corporate tax
Single social tax
Federation
VAT
50%
---
Property taxes as a percent of total city tax revenue are as follows:
Table 2.4 (in millions of US dollars)
Moscow City property related tax revenue
1997
$745.10
Property Tax
$169.40
lease
prop.
Rev. from
Rev. from prop. sales $159.70
1998
1999
2000
2001
2002
$458.90
$202.50
$51.60
$266.80
$111.10
$69.50
$392.90
$212.90
$538.40
$675.40
$0.20
$535.20
$314.10
$439.40
$1,074.20 $713.00 $447.40 $605.80 $1,214.00 $1,288.70
Total prop.
$9,532.30 $5,002.80 $4,311.80 $6,958.20 $7,819.00 $8,775.70
Total City rev.
14.68%
15.53%
8.71%
10.38%
14.25%
% Prop. to City total. 11.27%
We can see the effect of devaluation on the city budget in 1998-1999, and the lack of
property sales in 2000. These effects are due to Luzhkov's retention of city property for
leasehold purposes and the revival of sales in 2002 to certain insiders who realized the
drawback of land rent vs. direct ownership. The drop in leased property revenue can be
explained by the shortage of supply in the space market and the subsequent drop can be
explained by the following addition of a large amount of sq. in., lagging from the demand
of 2000.
Non-tax revenues associated with property consist mainly of payments and rentals
for the use of city property, asset sales and privatization proceeds. The property portfolio
of the City of Moscow is very large and diverse, and it generated relatively large revenue
totaling US $213m in 2000 and rising to US $314m in 2002. It is projected that by the year
2003 the city of Moscow will increase supply in the space market, and property related
revenues will rise to '%of the budget.
Moscow City balance sheet is as follows:
Table 2.5 (in millions of US dollars)
Moscow City balance sheet
1998
1997
2001
2000
1999
2002
$9,532.30 $5,002.80 $4,311.80 $6,958.20 $7,819.00 $8,775.70
Total City Rev.
Total City Expend. $9,203.40 $4,991.90 $4294.40 $6,154.10 $7,002.60 $9,089.20
$17.4
$804.10 $816.40 $ (313.50)
$10.90
$328.90
Surplus/ (Deficit)
Even though during the devaluation of 1998 Moscow managed to realize a surplus, the
recent deficit can be explained by the large amount of debt repayment in 2002. The budget
is expected to result in another surplus by 2003.
Figure 2.1
Moscow City debt structure
Debt Size -*-
2.5
-
-
-
-
-
-
-
-
-
Debt as % of revenue
-
-
-
-
-
-
-
-
-
-
- 120%
2 -100%
US $ bn.
1.5
80%
60/0
1
40%
0.5
20%
0
0%
1997
1998
2000
1999
2001
2002
Year
Considering all the factors, Moscow probably has the most opportunities for rich returns in
Russia. This is apparent to many foreign and domestic investors, as the fight for a share in
the market has already began without much investment from US capital in Moscow.
Land Use Segmentation in Moscow
Under central planning, construction primarily evolved on the existing perimeters
of the city. Like a tree's cross-section, the urban structure of Moscow reflects alternating
periods of residential and industrial construction that mirror changes in central planning
emphasis. Considerations of commuting time and energy efficiency have played little role.
For many years, large-scale, high-rise housing construction was assigned to raw land
remote from the city center. Effectively, industry has not yet left the center of the city. This
is true despite the fact that factories are under-performing in the current location and are
better served on the outskirts of Moscow. There are simply no resources to relocate them.
The situation is such that the highest and best use for the land in the center is residential
and commercial, but the banks of the Moscow River are still full of manufacturing and
production facilities. On the other side, the outskirts of Moscow have a residential density
that is higher than in the center of Paris as considered by the experts of the World Bank. At
the same time millions of citizens are traveling in and from the center causing congestion
as the transport systems are lengthy and costly to operate. This special evolution of cities
reflects the absence of land market as an instrument of land redevelopment.4 If there is a
municipal monopoly on land ownership then the administrative mechanism for allocating
sites is not sufficiently sensitive to market demand. In these circumstances, bribery can be
rationalized as a mechanism for making officials attentive to the market. If local authorities
allow for privatization of lands the situation would most likely result in construction
activity on industrial lands converted to housing use. Another reason for the residential
development on the perimeter of the city is the technology of the urban utilities developed
during the Soviet era. The centralized supply systems do not provide individual metering
or adjustments for heat, water, and gas. These systems are costly to redevelop in the center
of Moscow, even if they have sizable internal losses that could be monetized if systems
were properly reconstructed. The utility companies don't have an incentive to redevelop
the city center since they are private monopolies or city-owned agencies.
4 Bertaud
and Renaud 1997
Today's Product and Investment Markets in Moscow
In the retail sector Moscow brokers are predicting increased vacancy in shopping
centers; even though the city has the lowest square footage of retail as compared to other
capitals in Europe. While currently the amount of retail in Moscow is nearly 1 million sq.
m. with occupancy of 85-90%, it is rapidly dropping with the addition of the new supply
such as Mega Mall, Ikea, and the like, comprising nearly 800,000 sq. m. by 2003.
In the office sector income yields are coming down from 15-20% to 12-13% as
estimated by the specialists at the Noble Gibbons CB Richard Ellis brokerage house in
Moscow. The tenant demand demonstrates the Russian economy's continued reliance on
oil and gas exports. The most active sector drivers are oil and gas (17% of net absorption),
metallurgy and metal trade (15.5%), followed by the professional services companies
(11.7%) and financial and banking services (11.7%); telecom firms contracted 8.6%;
information agencies, mass media and TV took sixth place among the most active tenants5.
Demand is still growing in the office sector as more and more companies are demanding
quality space, which they can now afford due to the booming economy and the return of
foreign enterprise.
With a recovering economy, starting in year 2000 the demand for industrial space
soared. The outstanding demand comes primarily from both Russian and international
retailers with local production facilities. Both prefer built-to-suit projects. The market is far
from being saturated, as only few projects meet the Western standards commanded by
many potential occupiers.
5 Stiles & Riabokobylko Commercial Real Estate Services
When investing in Moscow real estate many investors first consider its closest rivals from
the adjacent former Soviet block. The following is a comparison of the economic and real
estate market performance:
Eastern-European Space Market Comparison6
Figure 2.2
GDP growth comparison
N Russian CEE
Year
The main macroeconomic indicators are as follows:
Table 2.6
Microeconomic indicatorsfor CEE countries and Russia
Poland
Czech Rep.
Hungary
Russia
1.6m
1.2m
2m
8.7m
Real GDP
$171b
$55b
$49.5b
$356.2b
GDP per Capita
$4,400
$5,400
$4,900
$3,100
GDP growth
1.50%
2.90%
5.20%
4+%
Moody's Rating
BBB+
A-
A-
BB-
Unemployment
16%
9.80%
5.90%
7.90%
4.20%
3.90%
6.20%
11%
Popul. in Capital City
Inflation
6
Data for this segment is provided by JJL and GE Golub
The tables show that Russia by 2003 is catching up to its former allies with very volatile
but high growth rates.
Real Estate Markets in Capital Cities:
Figure 2.3
Rental Trends for CEE capitalcities and Moscow
-$80.00
Moscow
-
Budapest -
Prague -
Warsaw
....
.
...
$70.00
$60.00
Rent per Month
$50.00
$40.00
$30.00
$20.00
$10.00
1996
1997
1998
1999
2000
2001
2002
Year
While most of the countries showed a slow down around 2000, Moscow's rent still grew at
a slow rate.
Figure 2.4
Office space market indicatorsfor ECC capitalcities and Moscow
asem Stock 2,500.000
- -- - - -
- - - -
Supply -.-*Vacancy
- - - - - -
-
-
25%
- - - - - - - - -- - - - - --.-.
20%
2,000,000
Sq. m.
1,500,000
15%
1,000,000
10%
500,000
5%
-0%
Moscow
Budapest
Prague
Warsaw
Moscow is still responding to the high demand for office space as demonstrated by low
vacancy and a supply higher than in other capitals. The reason for such disparity with other
countries of the Eastern block is that Moscow is much less open to the influence of the
West. Mainly, after the iron curtain was lifted, Prague, Warsaw and Budapest instituted
liberal investment and development policies for foreigners. The market was quickly
overbuilt by the year 1999 and rents started to decrease with increased vacancies. On the
other hand, Russia had much more control of foreign involvement in its economy and real
estate in particular. Corruption, unresolved property rights, a complex regulatory
environment and the crises of 1998 slowed the process of potential over-supply in the
market. While its neighbors were going through their first real estate down-cycle, Moscow
was still trying to identify development opportunities. Despite the fact that land ownership
issues are still being sorted out, the demand for space is going strong, responding to a
growing economy in Moscow. Thus, by way of small dosages of the real estate market
discipline, Moscow is still riding the growth era of its real estate.
Eastern-European Asset Market Comparison 7
Moscow
The investment market is thin, as few transactions are actually taking place in Moscow.
There are more transactions of the owner-occupier nature, as Russian companies prefer to
own the property they occupy. An estimated volume of such deals in 2002 was
approximately US $600 million8 . Despite the fact that there is an increased interest, there
were no transactions in 2002-2003 on investment/ speculative bases. Only two legitimate
transactions were recorded in 2001 with total volume of US $80m. Nevertheless, there is
much hope for supply entering the market that is targeting sale at the end of construction.
There still is a chance that developers will hold on to the property as senior debt
availability improves and cash flows entice developers to hold on to assets. One example
of such a hold-back was Berlin House, which was built with the intention of sale, but was
taken off the market once fully stabilized.
Budapest
The lack of investment product is the main problem in Budapest. There has been a
significant slowdown in the market in recent years. The demand is low and so is supply in
the market. The investors are predominantly focused on the office market. Only one
transaction was registered in the industrial market in 2002. Retail had no speculative
investment transactions recorded last year. The market is producing 5-7 transactions a year
with an approximate volume of EUR 200m and cap rates at around 9%.
Prague
There is a strong interest for investment in Prague by German investment funds. However,
only ten transactions were observed with only two on the open market. Cap rats are around
9-10%. The overall volume of transactions only reached EUR 177m. The general
prognosis is that the cap rates will continue to fall awaiting the accession into EU. Unlike
Russia, senior debt is readily available on the market with increased competition for
placement.
7 Data for this segment is provided by JJL and GE Golub
8 JJL, Richard Ellis
Warsaw
Warsaw remains the number one choice for investors in Eastern Europe. Despite the
overcrowding on the market and apparent drop in rent levels, last year's transaction
volume exceeded EUR 650m in the office sector and EUR 410m in retail. The market is
projected to remain stable and grow, with cap rates at 10-11%.
The asset market in Moscow is one of the most immature in comparison to EEC
countries. Although the reason for the very limited number of transactions at the moment is
a lack of sellers, not a lack of potential buyers, market liquidity remains a concern.
Nevertheless, what differentiates Moscow in the sample is its upward trend in rents. With
the predicted cap rate compression Moscow can be a winner with high gains on exit.
Systematic Risk and Return Analyses
As noted earlier, office properties appear to be one of the most profitable investments
in Moscow. Of all the office space in the city, Class A and upper Class B are still
considered investment-grade material. Many market observers might argue that there is no
Class A office space in Moscow. Nevertheless, the majority of the consultants ascribe to
the following gradations:
+ Al: Complete new building; fully controllable 4-pipe HVAC system; raised floors
and suspended ceilings; slab to slab height of 3.6 meters (11.8 ft.) or better (no less
than 2.7 meters (8.85 ft.) from the top of finished floor and to the suspended
ceilings); efficient column spacing (no less then 6 meters (19.7 ft.)) with rational
window spacing; sufficient underground parking (1car per 100 sq. in.); advanced
building management and security system; excellent utility capacity; UPS; modem
high speed lifts with maximum waiting time of about 30 seconds; proper legal
documentation.
+ A2: Complete new building or reconstruction; fully controllable HVAC system;
advanced building management and security system; sufficient utility capacity;
UPS; possibility to install raised floors; modem high speed lifts of sufficient
capacity; may lack underground parking.
+ A3: Either newly built or fully reconstructed in early 1990s', less efficient floor
plates and design, (including capital walls etc.); often with 2-pipe HVAC or
comfort cooling.
It is very ambiguous which buildings in Moscow should be in the A category since some
of the factors are very similar with the subsequent B class. In some cases it is the location
that makes the break in this tough allocation decision. However nebulous the gradation
might be, the following data is accumulated from the buildings that best fit the parameters
above including A and the upper B layer:
Table 2.79
Moscow City office market supply side data
Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
New Supply
40,000
90,000
100,000
300,000
250,000
200,000
220,000
240,000
260,000a
280,000a
2006
a
-
Stock
120,000
160,000
250,000
350,000
650,000
900,000
1,100,000
1,320,000
1,560,000a
1,820,000a
Adj. Stock
114,000
152,000
237,500
332,500
617,500
855,000
1,045,000
1,254,000
1,482,000a
1,729,000a
2,100,000a
1,995,000a
Projected.
These numbers reflect the supply side of the equation. The stock is adjusted by 5% for
depreciation and broker data discrepancy. The rents in Moscow are generally quoted
exclusive of insurance and operating expenses.
Table 2.810
Moscow City demand side data
Year
1996
1997
1998
1999
2000
2001
2002
2003
Vacancy
6.0%
7.0%
14.0%
16.0%
11.0%
7.5%
4.5%
4.5%
Occupied
107,160
141,360
204,250
279,300
549,575
790,875
997,975
1,195,062
Absorption
34,200
62,890
75,050
270,275
241,300
207,100
199,595
Asking Rnt.
$ 850
$ 820
$ 620
$ 500
$ 550
$ 560
$ 570
$ 580
Adj. Rnt.
$ 807.50
$779.00
$ 589.00
$475.00
$522.50
$532.00
$541.50
$551.00
Rent is paid quarterly in advance. The numbers above reflect the demand side and are
adjusted for 5% overage of operating expenses and assumptions about actual contractual
rent amount. Analyzing the two sides of the market, I will note a couple of trends:
9 Noble
1
Ibid
Gibbons, DTZ, JJL, Colliers, Stiles Riabokobylko.
Figure 2.5
Moscow City Supply and Absorption
Sq. M
-+-
--
Supply
Absorption
300,000250,000200,000
150,000
100,000
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
Year
Many developers found themselves in a difficult situation after the devaluation of 1998.
The construction projects in Moscow were virtually frozen. The flight of tenants from the
country paralyzed the space market, and construction money allocated in Russian banks
was unavailable for access. Those who were unable to wait went bankrupt and had to sell
or simply abandon unfinished buildings. Nevertheless, within a year development resumed
with the newly growing economy. The jump to finish the construction started in 1998 is
demonstrated by the positively sloped of the curves through 2000. Subsequent construction
didn't have the same volume and it took couple of years to pick up the velocity. When it
became apparent that the Russian economy was getting back on track (see Chapter Three),
many international companies started to come back or scale up in Moscow, demanding
quality space. In order to accommodate re-entrants and domestic new-comers, the market
responded with increased enthusiasm, as we see by supply from 2001 on. But how much is
enough? Considering that it takes 2-3 years to complete a 20,000 sq. m. (215,278 sq. ft.)
building in Moscow, the new supply is still responding to the demand of post-devaluation.
It is interesting to note that the composition of the post-devaluation Russian market is very
different. Many more Russian businesses were able to take advantage of the lower
production costs and get into the game.
Periodic Returns
Most of the rent is paid in dollars or rubles converted into dollars exclusive of expenses,
insurance and taxes. I will take adjusted rent (as a close approximation to net operating
income), and gathered information on estimated historic cap rates, and compare the returns
from investment grade office space for both Russian and US investors as an all equity
investment:
E(r) = (Vt - Vt-1 + CF) / Vt-I
Table 2.9
Nominalperiodic returnfor US investors
Year
Adj. Rnt.
Cap Rt.
Nom. V
1996
$ 807.50
22%
$3,670.45
1997
1998
1999
2000
2001
2002
2003
$779.00
$ 589.00
$475.00
$ 522.50
$ 532.00
$541.50
$551.00
23%
25%
24%
22%
20%
16%
14%
$3,386.96
$2,356.00
$1,979.17
$2,375.00
$2,660.00
$3,384.38
$3,935.71
Nom. r
14%
-7%
9%
44%
34%
47%
32%
As the table above shows, the returns were all over the map with a significant downswing
in 1998 due to the abrupt drop in rent in 1998 - the year of the Russian default and
currency devaluation. However, the geometric return of the combined data shows that a
rapid comeback of the market in subsequent years well overcompensated for the year of
the crisis:
(1.14*(-)* 1.09 * 1.44 * 1.34 * 1.47 * 1.32)^ 1/7 - 1 = 24%
As compared to the arithmetic mean of 25%.
Compared to the absorption and supply dynamic in Graph X, the downswing in 2000
reflects the end of the construction started in 1998 and an immediate response to the new
rise of the economy.
Even with the introduction of US inflation the returns still look attractive:
Table 2.10
Real periodic returnfor US investors
Year
Adj. Rnt.
1996
1997
1998
1999
2000
2001
2002
2003
$
$
$
$
$
$
$
$
US inflation
Inf. Adj. Rnt.
Cap
Real V
Real r
3.32
1.7
1.61
2.68
3.39
1.55
2.69
2
$780.69
$765.76
$579.52
$462.27
$504.79
$523.75
$526.93
$539.98
22%
23%
25%
24%
22%
20%
16%
14%
$3,548.60
$3,329.38
$2,318.07
$1,926.13
$2,294.49
$2,618.77
$3,293.34
$3,857.00
16%
-7%
8%
43%
36%
46%
33%
807.50
779.00
589.00
475.00
522.50
532.00
541.50
551.00
Figure 2.6
Real periodicreturnfor US investors
Return
50%
Real
-
..... ........
.............
.................
..............
-.
-...
---..
............
- - .-...
.
-..
.
-..
.
--..
...............
-....
-...
..
-..
...
.
-..
..
--..
...
..... ..
....-...
....
-..
..-..
..
.. .-..
-
40%
0/
30%
20%
10%
M\
0%
1997
-10%4-
\V,
1999
2000
2001
2002
2003
Years
To introduce the risk component into the picture I will compute the standard deviation for
the time series using the risk free rate of the intermediate term US treasuries:
Table 2.11
Risk and returnfor US investors
Risk Free Rate
4.64%
Arithmetic Average
Standard Dev
20%
Thus for one unit of return Americans accept .86 units of risk.
23%
The most important reason for the disparity between Russian and US returns is the
volatility of the exchange rate and inflation. After the devaluation of 1998, Russian
investors were offered an abnormal escalation in the rent base for the properties. The rent
was still pegged to a dollar but after the conversion into rubles, the profits for Russian
investors could only be curbed by the sky-high inflation. For comparison to Russian
investors I will convert dollar-denominated rent into rubles using the historic exchange rate
and construct the domestic return index:
Table 2.12
Nominal periodicreturnfor Russian investors
Rub. Rnt.
Cap
Nom. V
Nom. r
5.60p.
9.80p.
20.65p.
4,522.00p.
7,634.20p.
12,162.85p.
22%
23%
25%
20,554.55p.
33,192.17p.
48,651.40p.
83%
70%
$ 475.00
27.00p.
12,825.00p.
24%
53,437.50p.
35%
$ 522.50
$532.00
$541.50
$551.00
28.16p.
30.14p.
31.78p.
31.70p.
14,713.60p.
16,034.48p.
17,208.87p.
17,466.70p.
22%
20%
16%
14%
66,880.00p.
80,172.40p.
107,555.44p.
124,762.14p.
49%
42%
54%
32%
Year
Adj. Rnt.
1996
1997
1998
$ 807.50
$ 779.00
$ 589.00
1999
2000
2001
2002
2003
Exch. Rt.
Figure 2.7
Nominalperiodic returnfor Russian investors
Return
90%
+-Russian Investor Returns
-
..
...
...
......
....
...
..
.-.....
-..
..... ...-...
...
..
..
- --..
..
...
..
..
..
- .....
...
....
-...
--...
-......
- ..
-..
- - ..
- ....
- ....
80%
70%
60%
50%
40%
30%
20%
10%
0%
1997
1998
1999
2000
Year
2001
2002
2003
The exchange rate before the crises played quite a significant role in the nominal returns
for Russian investors; nevertheless few saw an opportunity or knew how to take advantage
of real estate as an investment vehicle. The real investment from the Russian side didn't
come until after the crises. As you can see, the returns are moderate compared to 1997.
To compare US and Russian investors, I will adjust nominal Russian returns by
US/ Russian inflation because rent is pegged to the US dollar. The following formula is
applied:
Adj. Rnt. -+ US inflation -> Nominal Exch. Rt. -- Real Exch. Rt.
->
Nom Rnt.
Table 2.13"
Inflation adjusted nominal rentfor Russian investors
Year
Adj. Rnt.
US infl.
Nom Exch. Rt.
Real Exch. Rt.
1996
1997
1998
1999
2000
2001
2002
2003
$ 807.50
$ 779.00
$ 589.00
$475.00
$522.50
$532.00
$ 541.50
$551.00
3.32
1.7
1.61
2.68
3.39
1.55
2.69
2
5.60p.
9.80p.
20.65p.
27.00p.
28.16p.
30.14p.
31.78p.
31.70p.
5.41p.
9.63p.
20.32p.
26.28p.
27.21p.
29.67p.
30.93p.
31.07p.
Nom Rnt. -- Rus. Infl.
->
Nom. Rnt.
4,371.87p.
7,504.42p.
11,967.03p.
12,481.29p.
14,214.81p.
15,785.95p.
16,745.95p.
17,117.37p.
Real Rnt.
Table 2.14
Real periodicreturnfor Russian investors
Nom. Rnt.
4,371.87p.
7,504.2p.
11,967.03p.
12,8.29p.
14.,214.81p.
15,785.95p.
16,745.95p.
17,117.37p.
Rus. Infl.
Real Rnt.
22.00%
11.00%
84.40%
36.50%
20.00%
19.00%
15.00%
11.00%
" US Census Bureau, Goscomstat, JP Morgan
3,410.06p.
6,678.93p.
1,866.86p.
7,925.62p.
11,371.85p.
12,786.62p.
14,234.06p.
15,234.46p.
Cap
Real V
Real r
22%
23%
25%
24%
22%
20%
16%
14%
15,500.26p.
29,038.84p.
7,467.43p.
33,023.41p.
51,690.21p.
63,933.08p.
88,962.87p.
108,817.54p.
109%
-51%
367%
81%
46%
59%
38%
Figure 2.8
Real vs. Nominalperiodic returnsfor Russian investors
Return
Real Returns -a- Nominal Returns
--
400%
350%
300%
250%
200%
150%
100%
50%
0%
1999
9 8
1997
2000
2003
2002
2001
-50%Y
-100%
--
-
-
-
-
-
-
-
-
-
-
-
-
-
--
-
Year
The abrupt jump from 84% inflation to 36% in 1998-1999 and simultaneous devaluation is
the cause for the distortion around the time of the crisis. The returns are negatively
correlated around the time of default and are positively correlated thereafter with stable
exchange rate and inflation.
Taking the Russian inter-bank rate as a risk-free rate, the following table will demonstrate
risk / return curve for Russian investors:
Table 2.15
Risk and returnforRussian investors
Risk Free Rate
19.60%
Standard Dev
Arithmetic Avarage
132%
91%
Thus for one unit of return Russians accept 1.45 units of risk
So far the analyses show that the risk for the Russian investors is higher than the
returns from the market; for US investors it is just the opposite. The returns for the Russian
investors are almost 4 times US ones and the risk is 7 times higher. But much of it comes
from the fact that the Americans are just more risk-averse than Russian investors as
represented by the respective units of risk above.
Table 2.16
Russian vs. US investor real returns
1998
367%
8%
359%
1997
-51%
-7%
-44%
1996
109%
16%
94%
Year
Rus
us
Spread
1999
81%
43%
37%
2001
59%
46%
13%
2000
46%
36%
10%
2002
38%
33%
5%
Comparing real Russian and US investor returns:
Figure 2.9
Russian vs. US investors realperiodic returns
Returns
400%
-- *-
Russian Returns --
US Returns
-
350%
300%
250%
200%
150%
100%
50%
0%
-50%
-+
1997
8
1999
2000
2001
2
-100%
Year
Just like the nominal vs. real returns for Russian investors, US and Russian returns are
positively correlated approximately from 2000 with the reducing spread trend. So risks
aside, Russian returns are still 10% higher in 2002. It is interesting to note that Russian
nominal returns and US ones are very similar due to the peg of the rent to a dollar
denomination.
Risk Analyses
So, are risks and returns really lower for US investors, or is it that the systematic
risks are lower following the diversification theory? To start analyzing that I will conduct
B analyses
for both types of investors, using a global investment portfolio as a benchmark.
Then, by way of Traynor Ratio's I will compare the two. To avoid additional noise I will
eliminate 4 in the regression equation by regressing mean deviations.
Table 2.17
Standardizedmean deviation returnsfor US and Russian investors
Year
Rus Arith. Av.
Mean Dev.
US Arith. Av.
91%
Mean Dev.
23%
1997
1998
1999
2000
2001
2002
2003
18.82%
-141.81%
276.71%
-10.00%
-44.84%
-31.38%
-67.50%
-7.04%
-30.24%
-14.77%
20.26%
13.27%
22.90%
-4.39%
The following is the data for Global investment return from Ibbotson Inc.:
Table 2.18
Global investment return benchmark
DJGI World TR
1997
1998
1999
2000
2001
2002
2003
13.%
20%
29%
-13%
-15%
-19%
-19%
Setting up mean deviations for global returns for the same years:
Table 2.19
Standardizedmean deviation returnsfor Global benchmark
World TR
13.13%
19.92%
29.47%
-13.02%
-15.45%
-18.61%
-19.12%
Arith. Av.
-0.53%
Mean Dev
13.66%
20.45%
30.00%
-12.49%
-14.92%
-18.08%
-18.59%
Regression output for Russian returns onto world returns:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.51
R Square
0.26
Adjusted R
0.11
Standard Error
1.25
Observations
7
ANOVA
df
SS
Regression
Residual
Total
1
5
6
2.68
7.79
10.47
Intercept
World Ret
Coeff
-8E-17
3E+00
Stand
Error
0.47
2.47
MS
2.68
1.56
F
1.719
SignifF
0.247
t Stat
-1.7E-16
1.3E+00
P-value
1
0.25
Low95%
-1.21
-3.11
Upp
95%
1.21
9.58
Low
95%
-1.21
-3.11
Upp
95%
1.21
9.58
The significance is pretty low, due to a low R2 and t-statistics. However I will proceed to
US investor output:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.80
0.64
R Square
Adjusted R
0.57
0.13
Standard Err
Observations
7.00
ANOVA
df
SS
Regression
Residual
Total
1
5
6
0.15
0.08
0.23
Intercept
World Ret
Coeff
-5E-17
-0.7595
Stand
Error
0.05
0.26
MS
0.15
0.02
t Stat
-1E-15
-2.9659
F
8.797
SignifF
0.0313
Pvalue
1
0.03
Low 95%
-0.13
-1.42
Upp
95%
0.13
-0.10
Low
95%
-0.13
-1.42
Upp
95%
0.13
-0.10
The statistic is much better for US investors with t-statistics above 2 and much higher R2 .
To set up Traynor Ratios I am selecting World 1-year Government treasuries to provide the
risk free rate. The following is the data from Ibbotson Inc.:
Table 2.20
Globalrisk-free rate
SB World Gov
1997
1998
1999
2000
2001
2002
Avrge.
0.23%
15.31%
-4.27%
1.59%
-0.99%
19.49%
5.23%
Traynor ratio:
Average Return - Risk Free Rate /
B
For Russian Investors:
91%
-
5.23% / 3.2 = 0.26
For US Investors:
23%
-
5.23% / -7.6 = -0.23
Setting up the comparison table:
Table 2.21
Beta/ Traynor ratio analyses
World
Rus
US
Risk Free
Historic Retern
Beta
T ratio
5.23%
5.23%
5.23%
-0.53%
23.0%
91.0%
1
-0.7595
3.2
-0.0576
-0.2340
0.2680
Because Traynor Ratio is a slope of the return line we can construct the following graph:
Figure 2.10
Risk adjusted US and Russian return comparison to a global benchmark
"
World -Russia
US
.
....
.....
....................
0.80
Average Return
0.00
0.40
I0.2
Beta
-1150
0.0
-1.00
iooo
00
1.00
1.503.50
-0.20
-0.40
-0.60
The results show that with a beta of -0.76, the market should reward an investor with a
return of 10%. The US investors in the Russian real estate market earned on average return
of 23%. They beat the market by 13%. So too for the Russian investors, their realized
return of 91% exceeds the market prediction of -13% by 104%.
This means that both set of investors earned more then their measure of systematic risk
suggests they should. It looks that Russians earned greater abnormal returns. However, the
time period analyzed is very volatile with the dramatic event of the devaluation in 1998,
and the time series is short due to the youngness of the market. Furthermore, the
observations have too much noise. The analyses paint a big picture, but are inconclusive
for investment decision purposes.
CHAPTER THREE: NON-SYSTEMEATIC RISKS & THE REGULATORY
ENVIRONMENT
Introduction
The preceding chapter assumes that both US and Russian investors were receiving an equal
amount of rent or revenue, thus equating non-systematic risks faced by the entities. But
most of the foreign entrants face risks in the emerging market environment, which are
greater than risks faced by domestic investors. The following is the risk gradation used by
a risk management team of an international development company:
Business Risk
The risk of failing to achieve business targets due to inappropriate strategies, inadequate
resources or changes in the competitive environment.
Credit Risk
The risk that a counterpart may not pay amounts owed when they fall due.
Sovereign Risk
The credit risk associated with lending to the government itself or a party guaranteed by
the government
Market Risk
The risk of loss due to changes in market prices. This includes interest rate risk, foreign
exchange risk, commodity price risk, and share price risk.
Operational Risk
The risk that is due to actions on or by people, processes, infrastructure or technology and
that has operational impact, including fraudulent activities.
Liquidity Risk
The risk that debts or accounts payable cannot be paid due to a lack of available funds.
Accounting Risk
The risk that financial records do not accurately reflect the financial position of an
organization.
Country Risk
The risk that foreign currency will not be available to allow payments because of lack of
currency or government rationing of what is available.
Political Risk
The chance that there will be a change in the political framework of the country.
Industry Risk
The risk associated with operating in a particular industry.
Environmental Risk
The risk that an organization may suffer loss as a result of environmental damage caused
by themselves or others which impacts their business.
Legal/ Regulatory Risk
The risk of non-compliance with legal or regulatory requirements.
Reputation Risk
The risk that the reputation of an organization will be adversely affected.
Systematic Risk
The risk that a small event will produce unexpected consequences in local, regional or
global systems not obviously connected with the source of the disturbance. This risk
cannot be diversified away.
From interviews with US development companies, I've ascertained that the value of
capital for investment in Russia is estimated at around 30-35%; which coincidently, equals
the historic return from the Russian stock market. Similar interviews with Russian
investors revealed a return requirement of 50-55% for equal projects. If Americans are
facing lower Systematic Risk (as it appears from the Traynor Ratios in the preceding
chapter) and are receiving lower returns, then risks other than those that are systematic
should account for the higher discount rate used by US investors. Several non-systematic
risks accounted above are the subject of this chapter.
Devaluation and Default of 1998
Many US investors have been frightened away from investment in Russia
following the default and devaluation of 1998, which led to the loss of millions of dollars
for US equity and debt investors. But what really happened in Russia that year:
In 1998 Russia reported a budget deficit of 3.2%, or R86.5 billion. International
estimates of Russia's budget deficit, however, tend to be at least a few percentage points
higher than Russian estimates. In 1997, for example, the Russian Government reported a
budget deficit of 3.3% of GDP, but other sources, such as the IMF, estimated Russia's
budget deficit to be closer to 7.7%".
Despite increasing corruption, misuse of funds and growth in the control of the
economy by criminal elements, the Kremlin administration was still trying to display its
adherence to the course set forth by the IMF. Early in 1998 Russia demanded $15bn to
rescue its economy. IMF declined additional aid, instead proceeding to negotiate interest
payments on already outstanding loans. This left the Russian economy exposed to the
possibility of a financial disaster. Left with holes on domestic and foreign fields' the
Russian administration quickly turned its attention to internal debtors. In the summer of
1998 the government made desperate attempts to collect taxes from large and politically
influential oil and gas companies. Some success was achieved in forcing such companies
as Gasprom, Sidanko and Onako to pay after the government resorted to various threats
that could potentially damage the cash flows of these companies. With this, the energy
sector remained one of the last sources of government revenues due to its relatively high
profitability and foreign currency earnings. Indeed, exports of oil and gas constituted
around 40% of exports to non-CIS countries, and tax revenues from the energy sector in
the consolidated budget were around 25%13.
The Anatomy of the Crisis
With such close links to its energy sector, the Russian budget was excessively
exposed to shocks in the world oil price. By fixing the exchange rate in such an
environment, the Russian government lost an independent monetary policy, putting an
excessive weight on the fiscal side of the policy mix. The subsequent liberalization of
capital markets turned that exposure into vulnerability. Nevertheless, the Russian
Federation persisted in displaying its credibility by adhering to a fixed rate regime.
To elaborate, additional vulnerability came from the fact that in 1998 all domestic
financial markets were opened to international investors. After Russia was awarded its first
financial credit rating in 1996, foreigners were allowed to invest in Russian government
bonds, initially only through the primary market. Then, they gradually were allowed to
Business Information Service for the Newly Independent States, Commercial Overview of Russia
(Washington, DC: Dept. of Commerce, June 1999).
12
13 Estimated
by the author from data of State Revenue Service
trade fully in the secondary market. With financial liberalization under the fixed exchange
regime, the investors in domestic-currency denominated instruments had an opportunity to
attack the currency peg (they were finally given an option to expatriate funds)".
Also, Russian citizens had no confidence in the policy of the Central Bank at large.
For instance, in 1993 and prior to that in 1991, Russia's Central Bank, governed by Viktor
Gerashchenko, decided to institute mass exchange of old rubles to new ones. In particular
they announced one Saturday that all ruble notes printed before 1993 would be worthless
on Monday. The move was designed to gain control of Russia's ballooning money supply.
Needless to say many Russians lost money that week and lost their confidence in Central
Bank's policies. After that many Russians preferred to keep their savings in hard currency
that would be readily available at a premium on the black market".
In the summer of 1998 the Central Bank was trying to buy rubles by issuing
treasuries at 30%-50% interest rates. However, demand for bonds had plummeted so much
that yields were more then 50% and the government failed to sell enough bonds at its
weekly auction to refinance its debts1 6 . Additionally, from January to August the Russian
stock market lost more than 75% of its value, 39 % in the month of May alone.
7
It is hard to say what came first - a fear of government insolvency in the eyes of
Russians, the fact that the Asian currency crises in 1997 fostered a speculative attack on
the ruble (due to which Central Bank defended losing nearly $6 billion), or simply that
world oil prices fell to $12 per barrel. The history shows that on August
1 7 th
of 1998 the
Russian Federation was forced to default on its foreign debt and almost simultaneously
devalue the ruble (loosing 2/3 or its value), with a moratorium on all payments to foreign
creditors.
Tatiana Kirsanova, Government Budget, Oil Prices and Currency Crises in Russia, 2002
James Rupert, Washington Post Foreign Service, 1993
16 Shleifer and Treisman, 2000,
p. 149
17 A. Chiodo and M. Owyang, A case study of a currency
crisis, 2002
14
15
Figure 3.1
Exchange rate volatility
Exchange Rate Volatility
-+-
Exchange Rate
--
--
---------
35.00p.
- --
--
-
- --
30.00p.
25.00p.
o 20.00p.
U)
Z
15.OOp.
10.OOp.
5.00p.
-P.
1996
1997
1998
1999
2000
2001
2002
2003
Year
Entrance and Exit of the Westerners
It was not surprising that many Western companies found themselves in a very
difficult situation in the summer of 1998 in Moscow. Many companies came to Moscow
right at the initial signs of liberalization and privatization in 1992. U.S. businesses in
particular were interested in Russia for very good reasons. Russia has an educated work
force, a strategic location straddling two continents, and a generous supply of natural
resources, including gold and timber. But energy is the true jewel in the Russian crown.
Oil and natural gas represent 60% of Russian exports and 25% of federal revenues.
However high American interests were in the stake for Russian natural gas, oil and mining,
their participation was intentionally limited at the privatization tables. Instead, familiar
multinationals entered markets of consumer products, agriculture, telecommunications and
aerospace. The majority of the companies such as Proctor & Gamble, Coca-Cola and
Boeing had enough bargaining power to enter into direct partnerships (official or
unofficial) with Kremlin administration. For those entering export sectors such as timber
and metals, strategic partnerships with the newly developing private sector were more
common. Consultancies such as PWC, Ernst & Young and McKinsey were at one or
anther time invited by the Russian government to participate in the pricing and
restructuring of the industries as well as follow their existing clients who were establishing
offices in Moscow. It is interesting to note that the entrance of foreigners was welcomed
for different reasons. On one hand Russians viewed western know-how with great respect,
but on the other hand they were ready to take any advantage they could of the naive early
entrants. Bureaucracy, corruption, and lack of reliable suppliers and distribution systems
became a major road-block for the foreign companies. Improved corporate governance was
a far-cry from Western standards along with any accounting or reporting procedures.
Nevertheless, investment in Russia was viewed by the majority as a long-term investment.
1998 was met in different stages of progress among the foreign community in
Russia. By that time some producers had sunk large amounts of capital into the
infrastructure for manufacturing, while others had just finished replicating their entire
value-chain in order to gain protection from the still volatile political and economical
environment. Those raising funds were showing the first signs of positive outlook on early
investments. But no one was hurt as much as those engaged in financial-engineering,
stocks and elaborate hedging. In 1998 the US Fed had to rescue several funds that were
threatening to bring down a major portion of the financial market at home. Many Western
companies folded their operations and left Moscow. Companies remaining on the ground
through the devaluation and default reported rising inflation and shrinking production.
Many had to freeze trade because they could not predict hard currency exchange rates,
which were changing daily. All foreign enterprises laid off staff and began observing a
"wait and see" policy. However, firms producing in Russia were not cutting back on
advertising as much as importers, since foreign companies saw a need to protect and
preserve their market share and brand images from domestic producers whose costs were
lower than those of foreigners. But companies whose equipment was domestically sourced,
or which had paid in full for imported equipment were better able to hold the line on their
prices, because their cost of production has not increased. Those that bought equipment on
credit with hard currency or leased it under hard currency contracts also needed to increase
ruble prices, but faced immediate market-share erosion in the latter case. Many importers
as well as locally-producing companies that used foreign ingredients or parts had suffered
heavy losses because their revenues were frozen in Russian commercial banks. Companies
that accepted rubles for payments could not convert them into hard currency.
In such an environment the ruble devaluation benefited Russian exporters as well
as producers who faced heavy competition from importers. The weak ruble greatly
restricted imports and decreased the purchasing power of Russians to buy foreign products.
Some Russian companies were profiting and replacing foreign products in specific market
niches. In the short term, few Russian banks became interested in processing operations,
but in the long term increasing inflation decreased the benefits to the Russian exporters,
since the cost of even domestic inputs rose dramatically.
In an effort to alleviate some pain, Russia's State Customs Committee removed the
20% value added tax on imported goods. But the real relief came through new commitment
to reforms and subsequent aid from IMF.
Another Turn-Around
Yeltsin was not expected to do well in the presidential election of June 16, 1996.
He had suffered two heart attacks and a drop in popularity as a result of the separatist war
in Chechnya and the hardship caused by economic reforms. Still, Yeltsin won the lead over
Communist rival Gennady Zyuganov in the June election and defeated him in a runoff in
July 1996. But in 1998 Yeltsin's situation was less then promising. After dismissing his
entire cabinet and switching prime ministers back and fourth for a period of a year, it
became obvious that the one factor that was not changing was Yeltsin himself. Yeltsin had
to step down as a leader of the country and a new energetic leader, Vladimir Putin, entered
the office. Putin was first appointed by Yeltsin in 1999 and later elected by the people of
Russia in 2000.
Putin, an ex-KGB field officer and more recently ex-deputy mayor of St.
Petersburg, managed to quickly lift the falling spirit of the country. He immediately
engaged in a battle with "oligarchs" who were tightly controlling private sector
development and withholding taxes from Oil and Gas trade. Putin threatened to cut-off
access to the pipeline controlled by the state. But on the other hand he invited them into the
Kremlin and reassured of his commitment to end organized crime, support business, and
increase the transparency and competitiveness that was needed to enter world markets.
Putin lifted foreign exchange control measures introduced after devaluation and began
restructuring the entire banking system. Putin was pushing production and output and
projected a nominal increase in GDP in 1999. He maintained a flexible exchange rate
policy and made an effort to reschedule all Soviet-era debt that was coming due in 19992000. Putin then calmed the public by promising to reform the malfunctioning pension
system, land code, contract and investor protection laws.
World oil prices were increasing and the Russian stock market responded favorably
- up 35% in the three months since Vladimir Putin took over as acting president18 . Along
came IMF's aid that approved 17-month credit of $4.5 billon for Russia's 1999-2000
economic programs. Seven installments of $640 million depended on quarterly reviews
dependant on performance criteria and structural benchmarks. The European Bank for
Reconstruction and Development, or EBRD - the biggest single foreign investor in Russia's
private sector- returned to favor Putin's policies and signaled the return of investors and
foreign operators into Russia.
The Real Estate Industry in Russia Before and After 1998
The real estate sector under the centralized economy was in a deteriorated condition
at the dawn of the first reforms in 1992. Gosplan (the Central State Planning Committee)
designated the amount of funding that was available for all building types, determined the
number of square meters to be built, and worked with Gosgrazhdanstroi and Gosstroi (two
subordinate committees) to establish the overall construction program for the Soviet
Union. Gosstroi was responsible for defining what constituted the main technical and
scientific problems in the field of construction and architecture1 9. The concept of a real
estate developer as a single governing force behind the process was absent in the system;
thus quality control suffered greatly and output rarely satisfied demand for space. Holding
real estate as an investment vehicle was also non-existent because all property belonged to
the people of the state and was controlled by the government.
When Western companies first moved their operations to Moscow in the early 90's,
they found a total absence of adequate space for their office workers. Many Western real
estate developers and investors became excited about the opportunity arising from the
unsatisfied demand for office, retail and industrial space in Russia. The housing market in
Russia was off-limits for western developers because of the heavy subsidies for living units
18
By Daniel Williams Washington Post Foreign Service, 1999; Page Al
19 Kimberly McKay, Business opportunities in the Soviet Union.
available to Russian companies alone. The Russian government further altered the demand
for housing by giving all state-owned housing back to the residents for full ownership.
Despite the satisfaction that Russians received by owning their homes, they quickly
became aware of the poor conditions of management and quality of the space. New space
was needed on the market, yet housing development was still subjected to strict state
regulations. Furthermore, the housing market became one of the most corrupt sectors in
real estate. Very few foreigners succeeded in office and retail development and investment,
and those who did attribute their success mostly to luck. It is not surprising because in the
early 90's they faced enormous challenges in regulatory, legal and tax practices, which at
the time were developing parallel to the frustration of impatient investors. One of the
biggest challenges Westerners faced was an ambiguous system of property rights, which
was necessary for financing the development and acquisition of properties. Early years
were spent in clarifications and research of the Russian market, which was ill with
corruption and lack of recognition of contractual obligations.
When the crises of 1998 hit in August, the real estate industry was instantly
paralyzed. Those in the middle of construction were forced to stop and abandon their
projects. Developers who took out debt financing from various sources left and swore to
never do business in Moscow again. The only investors who managed to survive were
those who had fully stabilized building. But even the lucky ones experienced the flight of
Western tenants. If it was difficult to be in real estate before the crisis, afterwards it was
deemed nearly impossible.
Nonetheless, the devaluation gave some advantages to Russian investors. Coupled
with the rapid recovery of the oil market, new Russian capital began investing into
unfinished projects left by the foreigners. Westerners were slow to come back, but the
rapid recovery and increased opportunities of 1999 were hard to neglect. Obviously the
ones that stayed had an enormous advantage, and for the rest of the days will proudly
proclaim that they survived the crisis. It took three years for foreigners to come back into
real estate but by this time Russians were dominating the market. English and German
investors were first to come back into retail and office construction. There were few US
real estate investors before the crisis, and considering that US financial markets suffered
the most from the default and devaluation, Americans were extra cautious in their return to
Russia. Even today, only a handful of US investors are operating in real estate and most of
them are still negotiating their entry.
The History of Economic Reforms and the Current Situation
Before the crisis of 1998 foreign investors were attracted to Russia because it had
various opportunities to buy things at a discount. They also hoped that the reforms dictated
by the IMF and World bank would put the Russian economy on its feet and turn their
investments into cash cows. However, acquisitions in Russia proved to be difficult to
complete since the competition from the Russian black market and the government itself
was hard to neglect.
The history of economic reforms started with Gorbachev's decree of
"cooperatives". Cooperatives were designed to create non-state owned businesses and thus
provide an alternative to a centralized economic system. The major flaw in the system was
its tax structure. All profits made through non-government contracts were taxed at 90%0.
Needless to say it was more than difficult to enter into any legal contract and make a profit.
Gorbachev also tried to increase foreign capital flow into the country by instituting a joint
venture structure that could theoretically open a still closed economy to foreign
participation. Nevertheless, such ventures were highly taxed and profit repatriation was
extremely difficult with the non-convertible ruble. However difficult it might have been
for foreign businesses to enter the Soviet market, some corporations responded favorably
to the first signs of an economic turn-around. One example is the McDonald's Corporation,
which entered the market in 1988. A partnership was formed between McDonald's (49%)
and Glavobschepit, the food service agency of the City of Moscow. McDonald's brought
its experience in building, training and operating, as well as capital, while the City of
Moscow contributed real estate and the permission to operate in the city. McDonald's got
around the obstacles of profit repatriation by reinvesting sales proceeds into real estate in
the center of Moscow. Major foreign tenants paid in hard currency by simply transferring
rent into offshore accounts from home base abroad. In later years, ease on repatriation of
profits led to most of the buildings being sold to the city of Moscow 2 1 . Today a Moscow
operation is the number one profit maker for the entire Corporation.
20
21
From personal experience of trying to start a family owned cooperative in Odessa, Ukraine in 1991.
Maximilian Yacoub, McDonald's in Russia, 2002.
It was not until Boris Yeltsin stepped into the office of the newly formed Russian
Federation cabinet that truly radical economic reforms took place. Until then, all prices
were governed by the centrally planned economy, and the prevailing domestic substitution
policy was protected by high tariffs and subsidization. In 1992, instigated by policies of
"shock therapy" propagated by the IMF, price controls were lifted practically overnight.
Because the state did not simultaneously disband the monopolized production and
distribution system, the result was hyperinflation and the destruction of personal savings.
Incomes fell. Russian industry suffered instant deterioration. Agricultural production
dropped. And in came a flood of imports that few could afford.
Privatization
In an effort to decentralize the Russian economy on August 14, 1992, Yeltsin
signed a decree on the institution of the system of privatization checks. Every Russian
citizen had those checks, and people could do anything they wanted with the first national
stock of new Russia. Those checks theoretically gave the opportunity to the people of
Russia to receive a piece of one-third of the national wealth, which was to be exchanged
into privatization checks. However, Russians at large didn't know what to do with
privatization checks. They didn't understand that they could buy a ticket to an exchange
and make a real stock deal. Instead people were trying to sell their checks and get some
money for them. Criminal structures were eager to acquire checks at discount and gain
control over larger shares of stock, thus creating the first signs of income disparity in the
early stages of privatization . Another example of an unprecedented theft became the
hand-over of thousands of enterprises to insiders, rather then the public at large. In 1995,
Anatoly Chubais, the new deputy prime minister, fostered loans-for-shares privatization.
The program distributed Russia's best performing enterprises into the hands of former
"apparatchik" and outright criminal elements of the black market. Oil companies like
Surgutneftegaz and Sidanko went for bargain prices. Chubais's attitude toward the
diversion of aid to shadowy business types was to "let them steal", for money would
transform the crooks into legitimate capitalists 2 3 . That of course generated a huge
22
Dmitry Slobodanuk, Pravda.Ru
Quoted in Anatol Lieven, Chechnya. Tombstone of a Russian Power (New Haven: Yale University Press,
1998), p. 176.
23
disproportion in income and continuing aggravation of Russians at large. Many
commented at the time that "oligarchs" jumped from being to millionaires to billionaires
virtually over night.
Post-1998 Economic Recovery
Today foreigners are attracted to Russia for very different reasons. The investment
is still opportunistic but much more conservative at large. The economy proved to be stable
and consistent for the past four years after the crisis and with the new leadership of Mr.
Putin, it is promising to remain on course. But a closer look may demonstrate that many
more issues need to be addressed before it can be considered to be a viable investment.
The Russian economy grew at a relatively fast pace in 1999-2000, changing the
social and economic face of the country. However, much of the capacity for further
growth, based on increased output using existing capacities, the mobilization of
temporarily available labor resources, and the channeling of financing into the industrial
sector, has been exhausted. Those opportunities originally arose as a direct consequence of
the 1998 crisis (the devaluation effect, reduced yields on government bonds, etc.) and the
favorable global economic environment. This is why we are now seeing a slow-down in
economic growth.
Economic growth in 1999-2002 followed a parabolic line, with industrial output
falling from 11.9% in 2000 to 4.9% in 2001, and 3.7% in 2002. Accordingly, GDP growth
fell from 9.9% to 5.2% and 3.9% in 2002.
If the Russian economy continues to evolve
through inertia along these lines, economic growth rates will continue to fall and the
economy may even contract. If such an outcome is to be averted, however, a whole new set
of factors has to be considered:
Growth in the export sector outstripped growth in the domestic consumption sector.
The oil and gas sector expanded by 8%, while the non-ferrous metals sector expanded by
9%25. Secondary industries focused on domestic consumption grew at a substantially lower
pace. This means that Russia's raw materials sectors are expanding at the expense of other
sectors offering greater added value. Thus there is the potential of GDP growth converging
24
25
Ministry of Economic Development and Trade
Goskomstat
with growth in raw materials exports, and with the fall of oil prices this could threaten the
entire economy again.
At the same time the share of conglomerates that made their capital in oil and gas is
increasing; the gap between the rich and the poor is widening. A similar picture is
observed with the regions. There is a saying in Moscow that everything would be even
better if the rest of Russia wasn't there. Also as the laws are being signed their actual
implementation is lagging. For instance, there is no clear mechanism for the
implementation of the land code itself. As it is, it's open to interpretation and misuse by
such cities as Moscow.
Growth in consumer demand, which so far has been a major factor for growth, has
not been accompanied by increased productivity and investment demand, and thus, sooner
or later, will be negated. Imports will increase, and in the worst case we will see a
disproportional relationship between disposable income and prices for goods and services.
By the year 2003 cumulative FDI are at $18.6b. The largest investors in the economy were:
United States (22%), Cyprus (19%), the Netherlands (12%), the UK (11%) and Germany
(8%). It is interesting to note that Cyprus is a favored offshore zone for Russian capital.
Effectively the investment was rerouted back from "Russian" companies 26 . It also should
be pointed out that most of the investments during the past two years can be classified as
venture capital, which will be withdrawn if the environment becomes less favorable. In
2002, there was a sharp decline in the growth of investments into fixed capital. According
to Goskomstat, in 2002 the growth of investments into fixed capital was only 2.6%. This
can be partially explained by the reinvestments into the oil industry. But for the fist time
since 1999, investment growth fell behind production growth.
The Russian economy in the past four years has been characterized by a very high
degree of savings (30-35% of GDP). In this share Russia holds the third position among
major economies, behind China and Malaysia. At the same time, almost half of the savings
are used to repay foreign debt and finance capital outflow. The macroeconomic situation in
the Russian economy is still stable, and there is every reason to predict that economic
growth in 2003 will continue, as investments whose rates decelerated somewhat will
increase. However, negative tendencies show that the economy is under threat of
26
Economist Intelligence Unit
stagnation and is seriously dependent on the world oil price. Fuel commodity stabilization
is not supported by the emergence of the market of new export products with high added
value. An institutional environment conducive to investment and commercial activities and
transformation of the people's savings into investments has not materialized.
Modernization processes are still slow both due to lack of investment resources and low
incentives for business entities.
Could it be that American investors have a low risk tolerance with Russia due to
the economic stability on the surface but high possibility for another crisis underneath? My
quick survey of the major US investors shows that when it comes to emerging market
investments, China, India and Brazil are still considered first before Russia. Thus the
inability to forget the 1998 crisis and the tendency to use a magnifying glass evaluation of
the economy is still reality when it comes to the Russia proposition.
Oil and the Russian Economy Today
A regression shows that federal budget revenues were highly dependent on world
oil prices in September 1998 and December 2000: each extra dollar per barrel of oil
corresponded to an extra RUB 10 billion to RUB 11 billion of monthly budget revenues in
1999 and RUB 12 billion to 13 billion in 2000.
Figure 3.2
World oil prices
--
US dollars per barrel
World Oil Prices
$30.00
$25.00
V
$20.00
$15.00
$10.00
$5.00
1995
1996
1997
1998
1999
Year
2000
2001
2002
2003
In 2001 there were some structural changes in the economy, and as a result the
correlation between the budget revenues and oil prices was disrupted. However, in 2002
there was a relatively strong correspondence between budget revenues and the fluctuation
of world oil prices. Roughly, each dollar of the oil price results in RUB 23 billion of
budget revenue monthly. The correspondence was less evident than in 1998-2000, but still
significant. There are therefore reasons to believe that a drop in oil prices will result in
problems for the Russian budget coupled with foreign debt repayments to the Paris club
scheduled for 2004. According to BP, Russia's proven oil reserves increased 23% during
2002, while output averaged 7.7mn barrels per day, second only to Saudi Arabia2 7
The situation in the OPEC is such that any agreement is difficult to reach between
the members. In the current situation, even with the slow recovery of Iraq there are some 8
million barrels from the reserves that are put up for sale. By the end of the year the export
from Iraq might reach 2.5 million barrels a day. If the world production is not reduced, the
reduction of the price to $19-20 is inevitable. There are at least two countries that are
against the reduction in the production volume - Algeria and Nigeria. They opened to
international investors who invested heavily in the production, and they need to maintain
maximum output to justify the investment. Additionally, if the political disputes were
resolved in Venezuela the world production would increase. It is interesting to note that
Saudi Arabia usually benefits more from the reduction since they hold 32% of the world
production. Based on the lobbying by the United States, the Saudis had also reduced their
production in 1998 in order to up the price on the world markets. The request was intended
to help Russia, as well as to return their capital on the investments they made in the
Caspian region and Western Africa. Additionally, Americans are investing in Iraq to secure
the production of the restored oil sector. Their investment in Iraq has to be around 100
billion dollars; obviously low prices on oil would not satisfy Americans as well. If the
prices drop below $20 per barrel American production in Texas might be in danger. The
vehicle for the control of Iraq's oil is the process of privatization which Americans are
structuring in the new "free" Iraq. As foreign investors are welcomed to the privatization
rounds, very few can afford to participate, politically and economically. Nevertheless, the
former head of the Saudi Ministry of Oil, Zaki Yamani, believes that the future export of
27
Economist Intelligence Unit and OPEC
oil that Americans secured in Iraq will eventually (within 10 years) bring prices to the midteens. By that time all of the investments would be returned and it might not matter for the
biggest consumer. However it presents a great danger for the Russian Federation as they
have an artificial deadline to diversify their economy.
As the dependency on Russian oil might diminish in Europe due to the new exports
by Americans from Iraq through the Israeli city Haifa, Russians are looking to open
Siberian oil to either Japan or a promising economic giant, China. To brace for the impact
Russia is also collecting a special fund for "rainy days" to buy time. But whether or not
American investors believe all the precautionary measures that Russians are putting forth
in preparation for the hit still remains to be seen.
Legislative Issues
The quality of laws remains an essential problem in Russia. This can be partially
attributed to errors and the insufficient qualifications of lawmakers, who are not always
able to anticipate the specific consequences of applying the law. At times, this is the result
of a compromise seeking to put together various proposals from lobbying groups. For
instance, the bankruptcy law and the Tax Code chapter on the taxation of small business
entities were subject to repeated amendments. Oddly enough, Russian laws are often
excessively detailed, yet insufficiently specific, and cannot be implemented without
additional clarifications and additions. There also remains an issue involving the late
development of by-laws, which are essential to making new laws workable, regardless of
how liberal, progressive, or timely they seem. As the key problem for the Russian
economy is weak enforcement, it is also essential to improve judicial proceedings.
Presidential and Parliamentary Elections
To a large extent the current political situation is a consequence of the historic
absence of democratic traditions, the totalitarian heritage, traditionally paternalistic
governmental policies, and the absence of effective and influential institutions of civil
society over a period of many decades. The disparity of power between the office of the
president and the people and organizations with influence on the government represents
one of the main obstacles to a coherent government policy and effective structural reforms.
Broad sections of the political elite habitually shirk their responsibility to formulate and
implement government policy during difficult periods that call for reforms, which
inevitably leads to the redistribution of wealth from certain categories of economic agents
to others, who continue to thrive based on their position in the social hierarchy.
Government policy and reform efforts are being carried out in a context of covert and
opportunistic resistance from opponents of reform, who, while being too weak to call a halt
to the reform process, are strong enough to slow the process down and distort its
realization.
This creates certain political risks for the Russian economy. The system of the
government is inherently unstable owing to the colossal role played by the office of the
president, and the absence of the stable political system capable of assuring the continuity
of government policy during and after the presidential elections. This in turn means that
reform is only possible when public confidence in the president is high. However, public
confidence in institutions such as the office of the president is unstable. If public
confidence in the president falls, it brings down with it the president's influence on the
reform process in particular and the broader social and economic situation as a whole.
The Russian leadership has stated its intention of intensifying the reform drive in
2003. However, the fact that parliamentary and presidential elections are due to take place
in December 2003 and April 2004, respectively, suggests that although the legislative
effort may well continue, the prospects for real progress on the reform front in the coming
year are not great. If the reform process is postponed until 2005, we will only begin seeing
tangible results in terms of increased investment and economic growth in 2006-2007. That
is incompatible with the government's long-term economic growth strategy on the one
hand, and raises the risk of economic crisis on the other. The structural and institutional
reforms required by the Russian economy were defined back in 2000, and the conceptual
framework for most of them is set forth in the Gref Program. However, due to enchantment
from high economic performance, the pressure from the lobby groups, resistance from
public service, and a reluctance on the part of the authorities to destabilize the social
situation on the eve of the parliamentary and presidential elections, the reform process lost
momentum.
Much of the stability in the country, politically and economically, can be attributed
to the leadership of Mr. Putin. Opinion polls show that President Putin enjoys a high level
of public approval for his overall performance and his re-election as President in March
2004 appears virtually assured. Consequently the political risk of Putin not being able to
continue with his restructuring of the Russian Federation appears to be low.
Debt Markets
Domestic Government Debt
The Russian debt market has three components: the government sector, municipal
sector and corporate sector. The Government sector, represented by the issuance of T-bills
and T-bonds, is very stagnant. There simply hasn't been any new issuance into the market.
It is not very dynamic simply because its primary buyers are state-owned or statecontrolled entities. According to the Central Bank of Russia, the total market value of all
GKO's and OFZ outstanding amounts to some RUB 218 billion. If it hadn't been for the
slight expansion in the market during 2002, it would already have folded completely.
Comparing the capacity of the Russian domestic bonds market with that of other countries
at the end of 2001 reveals a depressing picture. Russian domestic government bonds
outstanding expressed as proportion of GDP amount to about 2% - the lowest level in the
world 2 8 . In the US, the level is 87%, in Czech Republic and Hungary - 36%, in India 27%, in China - 23%, and even Argentina - 9%.
The low capacity of the market means that it cannot be used for the macroeconomic
regulation process. Sustainable economic development requires mechanisms that enable
the monetary mass, interest rate, and other macroeconomic parameters to be controlled. In
other countries, the government bond market provides that mechanism. The interest rate
(yield) on the government bond market acts as a guide-line for other sectors of the
financial market, and first and foremost of the corporate bond market. Unfortunately, the
financial sector continues to be dominated by traditionalists, who believe that the issue of
government debt and budgetary deficits are one and the same. In the US, meanwhile, about
US$3 trillion of a total of US$8 trillion in domestic government bonds is the Treasury
Papers. The bulk of the US government bond market is made up of mortgage bonds, which
are used by tens of millions of Americans to buy homes. Government borrowing is an
important factor for kick-starting the investment process in sectors and regions that are
unable to attract private capital on their own. This is not the case in Russia.
28
Yuri Danilov. Indicator 2002, issue 11.
On the Municipal side there are 47 bonds in circulation, with Moscow taking the
largest share of the market. But the development of the market will be limited by new
federal restrictions on the funding requirements in the amount of debt ratio of the local
governments.
Corporate Debt
The corporate side the bond market in Russia was virtually non-existent until 2001.
The issue was not necessarily with the perceived interest rate risk or fear of inflation, but
the with liquidity. Gradually the maturity of the bonds was raised from 3 months to 16, 18
and now up to two-year transactions with minimal intermediary costs. The reason for this
change is the increased inflow of capital, which is returning back from companies'
accounts overseas and being reinvested locally. It is not surprising that before and shortly
after the crisis in 1998 many domestic corporations were transferring money offshore, thus
diminishing the muscle of the market. Now with improved corporate governance and
numerous reforms this capital is coming back to aid the development of the corporate debt
market. The outflow of capital decreased from 20 billion last year to less then 10 billion
today. Also last year the amount of money entering the country exceeded the amount
leaving the country.
Thus with declining country risk, declining inflation and increased liquidity the
market grew from 2 billion dollars to 4 billion in a period of a year. The daily trading is
estimated at 50 million dollars and will likely increase as the yields have collapsed and are
down from 20-23 percent to 14-18. The investment specialists at Renaissance Capital in
Moscow are predicting next year issuance to be nearing single digits and overall market
capitalization of 5 billion dollars by the end of the year, growing to 10-15 by 2004. As the
yields are coming down the market will increase in its volume due to the perceived
liquidity as well. It is a radical change from three years ago when few large banks held
corporate bonds at high par without further sales. The number of banks participating in the
transactions is now up to 30 with the recent addition of the insurance sector. The reason for
the past cautious approach to the debt side of the market is partly explained by cultural
factors. Russians still have a negative attitude toward taking on debt. It took time for
people to start realizing that the risk of borrowing can be rewarded with higher returns.
Nevertheless many still perceive debt as a "sell out". Others have the unfortunate attitude
that borrowed money is just a "freebie", and they borrow without taking any contracts
seriously. There prevalence of such dealers is diminishing as the court system is getting
more and more developed in Russia.
The growth of the corporate bond market, which is the closest counterpart to the
CMBS and RMBS markets in the US, is partly due to the inefficiency of the Russian
banking system. Compared to the banking sector, the corporate bond market is much more
transparent and the pricing mechanisms are much more competitive. Because of this
efficiency the cost of capital will be lower than for bank loans. Therefore, the money will
go where the highest returns are. Another reason for the bond market to take business away
from banks is that Russian banks issue loans in dollars, but in the emerging market
economy firms are receiving their revenues in rubles. This means there is always the risk
of devaluation. Thus it is safer to raise debt in rubles and have a perfect currency matching.
Also there is still credit risk with the bank institution in Russia; this is one more thing that
is eliminated in the bond issuance process.
Despite the warning, Russian companies borrowed quite a lot in recent years from
the issuance of their Eurobonds:
Graph 3.329
Gross Russian corporatebond placement (US$ mn)
$3,000.00
0 Eurobonds
-
$2,500.00
$2,000.00
Value
$1,500.00
$1,000.00
$500.00
1999
2001
2000
Year
29
EY assembled data
2002
Further expansion of the corporate bond market will be due to new pension reform that is
scheduled to be in effect by the first quarter of 2004. The system will change from the payas-you-go system to a fully funded system, which will allow Russian pension funds to
invest in non-governmental securities. As the economy leverages itself out the system will
become more and more vulnerable to major economy shocks due to the dependence of the
economy on commodity prices. The specialists in Renaissance Capital believe that the next
major crisis would not come from the government-led debt problem, but from the
corporate-led debt problem. However there is a reason to believe that after-crises the
restructuring the assets will finally concentrated in the hands of more sophisticated players
and the market once again will allocate the resources efficiently.
Banking Sector
One of the most talked-about issues related to Russian accession into the WTO is
the reform of the banking sector. The requirement for WTO accession is reduction of
barriers to entry for international firms. Foreign capital can re-capitalize the banking
system, increase domestic competition to benefit consumers, and help build confidence in
the sector. But low capitalization isn't the only issue with the sector. The situation is such
that only a few state-owned banks are dominating the banking sector. At the same time
there are a number of smaller banks, which are not really banks, but a financial institutions
of the large conglomerates, which in are in turn only financing their owners. There are no
standards for financial reporting and transparency in the country. The Federal Government
does not yet insure bank deposits. Despite the fact that credits to the private sector
increased to 20% of GDP and there has been an inflow of money into the country, the
bankruptcy and money laundering laws has just been instituted but not yet tested by the
market. Living primarily on deposits, Russian banking is missing its most important
element - the flow of money that generates capital.
The danger is also the volume of currency inflow into the country. In the last ten years 250
billion dollars was transferred out of the country, as compared to last year's GDP of 340
billion. Today the inflow of capital is 5% of the GDP but with stability and a favorable
economic situation it can increase to 10%-15%. This would be is on top of the inflows
from the exports of natural resources. Inflow of petrodollars is threatening to destabilize
the domestic economy. Hard currency inflows are pressuring the ruble higher, especially
against the US dollar. In an effort to slow the upward movement of the ruble, the central
bank halved the proportion of hard currency earnings exporters are required to exchange
for rubles, from 50% to 25%30. The real issue is that the banking system is unable to
process and hold such a volume and is in danger of total collapse in the not-so-distant
future. The immature banking sector would have to issue new loans in order to preserve
the value of money, but without real experience in underwriting procedures or depth in risk
evaluation and credit history research, many loans might default and will eventually cause
a domino effect in the whole financial sector.
Real Estate Lending
There are very few institutions in Moscow that lend money for real estate projects.
With the exception of the three, there virtually are no foreign banks on the debt side of real
estate. The risks are just too high for domestic investors and are even higher for foreign
investors. To start with, the law in Russia does not recognize the concept of step-in
rights for secured lenders. Any enforcement will take the security of the asset being
charged and put it on the proceeds sale; avoiding the holder of the mortgage. The only
enforcement of the «mortgage in possession is via (i) judicial proceedings and (ii) a
public auction. The pre-lease agreements are not recognized by registration bodies like
Moscomregistratsiya. (Legal rights registration agency). A Debt Service Reserve Account
is hardly possible in Russia, since its enforcement is complicated and problematic. To
avoid some of the risks, several banks are coming out with the Mortgage Bond Issue.
Under the issue the bonds are secured by the pledge of the real estate object, then a bank
forms an underwriting syndicate and the bank acts as an agent for placing shares. This
innovation is very similar to the CMBS in the US, but the construction financing
securitization is too high of a risk in Moscow. So far there are no issues of such structure.
First and foremost, banks require collateral. The collateral is required on four
levels. The first, most common in all parts of the world, is the ownership rights to the land
(or the rights to the lease in Moscow) and the building to be constructed. Second is the
collateral unrelated to the development project from the LLC (limited liability company),
that is developing the project in the amount of the loan. Third is the collateral from the
parent company that is a general partner in the LLC. And fourth is the guarantee from the
30
Economist Intelligence Unit
third party individual or company. All assets or rights to the collateral held by the bank
have to be insured. The insurance for the property shall be assigned to the bank. If the
project is developed as a rental property, the bank has to hold rights to the leases and the
agreement of sale with respect to the sale of the property. The letter from the parent
company shall be provided for additional financing in cases of cost overruns during
construction. An equity position for the bank is not accepted as collateral. If the parent
company is offering its stock as collateral all books must be opened for review by the
bank. The banks also require partial pre-leasing of the property as well as the construction
completion guarantee from the general contractor. Most of the banks finance 50-65% of
the construction cost, with a rate of 13-15% for a period of 3 years with a grace period of
18-24 months. The permanent financing is of a similar character with 6-year full
amortization and an interest rate of 9-12%. The following is the comparison table for
permanent financing with developed and developing countries:
Table 3.1
Country indicatorsforpermanent debt placement
Russia
USA
Japan
Central Europe
LTV
Rate
Amortization
50-65%
70-80%
80%
65-75%
9%
5-6%
2.50%
2.25%
6 years
25-30 years
30 years
15-18 years
The reason for the banks to hold ownership of the asset other than the project is the
risk that the developer does not have either proper documentation or simply does not own
the building until it is fully complete, inspected and transferred into ownership from the
city. The immature bankruptcy law is another reason for the strict requirements by the
banks.
Hernando de Soto on Land as the Source of Capital
In his book «The Mystery of Capital , Hernando de Soto argues that most of the
developing countries already possess the assets they need to make a success of capitalism.
Capital is prevalent in the underdeveloped world, but it is held in defective forms. Even the
poorest people have the ability to extract capital from things we know exist but cannot see.
But the mystery of capital is one that needs to be unlocked by the third world, and the new
force that raises productivity of labor and creates wealth of nations can finally be put to
use. In his book he presents five mysteries of capital:
* The mystery of missing information is the lack of properly documented systems or
capacity for accumulating assets.
* The mystery of capital is the way capital relates to money.
* The mystery of political awareness is the capital result of the movement of
population into the cities.
* The missing lesson of US history is the missing documented path to success of the
capitalist system.
* The mystery of legal failure is the lack of property law in the third world.
a'magine a country where nobody can identify who owns what, addresses can not be easily
verified, people can not be made to pay their debts, resources can not conveniently be
turned into money, ownership can not be divided into shares, description of assets is not
standardizedand can not be easily compared, and the rules that govern property varyfrom
neighborhoodto neighborhoodor even from street to street. You have just put yourself into
the lfe of a developing country or former communist nation.>>
Hernando de Soto.
There is no reason to deny that Russia in 1992 fit the description painted by De Soto in this
quote. However, much has been done since then and many intangible assets have been
converted into capital in Russia. The emergence of the equity and debt markets gave way
to secondary markets, and the Federal Land Code of 2001 fostered the new wave of land
privatization. The legal and administrative environment has been improved and tax and
labor codes have brought transparency to the country. Nevertheless, «the mystery of
missing information is yet to be unlocked by Russians. Moscow's land development and
land rights remains the worst if one considers the amount of «dead capital in the city.
The absence of direct land ownership in Moscow limits the ability to use land as
collateral for a loan. Even if the potential borrowers own buildings but have only use-rights
for land, bankers do not include a potential land value in the property's mortgage value. As
a result, the mortgage value, which can unlock the mystery of capital for Moscow, is
reduced. Secondly, the inability to recycle land for new use, which results from absence of
land ownership, postpones redevelopment and involvement of urban land in economic
turnover. (See section Land Use Segmentation in Moscow) The resistance to change comes
from Moscow authorities of various levels, who are unable to let go of land since it seems
to be their most abandoned source of control.
Land Ownership Rights & Development in Moscow
On July 3, 1997 the Russian Federation adopted a new Land Ownership
Registration Act and in October 2001 the Land Code was signed which was supposed to
facilitate outright land ownership by non-governmental organizations and private
individuals. At the same time the Federal government transferred the control of approvals
for the development of plots unoccupied by federal or local governments into the hands of
local municipalities. Under the new code two forms of land development are offered to
future developers. One form is without municipal predevelopment documentation and
price. The other form is with a schematic development plan pre-approved by the
municipality for the given plot of land and a stated price. In the latter case city government
already predetermines use classification for the potential project, available number of
square meters for the site, set-backs and other limits of construction and price of the plot.
Generally, the disposition of plots differs with each form of land development. In the first
case the city government organizes a competition for best price/ use development or
simply waits for an interest from the private sector in a particular plot of land. In the case
of a predetermined scheme, the municipality offers the plots to certain individuals or
organizations that are capable of implementation of the predetermined development
scheme. Obviously both methods are open to a number of subjective decisions which
leaves numerous opportunities for corruption and self-dealing. So far no rule has been
developed for the clear implementation of either method of disposition. In either case local
governments only receive 50% of proceeds from sale of land, and the rest is allocated to
the federal and regional governments. The method favored by the local governments is the
one without pre-approved documentation and price. In this case they can gain from sale in
various forms. One form of gain that remains undetected by the federal government is a
forceful share in the ownership of the future development in its physical form or stocks of
the holding company of the project. Therefore any further entrance of the project into the
secondary market for resale or lease-hold is blocked by the partnership with the
governmental agencies. Further, no mechanism exists for the sub-division of land between
municipal share of the project and a private owner in the case of physical ownership, which
makes the private sector forever married to a given municipality.
Despite the fact that the federal government clearly stated its intentions in the land
code for the development of zones with pre-determined use parameters, it also allowed for
individual case-by-case use determination. Thus, instead of a unified zoning plan, the land
approval process is separately investigated and determined by the municipal boards of
architects and urban development organs. It is obvious that municipal share from the
proceeds can only grow under the case-by-case determination method. Many
municipalities hide behind the budget deficit statements, which delays the development of
comprehensive zoning parameters. Even if the comprehensive package of allowable
construction parameters is developed for a given plot, it often is unacceptable for the profit
driven private sector.
The city of Moscow has by far the most complicated set of approvals on land
development. Right after the land code was signed by the state Duma, mayor of Moscow
Mr. Luzhkov quickly signed a decree which states that the city of Moscow will only enter
into the leasehold agreements (25 and 49 years with extension rights) with potential
developers. Under no circumstances will it sell the land outright based on the very low
prices (in his opinion) set by the federal government. The division of ownership between
federal and city owned land is the source of many disputes between the two parties. But in
this dispute, mayor Luzhkov seems to be a bit more aggressive in his position. The
federation is constantly threatening to reevaluate the division with a potential 20%
reclaimed by the Fed. Currently less then 20 entities are occupied by federal organizations,
including the Kremlin, Supreme Court, Constitutional Court, and Federation Council. The
city is split into 10 administrative areas and 125 districts. It should be noted however that
they do not coincide with the administrative divisions.
The land tax structure in Moscow is based on the cadastre blocks. There are some
14 categories of value, depending on how the land is used or intended to be used. Cafes
and restaurants are in one category, industrial enterprises are in another, for example. The
value of each cadastre is then multiplied by the usable square meters and then by the
appropriate tax to determine the payment. The cadastre value also varies with location, i.e.
its proximity to landmarks and transportation nodes. But the cadastre values do not reflect
the market price of land; it is an approximation that is quite artificial. Currently, the
cadastre for Moscow has not yet been approved and no precise figures are available.
Based on this decree any developer has to first acquire the rights to investigate the
possibility of development - (the equivalent of the sales and purchase agreement in US but
with no guarantee on the part of the city), and then purchase the rights to produce a project
for the site. Then, after the formal agreement by the city, the developer may purchase the
rights to lease a given plot. All three steps might take from a year to a year and a half, with
numerous associated expenses. The developer can never be certain whether he will be
allowed to construct the desired project or not. Parallel to that there is no mechanism to
prevent one's competitor from going through the same process for the same site. There
also is not guarantee that adjacent plots would not be developed as a negative externality to
the proposed project. In the absence of zoning there is no way to know what exactly will
be coming "next door" in the near future.
Land Lease Rights Acquisition and Approval Risks
The first risk element in the process is the identification of the existing ownership
of a given plot of land. The only way to discover the availability of the site and the
ownership structure is through private relationships with various Moscow city
organizations, which on your behalf (for an undisclosed fee) will further set in motion their
connections and relationships to uncover a vague answer on the developer's request. One
of the cleanest methods to retain the information is to hire the so called lobbyists who will
contact an associated deputy of the Moscow city Duma who would in turn put in the
deputy's request for information. The Deputy's request by law has to be answered by the
city but can come in various degrees of certainty. It is hard to estimate the time and money
dedicated to this stage, but it probably is the least expensive and efficient method. This
procedure would have to be employed for each individual site separately. Once the
developer determines the ownership structure, there is virtually no way to insure that the
owner's documentation for the ownership of the site is indeed correct. There are no
underwriters as in US who can guarantee that in a few years some governmental agency
such as a university or a municipal sewer committee would not claim the rights to the site
with a document that was not found through the due diligence process. Additionally, as-ofright development documentation for the site disclosed through the lobbying process
would most likely not satisfy the developer because the existing approved schemes for
each site were developed many years ago and were never updated. Thus he would have to
go through the rezoning or reconditioning of the design parameters set by the city. But that
is not after he would have to negotiate with the seller (a hypothetical city agency which
owns the site) on the purchase of the rights for the feasibility of the project. The price for
the land in Moscow is also ambiguous and intentionally not disclosed by the agencies. The
determination seems arbitrary. It depends on the proximity to the metro station and to the
historic center, but is never quantified by any method. Latest land rights sales range from
US $6m. to US $8m. for a hectare (107,639 sq. ft.). Assuming that the developer reaches
an agreement with the governmental agency, he then has to submit his architectural
concept for the site to the Moscow Committee on Architecture and Urban Planning
(Moscomarchitektura); this agency will determine the use group, number of square meters,
property lines and over-all design style of the building including the color scheme. There
are some 200 parameters that the Committee uses in the evaluation of the proposal. The
codes are available and published in a form of a SNIPS Code (similar to Uniform Building
Code in US) and supporting directives that have stylistic orientation. The issue for
example, could be with the adjacent buildings- whose size and shapes determine the shade
and light pattern of the neighborhood. Any proposed building might cast a shadow on a
playground or a metro station in a way that is unacceptable for the Committee. The
example is only one of many parameters in the evaluation, which obviously is exposed to
corruption and self-dealing. It is estimated that from the first rendering to the final
approved elevations and plans for the site the developer must allot up to a year and a half.
The end result is a list of signatures from up to 29 agencies related or vaguely associated
with Moscomarchitektura. One of the biggest risks is not from the local fire department or
a municipal sewer agency - it is with from the local district committee which in turn can
require so called linkages as we know them in US. A new school or an exit ramp can be
forced on the developer in turn for the much needed signature. Any and all of the risks
associated with this stage in the development are not quantifiable and are a reality of an
emerging market environment. To summarize at this point, it is interesting to note that
unlike in the US, architects have a lot more control over the face of the Moscow
streetscape. The developer has virtually no say in the determination of the shape, number
of stories or style of the building. He simply has to evaluate an already negotiated project
from the cost benefit standpoint and either forfeit or go forward with the project. Hopefully
the architect and the lobbyists employed by the developer have enough experience and
relationships with the city architects, and the approximate FAR desired by the developer
could be achieved with a minimal amount of cupolas on the fagade of the building. The
Institute of Urban Economics in Moscow estimated that 40 city agencies are involved in
the process; the developer has to produce 77 official documents for the approval with 4-6
contacts for the same agency on average.
After the approval of already detailed documentation, the developer may purchase
his final land lease rights from the Moscow government in the face of the representative
agency who is the seller of the site. In the rare case of private ownership, the owner has to
repurchase the rights for the leasehold and still enter into the concept approval process with
the Moscomarchitektura, regardless of the previously approved scheme for the site. This
virtually eliminates land speculation and at the same time diminishes the value of the
subdivision and ready-to-go approvals, as we know them in US. To detail this point - there
is no value created in the receipt of the approvals if the given developer does not develop
the site himself. The way around it is found through the purchase of the organization that
lobbied for the project, i.e. original developer, but there are no guarantees that such
organization doesn't own other assets or holds an unacceptable amount of debt from the
previous project.
There are numerous construction risks that are standard across the borders, but one
issue is unique to the process - the developer does not own the building until it is complete
and approved by the city inspectors. Only then is it allowed into the ownership through the
official entry with Moscomzem - Moscow Committee on Land.
There also are so called "special investment projects" that guarantee the developers
immunity from future increase in taxation and the return on investment. This so far is the
only vehicle to aid the private sector in the development process. However, most of the
projects offered with such status are either unfeasible or highly political. The only reason
for the City of Moscow to offer such guarantees is the share of the project proceeds that is
negotiated in the beginning of the project. Needless to say, the city of Moscow has their
preferred group of developers who are selected for the few reasonable projects. Many
companies are partly owned by the state through some opaque, convoluted structure.
Additional breaks offered to the foreign investor include immunization to the changes that
may affect the return for a period of seven years. In the volatile environment of the Russian
emerging market where laws are being revised every other month this would seem like a
reasonable protection. However, this might be neglected in cases where the interests of the
Federation might change in circumstances such as profit repatriation and tariffs important
in development and construction. Also, the building and the land can be taken by the
government - eminent domain; but not without compensation to the developer. The
determination of the compensation is not yet determined by any decree. To summarize the
risks:
* No Zoning, no method to calculate FAR; each site is considered individually.
+ One has to first buy the right to develop land without knowing what can actually be
developed.
+ No rules to calculate the escalators for land rent.
+ Lack of secure building rights during the construction period, since titles and longterm land lease agreements are available only after construction is completed.
+ Unreliable real property registration system.
+ Uncertainty concerning the expense requirements imposed by the city.
Russian investors are apparently less concerned about these problems, although the
absence of mortgagable right during construction is an issue for them as well. The courage
of Russians to invest under uncertain and unclear conditions can presumably be explained
by their relative inexperience and, in some cases, the priority of money laundering over
investment return.
Construction
The Russian construction industry remains highly inefficient, with a great deal of
power remaining with the large kombinat enterprises inherited from the Soviet past. Their
power lays in relationships with the municipal agencies that provide land and construction
approval, and in priority access to construction materials, both from established networks
and from direct control (vertical integration). The construction scene in Moscow is still
dominated by the Glavmosstroi, which was designed in the Soviet era to perform
construction for the state. The function of the new Glavmosstroi is still the same government contracts financed with the state's and the city of Moscow's budgets.
However, the function of the organization changed with the economy. Now it's a holding
company that owns other construction companies while merely passing along the money
received from the government budget. The trick is that it does not pay all at once but over a
period of time after construction. The system is such that the contractor is getting paid first
without the ability to pay the sub-contractor. The sub-contractor is the lag in the system.
The general contractor first reports to Glavmosstroi on the work performed by the subcontractor and then Glavmosstroi pays directly to the sub-contractor without holding the
contract with the party. Another trick is that the contractors are getting paid in bonds that
are bought by Glavmosstroi from the Independent Construction Bank. If the contractor
wants to get cash from the bank he is forced to wait until the maturity of the bond or take a
loss on the redemption. Despite the situation many construction companies are tied to
government work. They were developed in the Soviet era and are staffed for large capacity
projects that only come from the city or the state. In order to survive they have to stick
with Glavmosstroi's system. In such conditions contractors and sub-contractors are losing
qualified workers and are cutting corners with substitutions, safety requirements and overall quality of work. It is interesting to note that Glavmosstroi has a small development arm
that is supposedly financed out of the private funds separate from governmental moneys.
This small business is advertising luxury condominiums at a high price. It would be safe to
consider that the money delayed from the payments to construction companies for the
municipal projects could be at work here.
Legal Issues and Taxation
There have been some significant improvements in the tax structure of the
Federation. Lower tax rates and an improved tax administration have allowed the
government to reduce the tax burden on the economy, yet the budget revenues have also
grown thanks to the expansion of the tax base by 3% of GDP3 1 . A new procedure for the
taxation of corporate profit came into effect in 2002: the profit tax rate was brought down
from 35% to 24%; and the list of legal exemptions was expanded. Capital gains tax was
also reduced to 20/24% and the loss carry-forward is now set at 10 years. However, only
30% of any current year profits may be sheltered with prior year losses. Value added tax
(VAT) was also reduced to 20% and is expected to be further reduced by 2004.
The privileges for investment were abolished, and instead the depreciation rate was
accelerated. Personal income tax since 2001 is a flat rate of 13%. But further targeted
reduction in taxes might lead to some unexpected consequences. For instance, the intended
lowering of Unified Social Tax (currently 35.7%) will lower the excess tax pressure on
businesses and stimulate economic growth, but Russia's pension age is one of the lowest in
the world (55 years for women and 60 for men), and in a few years, due to the specific age
structure of the population, the share of the pensioners will sharply increase. In Russia, for
every 100 workers there are 69.2 pensioners, while in Germany there are 55.3, and in the
UK 40.6. Russia might have to accept the painful, but absolutely necessary, decision to
increase the retirement age.
Amounts of tax paid in accordance with the legislation of foreign countries by a
Russian organization shall be credited against the Russian tax payable by this organization.
In this respect, the total amount of taxes paid outside of Russia and subject to credit may
not exceed the amount of tax payable in Russia. The foreign tax on dividends received
from foreign sources, however, can be credited against the Russian tax only if such credit
is provided for by the double tax treaty (with the US in this instance). For other types of
income, a tax credit can be made regardless of whether a treaty exists.
Interest expense paid to a bank or non-bank company is deductible subject to arm's
length and thin capitalization tests (a debt to equity ratio of 3:1, or 12.5:1 for banks and
31
32
American Chamber of Commers in Moscow
Tax Code
leasing businesses). Thus, interest on any type of loan taken out to finance business related
expenses (current or capital expenses) is tax deductible. Interest expense on funds used to
acquire or construct capital assets will be deductible against operating income. Generally,
this was not previously deductible, although certain double tax treaties allowed
deductibility where shareholders were resident in such countries.
For real estate, stamp duty is not payable on real estate transfers, share sales or
leases. Land tax is fixed and paid quarterly based on the charges set by the government.
The tax determined based on location, proximity to metro, main roads etc. Complex ratios
are used but the charges are relatively minor. The Transfer tax is paid as VAT on a
building's value paid by the purchaser. However, recent changes may allow for full
recovery of payments. Capital gains tax is present in all transactions. Input VAT charged,
but only recoverable on completion and use of construction projects against rental income.
Nevertheless if the tenant is a foreign representative office it is exempt from paying VAT,
therefore full recovery may not be possible. Asset tax (up to 2%) is levied on net book
value of property and fixed assets. This usually is recovered via service charges and is
exempt during construction. Property's useful life is set to 30 years, with annual
depreciation of 3.32%.
Structuring Foreign Investment in Russian Real Estate
It is uncommon for foreign investors to conduct real business in Russia through a
branch of a foreign company. So, the classic offshore structure for the investment in
Russian real estate proves to be very efficient. In this case, the foreign institution
establishes an offshore development/ construction company that will in turn establish an
SPV (special purpose vehicle) in Russia to hold the property. If a Russian company owns
substantial real estate (more then 50% of its total assets), then it is advisable for an
offshore holding entity to be located in a country with which Russia has a tax treaty.
Capital gains from sales of shares in such Russian real estate companies are subject to a
20% capital gains tax in Russia unless exempt under a tax treaty. If the Russian company
pays dividends, a tax treaty will reduce the normal 15% Russian dividend withholding tax
to 10%, 5% or even to 0%. Cyprus has been the most popular location for such companies.
Cyprus has a tax treaty with Russia and also has a low income tax rate for such offshore
companies. Some investors in Russian real estate prefer the Netherlands, Luxemburg or
Denmark. These three countries have participation exemptions that exempt them from
local tax dividends and capital gains on qualifying investments. The Netherlands and
Luxemburg also permit the tax-efficient repatriation of capital and profits to tax havens.
When the company acquires real estate directly, the purchasing company obtains a
fair market value cost basis in Russia for depreciation purposes. There is no assumption of
liabilities for the selling entity. If debt financing is put in place at the level of acquiring the
company, the tax benefits in Russia allow for greater flexibility in repatriation of capital
and profits from Russia. However, the acquiring company is liable for 20% Russian VAT
on acquisition. Theoretically, Russian VAT is refundable after three months and accrues
interest until refunded, but there are no clear cases so far of such refund. Additionally an
accruing company may (directly or indirectly) incur capital gains tax in Russia upon the
sale as well as other tax costs in repatriating proceeds offshore.
The more popular method is the acquisition of the Russian holding company. This
method avoids the payment of VAT. However the company assumes the seller's historical
basis for depreciation purposes in Russia. Additional risks are the assumption of the
liabilities born by the seller company, difficulty in obtaining financing and issues with
capital and profit repatriation. If debt financing is not an issue, the most tax efficient
method remains an acquisition of the offshore company that holds Russian real estate.
The benefits of debt financing in Russia are worth considering. If a Russian entity
is used for the acquisition, the interest on debt can reduce the profits' tax exposure in
Russia and be used for more tax-efficient repatriation of profits from Russia. As noted in
the preceding segment (Legal Issues and Taxation), a Russian company with debt can
deduct interest on the debt if on an arm's length basis. If the debt is loaned by a foreign
person who is a more than 20% direct or indirect shareholder of the Russian borrower, then
there are limitations on the deductibility of interest if the borrower's debt/ equity ratio is
more then 3:1. However, an optimal debt structure may involve a foreign lender who is not
taxable on interest received, is exempt form the 20% interest withholding tax in Russia and
is allowed tax-free repatriation of Russian profits.
As it relates to local laws, foreign entrants should realize that land lease agreements
in Moscow prevent the secondary market. It only is possible to sell the building with the
land right agreement, but land speculation itself is not permitted. In acquiring the lease
rights one should examine for absence of material claims or lawsuits from competing
owners, the ability to pledge property as security for debt finance and for the ability to sell
the property in the future.
Corruption and Self Dealin2
The blurring of the distinction between government and business is a reality in the
Russian economy. In many regions, the executive bodies are headed by representatives of
the major financial and industrial groups with economic interests in regions. These
politicians make no distinction between the respective status of the businessman and public
servant. In Moscow, mayor Luzhkov owns few businesses and has direct and indirect
ownership in many more commercial organizations. His wife, for instance, controls all of
the manufacturing of the construction materials and a financial investment group. This
trend is detrimental to the emergence of fair competition in Russia, especially given that
large sectors of the Russian economy are operated by monopolies as it is. The United
States economy only became the world's most efficient after the adoption of tough antimonopoly legislation. Despite the fact that similar anti-monopoly stipulations exist in
Russia its enforcement proved to be difficult due to politicians' involvement on various
levels in the private sector.
Also, the research by the INDEM, 2002, reveals that business involvement in
corruption does not lead to enhanced efficiency.
It reveals that the executive branch plays
the greatest role in influencing business. Indeed the executive branch accounts for 98% of
the bribery that takes place in the Russian Economy. Overcoming administrative barriers
and pressure from official bodies costs business the equivalent of more then 10% of the
GDP.
3
American Chamber of Commerce in Russia, Economic policy review.
CHAPTER FOUR: FORECASTING
Market Forecast
Despite the limited number of observations and a significant discrepancy in sources
(±25%) I will attempt to forecast rent in two ways; one with Rent only Multivariate and
another using Rent and Vacancy Multivariate. The components of the forecast are:
Table 4.13
Russian macroeconomic indicators
INFLAT. EXCHG. UNEMPL.
M.
EMPL.
REF.
RT.
Year
FDI
OIL
GDP
1995
$2.1
$16.9
-4.0%
131%
$0.200
8.45%
1996
$2.6
$20.4
-3.4%
22%
$0.179
9.63%
3,900
84%
1997
$4.1
$18.3
1.4%
11%
$0.102
11.76%
3,800
34%
1998
$2.9
$12.7
-4.9%
84%
$0.048
13.22%
3,800
60%
1999
$3.1
$17.2
4.6%
36%
$0.037
12.93%
4,000
55%
2000
$4.4
$28.5
9.9%
20%
$0.036
9.90%
4,100
48%
2001
$3.9
$24.5
5.2%
19%
$0.033
8.74%
4,200
35%
2002
$3.0
$25.0
3.9%
15%
$0.031
8.00%
4,220
22%
2003
!4 0
1245
500/
11%
%0.032
7.92%
4.500
19%
180%
2004
2005
2006
2007
The independent variables are: Foreign Direct Investment (in billions), OPEC Oil prices
per barrel, GDP, Inflation, Exchange Rate, Unemployment Rate, Moscow Employment (in
millions), and Refinancing Rate. I will also use Supply, Stock, Occupied Stock, Vacancy,
and Real Rent using Tables 2.7, 2.8, 2.10, and 2.14.
3
Goscomstat, Economist Intelligence Unit, IMF, EBRD, JP Morgan, OPEC
Rent only Multivariate
This tests the significance of the independent variables and lags for Rent as a
dependant variable for the Rent Model. The results are as follows:
Table 4.2
Independent variablessignificancefor rent
RNT
R2
t-STAT
RNT-1
INFLAT
STOCK2
FDI-1
OIL
EXCHGE
UNEMPL-1
MOS. EMPL-1
REF. RT-1
0.366643061
0.721324627
0.612201895
0.253284713
0.157711879
0.323784348
0.294201567
0.197174784
0.225349482
-1.52169
-3.94087
2.176232
-1.3023
1.059931
1.694966
-1.44367
1.108154
1.206036
The most significant variables are Rnt-1, Inflation, Stock-2 and Exchange Rate with above
2 t-stats but still lower R2. The highest R2 in the results is 72% for Inflation.
Testing the significance of the independent variables and lags for Supply as
dependant variable for the Supply Model. The results are as follows:
Table 4.3
Independent variables significancefor supply
R2
t-STAT
0.318695016
0.382545103
0.863979632
1.809530355
2.082513012
-5.635530192
SUPPL
STOCK-1
SUPPL-2
RNT-1
Out of all the variables tested the most significant are in the table above with Rent-I
having the highest significance - R2 of 86%.
Setting up the regression tables:
Table 4.4
Regression table set-up for rent
Rent
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
$629.85
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
$490.39
Rent-1
Inflation
$629.85
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
$490.39
22.00%
11.00%
84.40%
36.50%
20.00%
19.00%
15.00%
11.00%
9.00%
7.70%
Stock-2
Exchange
114,000
152,000
237,500
332,500
617,500
855,000
1,045,000
1,254,000
$0.179
$0.102
$0.048
$0.037
$0.036
$0.033
$0.031
$0.032
$0.031
$0.029
2006
7.50%
$0.028
2007
7.00%
$0.026
Table 4.5
Regression table set-upfor supply
Supply
40,000
90,000
100,000
300,000
250,000
200,000
220,000
240.000
Supply-1
Stock-i
Rent-i
40,000
90,000
100,000
300,000
250,000
200,000
114,000
152,000
237,500
332,500
617,500
855,000
1,045,000
$629.85
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
Regression Results for Rent:
Table 4.6
Regresion resultsfor rent
Intercept
R2
Rent
0.99998
t-STAT
Coefficient
437.85789_
Rent-1
Inflation
17.74376
-39.7599
0.090059
-594.133
Stock-2
4.771138
2.09E-05
Exchange
2.644807
1871.357
The Regression has a good significance with the high R2.
Model for Rent:
Rent = 437.85789 + (0.090059 * Rent-1) + (-594.133 * Inflation) + (2.09E-05 * Stock -2)
+ (1871.357 * Exchange)
Regression Results for Supply:
Table 4.7
Regression resultsfor supply
t-STAT
Coefficient
Supply-1
Stock-1
-2.90738
6.217925
-0.15117
0.09252
Rent-1
-19.1841
-336.418
Supply
R2
Intercept
0.994823
327415.1
The Regression has a good significance with the high R2.
Model for Supply:
Supply = 327415.1 + (-0.15117 * Supply-1) + (0.09252 * Stock-1) + (-336.418 * Rent-1)
Model for Stock:
Stock = Stock-I + Supply
Solving all three formulas simultaneously:
Table 4.8
Rent only multivariateforecast
From the forecast it appears that rent, stock and supply are increasing.
Rent and Vacancy Multivariate
Using Tables 1 and 2, I am now testing the significance of the independent
variables and lags for Rent as the dependant variable for the Rent Model. The results are as
follows:
Table 4.9
Independent variablessignificancefor rent
R2
t-STAT
0.366643061
0.449223048
0.721324627
-1.521694476
1.564241356
-3.940866376
RNT
RNT-1
VAC-2
INFLAT
Out of all the variables tested the most significant are in the table above with Inflation
having the highest significance - R2 of 72%.
Testing the significance of the independent variables and lags for Supply as dependant
variable for the Supply Model. The results are as follows:
Table 4.10
Independent variablessignificancefor supply
R
SUPPL
STOCK-1
SUPPL-1
RNT-1
VAC-3
2
0.318695016
0.382545103
0.863979632
0.774538511
t-STAT
1.809530355
2.082513012
-5.635530192
-4.144482634
Out of all the variables tested the most significant are in the table above with Rent-1
having the highest significance - R2 of 86%.
Testing the significance of the independent variables and lags for Occupied Stock as
dependant variable for the Occupied Stock Model. The results are as follows:
Table 4.11
Independent variables significancefor occupiedstock
OCC STOCK
R
OCC-1
OCC-2
RNT-2
FDI
OIL-1
GDP-1
INFLAT
EXCHANGE-1
UNEMPL
MOS. EMPL
REF. RT
0.975578981
0.914922068
0.161603822
0.420791436
0.479505477
0.426935889
0.242739768
0.515683652
0.691439697
0.941993242
0.676053186
2
t-STAT
15.48192463
7.332778906
-0.878074095
2.255095712
2.351063338
0.426935889
-1.4979486
-2.307342786
-3.960555911
10.66187571
-3.822104841
Out of all the variables tested the most significant are in the table above with Moscow
Employment having the highest significance - R2 of 94% and a t-stat of 10; well above 2.
Another winner is its own lag OCC-I - R2 of 97% and a t-stat of 15.
Setting up the regression tables:
Table 4.12
Regression table set-up for rent
Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Rent
$629.85
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
$490.39
Rent-i
$629.85
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
$490.39
Vac-2
Inflation
22.00%
11.00%
84.40%
36.50%
20.00%
19.00%
15.00%
11.00%
9.00%
7.70%
7.50%
7.00%
6.0%
7.0%
14.0%
16.0%
11.0%
7.5%
4.5%
4.5%
Table 4.13
Regression table set-upfor supply
Stock-1
Rent-1
90,000
114,000
$629.85
100,000
300,000
250,000
200,000
220,000
240,000
152,000
237,500
332,500
617,500
855,000
1,045,000
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
Year
Supply
1996
40,000
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
$490.39
$507.18
$516.39
$519.12
Vac-3
6.0%
7.0%
14.0%
16.0%
11.0%
1
7.5%
4.5%
4.5%
Table 4.14
Regression table set-upfor occupied stock
Occ. Stock-1
Year
1996
Occ. Stock
1997
141,360
107,160
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
204,250
279,300
549,575
790,875
997,975
1.195.062
141,360
204,250
279,300
549,575
790,875
997,975
1,195,062
1,400,190
Rnt-2
107,160
Mos. Employ.
3,900
Exchange
$0.179
3,800
$0.102
3,800
4,000
4,100
4,200
4,220
4,500
4,510
4,530
$0.048
$0.037
$0.036
$0.033
$0.031
$0.032
$0.031
$0.029
1,613,238
4,560
$0.028
1,838,158
4,563
$0.026
$629.85
$693.31
$91.88
$301.63
$418.00
$430.92
$460.28
$490.39
Regression results for Rent:
Table 4.15
Regression resultsfor rent
R
RNT
2
0.999910294
Rent-1
Inflation
Vac-2
Intersept
t-STAT
Coefficients
18.88493713
0.109650754
-117.4365847
-578.9905452
-2.59362407
-76.4583352
508.9557597
The Regression has a good significance with the high R2 - 99%.
Model for Rent:
Rent = 508.9557597 + (0.109650754 * Rent-1) + (-578.9905452 * Inflation) +
+ (-76.4583352 * Vac-2)
Regression results for Supply:
Table 4.16
Regression results for supply
R
Supply
Intersept
2
0.981390868
t-STAT
Coefficients
333220.4074
Stock-i
2.691916743
Rent-i
-3.647112098
-282.4138873
Vac-3
-2.109661928
-415398.1666
0.080673758
The Regression has a good significance with the high R2 - 98%.
Model for Supply:
Supply = 333220.4074 + (0.080673758 * Stock-1) + (-282.4138873 * Rent-1) +
+ (-415398.1666 * Vac-3)
Model for Stock:
Stock = Stock-1 + Supply
Model for Vacancy:
Vacancy = 1.0 - Occupied Stock / Stock
Regression results for Occupied Stock:
Table 4.17
Regression resultsfor occupied stock
Occ. Stock
R2
Intercept
0.998707039
153298.8356
Occ. Stock-i
Rent-2
Mos. Employment
t-STAT
Coefficients
12.41999849
1.050805736
-6.306609108
-341.6642451
.262935196
34.64643838
The Regression has a good significance with the high R2 - 99%.
Model for Stock:
Occ. Stock
=
53298.8356 + (1.050805736* Occ. Stock-1) + (-341.6642451 * Rent-2) +
+ (34.64643838 * Mos. Employment)
Solving all formulas simultaneously and adjusting forecasted stock for depreciation at 5%:
Table 4.18
Rent and vacancy multivariateforecast
YEAR
2004
2005
2006
2007
SUPPL
264,737
288,915
303,109
325,625
I
STOCK
OCC STOCK
I VAC I
REAL RNT
From the forecast it appears that rent, stock and supply are increasing but with a slower
rate than the first forecast model. The vacancy is decreasing with the high increase of
supply, thus the rent is increasing. Comparing Rent only Multivariate and Rent and
Vacancy Multivariate:
Table 4.19
Rent only and rent and vacancy multivariatecomparison
Rnt.
Only
$507.98
$519.12
$522.71
$ 525.97
Rnt. & Vac
$
$
$
$
507.18
516.55
519.55
522.90
%
-0.16%
-0.50%
-0.60%
-0.58%
The rents from the forecasts of each model are very close to one another. The difference is
less then one percent per year. Thus I would consider the outcome to be significant. I will
use the results from the Rent and Vacancy Multivariate forecast from this point forward.
Table 4.20
Forecastingresultsfrom the rent & vacancy model:
NOM RNT
YEAR
SUPPL
STOCK
OCC STOCK
VAC
RNT
1996
40,000
114,000
107,160
6.0%
$ 629.85
$
807.50
1997
90,000
152,000
141,360
7.0%
$ 693.31
$
779.00
1998
100,000
237,500
204,250
14.0%
$
91.88
$
589.00
1999
300,000
332,500
279,300
16.0%
$ 301.63
$
475.00
2000
250,000
617,500
549,575
11.0%
$ 418.00
$
522.50
2001
200,000
855,000
790,875
7.5%
$ 430.92
$
532.00
2002
220,000
1,045,000
997,975
4.5%
$ 460.28
$
541.50
2003
240,000
1,254,000
1,195,062
4.5%
$ 490.39
$
551.00
2004
2005
2006
2007
Table 4.21
Market Dynamic / Percent Change:
YEAR
SUPPL
STOCK
OCC STOCK
VAC
RNT
NOM RNT
1997
125.0%
33.3%
31.9%
16.7%
10.1%
-3.5%
1998
11.1%
56.3%
44.5%
100.0%
-86.7%
-24.4%
1999
200.0%
40.0%
36.7%
14.3%
228.3%
-19.4%
2000
-16.7%
85.7%
96.8%
-31.3%
38.6%
10.0%
2001
-20.0%
38.5%
43.9%
-31.8%
3.1%
1.8%
2002
10.0%
22.2%
26.2%
-40.0%
6.8%
1.8%
2003
9.1%
20.0%
19.7%
0%
6.5%
1.8%
2004
2005
2006
2007
Figure 4.1
Market Dynamic / PercentChange:
As apparent from the graph the market is calming down in the beginning of the century. It
would be useful to observe this part in detail:
Figure 4.2
Moscow office market real estate indicatorsgrowth rates (2001-2007)
% Change
-- +- Supply -a-
Stock -*-
Vacancy -l-- Real Rent -.-
Occ Stock
Nominal Rent
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
-10.0%
-20.0%
-30.0%
-40.0%
-50.0%
Year
As inflation is calming down Real and Nominal rent appear to be the same. Vacancy is
increasing due to the still abundant supply coming to the market with the lag; however it
will soon drop as the supply will slow down its pace and its rate will start to look a lot like
stock. With increased demand and limited supply, vacancy will drop again, driving up
nominal rent in 2004. The downward trend for vacancy from 2005 on continues with high
demand for space, matching rent recovery at around 2006.
Forecasting Cap Rates3 5
Using Tables 2.7, 2.8, 4.1, and 4.20, I am testing the significance of the independent
variables and lags for Cap Rate as the dependant variable for the Cap Rate Model. The
most significant regression was as follows:
35
Historic cap rates collected from Noble Gibbons, DTZ, JJL, Colliers, Stiles Riabokobylko.
Table 4.22
Cap rate regression output
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.98
0.97
0.93
0.01
8
ANOVA
4
3
7
SS
0.01
0.00
0.01
Coef
-0.05
-0
0
1.86
0.04
Stand
Err
0.06
0.00
0.00
0.35
0.02
df
Regression
Residual
Total
Intercept
Supply
Oil Price
Unemployment
Refinancing Rate
MS
0.00
0.00
t Stat
-0.93
-1.53
2.21
5.32
1.85
F
23.57
SignifF
0.013
Pvalue
0.42
0.22
0.11
0.01
0.16
Lower
95%
-0.24
0.00
0.00
0.75
-0.03
Upper
95%
0.13
0.00
0.01
2.98
0.11
Lower
95.0%
-0.24
0.00
0.00
0.75
-0.03
Upper
95.0%
0.13
0.00
0.01
2.98
0.11
The Regression has a good significance with the high R - 97%; most of the t-stat above 2.
2
Model for Cap Rate:
Cap Rate = -0.0541047 + (-.00000001 * Supply) + (0.0032626 * Oil Price) +
+ (1.8647835 * Unemployment) + (0.0395307 * Refinancing Rate)
Cap Rates are as follows:
Table 4.23
Cap rateforecast
Year
96
Cap
22%
97
98
23% 25%
99
00
24% 22%
01
02
03
04
05
06
07
20%
16%
14%
13%
12%
12%
11%
Reconstructing Figure 2.10 to include forecasted returns for US investors:
Table 4.24
Real returnsforecastfor US investors
Year
Real Rnt.
Cap Rt.
Real V
1996
$780.69
22%
$3,548.60
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
$765.76
$579.52
$462.27
$504.79
$523.75
$526.93
$539.98
$552.60
$555.91
$557.79
$558.72
23%
25%
24%
22%
20%
16%
14%
13%
12%
12%
11%
$3,329.38
$2,318.07
$1,926.13
$2,294.49
$2,618.77
$3,293.34
$3,857.00
$4,228.43
$4,470.63
$4,674.27
$4,864.83
Real r
16%
-7%
8%
43%
36%
46%
33%
24%
19%
17%
16%
Reconstructing Table 2.14 to include forecasted returns for Russian investors:
Table 4.25
Real returnsforecastfor Russian investors
Year
Real Rnt.
Cap Rt.
Real V
1996
3,410.06p.
22%
15,500.26p.
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
6,678.93p.
1,866.86p.
7,925.62p.
1,371.85p.
12,786.62p.
14,234.06p.
15,234.46p.
16,343.22p.
17, 4 45. 5 5p.
18,367.94p.
18, 86 1.6 8 p.
23%
25%
24%
22%
20%
16%
14%
13%
12%
12%
11%
29,038.84p.
7,467.43p.
33,023.41p.
51,690.21p.
63,933.08p.
88,962.87p.
108,817.54p.
125,055.77p.
140,297.17p.
153,923.60p.
164,231.68p.
Real r
109%
-51%
367%
81%
46%
59%
38%
29%
25%
22%
19%
Reconstructing the return index for both Russian and US investors (Figure 2.9):
Figure 4.3
US vs. Russian investors realperiodic returnsforecast (1997-2007)
Returns
---
..
400%...........
..-
Russian Returns -- m- US Returns
- -----.-
....-
--
-.
----
350%
300%
250%
200%150%
100%
50%
0%-50%
1997
-
8
1999
2000
2001
2002
2003
2004
2005
2006
2007
-100%
Year
Figure 4.4
US vs. Russian investors realperiodic returnsforecast (2000-2007)
-4*- Russian Returns
Returns
-m- US Returns
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2000
2001
2002
2004
2003
Year
2005
2006
2007
As apparent from the graph, the returns are diminishing and stabilizing for both investors.
Russian and American returns are becoming highly correlated with similar volatility from
2000 on. The comeback of the Russian market is projected to sustain itself; thus the rapidly
growing Real Estate sector might take a similar position as it does in the US. The supply
and absorption (reconstructing Figure 2.5) are projected to rise taking the shape of a
healthy market:
Figure 4.5
Supply and absorptioforecast
Sq. M
---
Supply --
Absorption
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
1996
1997
1998
1999 2000
2001
2002 2003 2004
Year
2005
2006 2007
Figure 4.6
Stock vs. cumulative absorbtion
Sq. M
-4-
2,500.000 - -
-
-
-
- - -
Stock -M- Cumulative Absorption
- - -
-
--
-
- -
-
-
-.........
2,000,000
1,500,000
1,000,000
500,000
1996
1997 1998
1999 2000 2001
2002 2003 2004 2005 2006 2007
Year
IRR Comparison
Since most of the institutional investors would consider Russian real estate an
alternative investment, it would be reasonable to conclude with historic and projected
IRR's from Russian real estate:
Table 4.26
Historic andforecastedIRR's for US and Russian investors
US Investors
Russian Investors
1996-2003
16.88%
54.87%
2000-2007
|
2003-2007
I
As most of the opportunity and venture capital funds operating in the emerging
markets report IRR's of 22%, Russia presents a mixed bag ranging from a historical 16% to
a projected 30%. Despite the infamous devaluation of 1998, Russian real estate can still be
considered an attractive alternative investment to hold in the portfolio of an institutional
investor as it appears to be negatively correlated with World securities (Figure 2.10).
CHAPTER FIVE: CONCLUSIONS
An Overview of the US Market Participants
There are several Western companies that are seriously involved in Russian real
estate today. US representatives are Hines, AIG, Harbor Global Company, GE Capital
Golub, Hiteman Group and NCH Capital. There also is a strong presence of Fleming
Family fund from England, which is partially owned by US investors. All companies have
global holdings and are well diversified in their assets.
Hines is by far the most enduring company on the market. In the early 90's Hines
entered the Moscow market as a property and construction manager. This method of entry
allowed Hines to become familiar with the market. Hines can be considered one of the few
real estate companies that until recently did not have a Russian partner. Their first
development scheme was rather conservative. They secured a plot of land for the
construction of the Russian-American school for the children of American diplomats in
Moscow. Subsequently they developed a housing neighborhood for the whole diplomatic
mission. The project enjoyed various benefits, including some tax relief, due to its
diplomatic status. The houses are still held by Hines as rental properties, yielding high
returns. The recent investment of Hines is a bit more aggressive in nature. Hines is
developing a multistory office building with a Russian partner who contributed land to the
partnership. The project is being financed from the Hines Emerging market fund and is
scheduled to break ground this year.
Harbor Global owns the Meridian tower through its Moscow company - PIO
Global. The tower fully recovered the investment made by the company in 1996 and is
operating as a pure profit-maker for the company. The tower is considered a class B
building by location, as it is located in one of the most remote locations from the center of
Moscow. However its proximity to the airport and traffic-free environment led to 100%
occupancy by foreign companies. PIO Global is an asset management company that
invests in Russian equities and debt instruments. The company recently came out with the
first Russian index fund. The company holds high hopes on the restructuring of the
Russian pension system. By the end of this year, some three billion dollars of Russian
pension money is scheduled to flood the securities market. PIO Global is well positioned
for the investment management service because they have fit the requirement for
experience and sufficient capitalization on the market. The management believes that the
cash stream from the Meridian tower could be further securitized and held as an asset in
the portfolio of the future pension fund investors. Additional investments would allow the
company to expand into real estate, as they have much experience with their star asset.
Both AIG and GE Golub are in the early stages of entry into the Moscow market.
The companies are being very careful in choosing strategic partnerships for their schemes.
AIG and GE Golub, became interested in the market when their Eastern European holdings
began showing the signs of weakness. Using their operations in the East, the two are
evaluating a couple of acquisition opportunities; nonetheless both are more interested in
development.
Fleming Family dedicated US $60m. early this year for the acquisition of prime
real estate in Moscow. The intention is to lever up to US $160-170m and become the only
dedicated real estate Moscow fund. Despite such a bold commitment, property acquisition
in Moscow has proven to be a difficult business. The only negotiations for an asset located
in the city center were abandoned due to the lack of transparency in the ownership
structure of the building.
NCH Capital is the largest foreign owner of real assets in former Soviet republics.
The fund currently has US $2b under management in their private equity portfolio. The
investments are held in Baltic republics- Kazakhstan, Ukraine, Belarus and Russia.
Moscow is the only place they are not. The strategy of this company is to dominate early
on the markets where there is no competition. The management believes that Moscow is
becoming too political and expensive to compete for; the lack of land rights and overall
immaturity of the market steers the fund into second tier cities in Russia.
All companies found it difficult to compete on the market due to its immaturity and
high risks involved in the regulatory system. An undisclosed US fund lost as much as US
$30m in the approval process, before its exit from the market. However, remaining entrants
are counting on 25-35% IRR on their investment, while none, except for AIG are hedging
the currency. To better manage regulatory risks, those involved in the development
schemes are all negotiating with local partners. Despite the all the risks, the majority of the
participants are as exited about Russian real estate as they were before 1998.
Conclusions
The source of the advantage for Russian investors/ developers in Moscow has been
their opportunistic entry after the devaluation of ruble in 1998. Exchange rate volatility and
inflation were the guiding factors for domestic capital that didn't need to cross borders to
repatriate profits. Rising oil prices and economic stability secured the position of the
domestic investors, while US institutions were still getting over the shock of the default.
By the time foreigners began to come back into Moscow, lured by the rampant progress
and political commitment to reforms, the Russian companies were already dominating the
market by their superior returns and experience with the regulatory system. However, most
of the abnormal returns can only be attributed to the volatility in the historic time period
chosen for this thesis. As the inflation and exchange rate become more stable, the returns
for Russian investors will come down to the conventional norms; thus allowing US
companies to enter the market in an efficient way. As the spread between Russian and US
risk-adjusted returns narrows, the only risk remaining for the US investors/ developers will
be in the regulatory system.
In order to become a globally recognized as a free market, Russia has to, and
pledges full commitment to, continuing reform of its regulatory environment. It is
important to reform the banking sector and reduce dependency of the Federation on the
natural resource sector. Restructuring is needed in the governmental sector, as there are too
many agencies involved in contradictory actions without clear hierarchy, direction and
mismatched responsibilities. The involvement of the government in the quasi-private
monopolies has to stop as its stake in private companies negates free competition and
defies the rules of the open economy.
In the area of real estate, free-hold of land has to become uniform throughout the
Federation. Clarity in title registration and reform of the development approval system is
needed. Land ownership will help to improve real estate lending. Zoning guidelines have
to be instituted in all areas of the country to aid investment evaluation. Reduction of
control of the municipal government in regulatory process and construction will unlock the
power of the capital and reward Russian real estate with increased liquidity on the asset
market.
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Interviews:
Eugine Golub - Golub and Company; Kevin Fitzpatric,PeterSeeley - AIG Global Real
Estate Investment Corp.; Alexei Balanin - Hines; Maksim Kunin - FFP;Mark Bartholomy
- Clifford Chance; James Sheppard, Stephen Kasnet - Harbor Global; Artem Grigorian-
GE Capital Golub; Ilya Metelkin, Mikhail Yakoubov - The Institutefor Urban Economics;
Mikko Petrov - Skanska East Europe Oy; James Smyth - Baubetreuungs and
Beratungsgmbh;Ivan Antonov - Moscow City Gov; Alla Svirschevskaya - Brunswick
Capital;Pavel Barbashov - CMI; Stephen Wilson - DTZ; Andrei Tkachenko - Tonnex;
Andrei Uspensky - PIO Global; Gerald Gaige - EYI; PeterRoshchin, Jack Kelleher Noble Gibbons, DaryaAfanasieva - Stiles & Riabokobylko; Igor Litvak - Delta Capital;
Natalia Osipova - ColliersInternational,Veta Riabtseva - Jones Lang LaSalle; George
Rohr - NCH Capital;Miff Chichester- CB HillierParker.