Real Estate

The Collapse of the Moscow Office Market

Anyone driving around Moscow this spring cannot help notice the number of shell and core buildings that appear to have been abandoned, which the real estate people aptly call: ‘distressed buildings’. Hard not to notice also, are the signs over the streets advertising offices to rent at ridiculously low prices, such as: ‘office to rent by a Metro, $350 a sq metre per year’ (psmpy). As the months go by, there are fewer such signs around, but nevertheless they are there. Even if the Metro concerned is in a rough area right on the outskirts of the metropolis, and the office is class B or below, these kind of prices in a city that was up to eighteen months ago was as expensive as Manhattan are truly remarkable. Good news for the end-user, but catastrophic for developers, investors and owners.

You can now pick up a ‘prime class A’ (meaning within the boulevard ring, although classification of offices has never really been sorted out in Moscow due to various vested interests) office suite for around $1000 psmpy, space which used to cost up to $2000 psmpy. Prices have not just fallen, they have collapsed. Between the boulevard ring and the garden ring, good ‘class A’ office space can be found for between $600 and $700 psmpy, which also represents a significant drop on the 2nd or 3rd quarter of 2008. You can sublet space in a building leased by another company for around $400 psmpy, although the original tenant may be locked into a lease of $800 or $900 psmpy. The class B office space, which represents about 10 million square meters of the total 11.5 million square metre’ office market has also fallen dramatically, and offices which can be leased for prices descending to lows not reached since 1999. Cushman & Wakefield Stiles & Riabokobylko report a 41% drop in class A office prices in Moscow from September 2008.

The office market was hit on all sides, at the same time. Financing collapsed at the same time as the nature of demand changed radically, and this was just after a boom when companies took on more office space to cope with future expansion. Almost all the buildings earmarked for completion in 2009 and 2010 have been halted. Vacancy rates, according to various sources is in the region of 20- 25% even now, when we are supposed to have come out of the crisis. According to Credit Suisse, about 2.5 million square meters of office space in Moscow is now empty, needing 3-4 years to fill under normal circumstances.

Maxim Zhulikov, leading expert in commercial real estate department Penny Lane

Many cranes are at a standstill even at Moscow landmark project, Moscow City. Two projects, one being North Tower, constructed by Severstaltrans, and the other Embankment Tower being constructed by Enka will be finished, but all other projects appear to have halted, although it is now extremely difficult to obtain accurate information from developers who were falling over themselves to talk to the press a year ago. Governmental agencies will not allow the Federation Tower project to fail, and information from various sources indicates that Alfa Bank, through stock acquisition, will ensure the troubled developer finishes the project. Whether or not these buildings, once completed, will be financially viable is another question that nobody is prepared to answer now.

Maxim Zhulikov, leading expert in commercial real estate department Penny Lane commented: “The nature of the market has shrunk, tenants are not leasing for strategic goals, they are taking advantage of short term opportunities. People [developers] panicked a year ago and thought that perhaps there will be no demand for their building, perhaps there will be no market at all, so they decided not to finish their projects, with a few exceptions. Those that finished have come up against another problem: how to lease in shell and core condition. Before, lessees were happy to take on property in this condition and pay for fit out, now they are not, and there is zero demand for such office space. It costs $600- $700 a square meter to fit out shell and core, you have to communicate with a whole load of builders, it is a nerveracking, expensive experience. Prices have returned more or less to what they were in 1999. There are many similarities between the market then and now, with the exception that there are many many more buildings now than then.”

However it is not only demand that has shrunk, most Russian developers (and it is they who are building 99% of real estate in Moscow) are experiencing severe financial difficulties, and would not be able to complete their projects even if demand was to take off tomorrow. About 50% of class A and even class B projects were refinanced by Western banks once construction was complete. The projects were financed by Russian banks during construction with high interest corporate loans (usually 7%-15% which have risen to up to 25% per year) with clauses stipulating that the whole corporate structure would be at risk if the developer defaulted on payments.

Elisabeth Pestl, partner in the estate team at CMS Russia explained: “All the developer’s projects would be at risk rather than one particular building, as would be the case with construction finance in countries such as the UK, where in a severe crisis, it would be possible to cherry- pick the best projects and leave the others to fail. Non-recourse construction finance never really appeared in Russia because of issues with registering the title of the building before it is completed. It is not easy to enforce loans secured by the title over the course of the construction period, and so the developer had to go elsewhere for a relatively large part of the development financing, but could expect the final financing to be refinanced by a western bank.” But western banks have more or less stopped lending.

Some Russian banks have demanded stock in place of repayment of debt. Almost all buildings built in Moscow recently, with the exception of the Lesnaya building (AIG Lincoln) were constructed on a partnership basis between a western developer and a local Russian developer, with the Russian developer bearing most of the construction development costs.

The little acquisition activity that there has been, commented Elisabeth Pestl, has been financed by funds which already had commitments from their investors, and they simply had to make an acquisition within a certain period of time. Even with funds an acquisition is not 100% fund money but also involved some third party debt. “Such funds are usually designed for a 5-7 year program, and they are usually committed to spend this money within certain time periods. However there has not been a lot of ‘quality product’ coming to market. At least one fund has left Russia without making any acquisitions; others have achieved serious price reductions.”

The German fund Kanam Grund, for example, which intended to acquire the ‘Vivaldi plaza’ Business Centre before the crisis for $900 million and Citydel business centre for $600 million, achieved a 25% reduction on ‘Vivaldi Plaza’ and refused to purchase the Citydel complex altogether. Some Russian banks are stepping in to help chosen Russian developers through stockbuying programs, but this has meant that developers are not looking to reduce the prices of their buildings in the near future (why should they, there may be more bailouts), and by no means all developers will be favourably treated. Furthermore, the Russian banking crisis is not yet over.

Olga Archangelskaya, partner and head of real estate advisory services Russia and the CIS of Ernst & Young

At the same time that financing has dried up, demand has contracted. As a result few people are now looking for new space for expansion, they are looking for tenants to sublet the spaces they have. Maxim Zhulikov added that demand has not really evaporated, it has changed. “Demand has not become less, it has just changed. Many foreign companies, for example, stopped leasing large premises, but when prices fell from their peak in late 2008, many Russian companies which previously had to decentralize their offices to cut costs moved back downtown. Whereas they were paying $600 or $700 for class B in the outskirts, now they could centralize and pay less for a class A office. The number of sq. meters dealt with by this company has not changed throughout the last year, but prices have changed. On average, tenants agree to sign leases of about three years now, not ten years because the owners hope that the market will recover eventually.”

One would hope that the current crisis has a silver lining, and developers will act differently in the future. Olga Archangelskaya, partner and head of real estate advisory services Russia and the CIS of Ernst & Young commented: “Personally speaking, I don’t think developers will change their practices strongly, however it does seem that huge projects of four, five or six thousands meters will not be built, or at least they will not be built in the way they were originally conceived. Secondly, I think that more attention will be placed on the quality of construction, and I mean bad building practices where a developer will build with lower ceiling heights to fit more people in, because then the market would pick that up. Now the market will not accept that kind of building. I also think that development beyond MKAD will resume, but not for a while, because lease rates there have fallen even more in these areas than in the center and vacancy rates have risen faster. I don’t though that even the present crisis is enough to change the legal environment for the better.”

Now that there is real choice, there may be an increased demand for more sustainable, comfortable buildings, but unless there is a sea-change in public awareness in this regard, only for Western corporate clients who demand this kind of accommodation.

Maxim Zhulikov commented: “My own opinion is that the market, like all real estate markets will fall back into the boombust cycle, starting in the autumn.”

The fundamental shift from looking at real estate as a short-term, low-quality ‘product’ which can be built for maximum profit only, to a long-term, high quality, income producing investment is not about to happen in Russia, as in many other countries, unless activists in organizations such as the Russian Green Building Council actually start changing public opinion, and that is extremely difficult in Russia.