Tim Gosling in Moscow -

The booming real estate sector in Russia is anything but a secret. However, with the majority of international developers unable to vault the barriers to market entry and no more than a handful of institutional investors making headway – and even those through joint ventures at the far end of the pipeline – it's been left to domestic developers to make most of the running.

Russian companies have been keen to take up the baton, and those that have managed to structure themselves transparently enough have rushed to float on the international markets – with London's AIM the choice of many. In the last 12 months, IPOs have come thick and fast, raising $2.85bn, according to Renaissance Capital – with each apparently keen to outbid its predecessor in terms of size and success.

However, this year, as the pace has accelerated, disappointing results have started to appear. And although property remains atop the wave it has been riding across Europe for at least 36 months, analysts suggest investors are becoming more discerning.

AFI's float in May, which was followed by a dramatic drop in value, was a focal point. Since then, only PIK has gone to the market, and although Europe's fifth largest property IPO raised $1.85bn, it was still priced towards the bottom end of its range. However, recent history suggests the sector is more than robust enough to overcome the occasional blip.

For instance, it was only just over a year ago that the first institutional investor to buy in Russia, UK fund manager Fleming Family & Partners, had to pull its offering of a new development fund on AIM. The managers turned around almost instantly and found enough cash to power the vehicle privately.

Still, although the fundamentals remain strong enough to drive impressive growth for the sector as a whole – rental rates for prime office in Moscow have increased 38%, sale values for warehouses jumped 33% and retail rose 56%, according to Renaissance Capital – as with the rest of the equity universe, investors will need to start paying greater attention to specific companies. The nature of the sector demands it – it's one of the least transparent, is highly dependent on contacts within the public sector, features relatively small companies and is high risk in terms of land rights.

Going for gold

The latest fillip for the country as a whole illustrates the point. Although merely being a candidate to host the 2014 Winter Olympics was enough for development to flourish in Sochi over the past year or so, actually getting the games will power a wave of construction unprecedented outside of the major cities. Those companies that got in early to claim rights to plots are top of the list, UBS wrote in a note, while it also points out the advantages for retailers, and therefore retail development.

"Sochi creates a major upside for developers with Krasnodar Region exposure — in particular Open Investments, somewhat Sistema-Hals, and potentially Mirland. Finally, Krasnodar-headquartered Magnit already derives 14% of its revenues from the Black Sea shore and owns eight sites for hypermarkets there. This gives it an essential presence as development triggers consumption over the next seven years," UBS said.

While investors have few choices outside the riskier development phase of the market in Russia, given the lack of suitable standing product available for dedicated investment vehicles, this offers the prospect of significant upside in the coming years.

Renaissance Capital suggests that capital market yields have fallen by 300 basis points in office and retail in the last year, warehouses by 400 basis points, and it could be assumed there's still room for further pricing growth, given both global and – nearer to home - CEE trends.

Certainly, Renaissance Capital joins the bullish camp: "Although property values in all segments are at an all-time high, most leading indicators point to further strength in the market and, we believe, the boom in the real-estate sector is set to continue. Real-estate performance should be well supported by growth in the economy, falling interest rates and the increasing availability of credit financing, as well as an increasing influx of Western developers and investors into the local markets."

Developers look set to benefit from both ends. The cost of financing has dropped dramatically in the last 18 months, as European specialists such as Eurohypo and Hypo Real Estate have launched operations in the country. The likes of Sberbank have responded by slashing interest rates and improving terms. Still, most deals are refinancing loans for the moment. As things progress, however, the banks are becoming more comfortable with offering project financing, which will offer further cost advantages.

On the other side, there is a growing amount of cash waiting to be invested. International property funds have been setting up huge investment vehicles over the last two years, and although they've been holding out a little in the face of high prices, they're likely to be forced to pay top dollar for institutional product when it eventually does come to market.

With a first proper wave of quality product on the horizon – likely to come onto the market towards the end of the year – it seems probable that the first large deal or two will see a domino effect. Who wants to be left out after financing an office for a couple of years? In addition, if the move towards euro-denominated deals continues, developers should be able to shave another 100 basis points or so off yields.

Given all this then, it can be a struggle to see the wood for the trees, but there are differentiations to be made.

Variations on a theme

Firstly, although retail space still lags other major European cities – Moscow has around 148 square metres (sqm) per 1,000 inhabitants compared with 700 sqm in Barcelona, according to Renaissance Capital - and the Russian consumer boom continues unabated, this segment is the furthest progressed. The shopping centre pipeline in Russia is already the largest in Europe by some way. There's already concern that some regional cities will see over-supply in the medium term, and it's no coincidence that retail dominated the property investment market last year.

Office, warehousing, hotel and residential all remain significantly undersupplied. That said, there's also some variation here. While residential prices rocketed last year, with price growth in the upper segments around 90%, that has slowed dramatically this year, and although set to continue, the pace has now slowed to walking pace. Office, on the other hand, remains in huge demand as companies expand and new entrants arrive in Russia. Thus far, expansion among domestic companies has been only the tip of the iceberg, suggest analysts.

Yet once again, both barriers and demand remain in all the segments and, therefore, strong opportunities exist across the board.

"The market is still in a speculative phase of development," Renaissance Capital comments. "In an environment of fast-moving property prices, and dwindling availability of land plots suitable for development and with the appropriate infrastructure, most real-estate developers are focusing on expanding their property portfolios and exploiting the best opportunities on the market. Building a strong pipeline of projects stretching well into the next decade is considered a prerequisite of gaining competitive advantage … Among developers, companies with a strong, diversified pipeline of projects and land banks concentrated in high demand/high growth areas are likely to outperform."

Given the issues facing developers mentioned earlier, publicly traded companies are only likely to see their values rise suggests Renaissance Capital. "Over time, the advantages of public real estate companies such as liquidity, transparency, access to capital and higher market profile will stimulate a continuous increase in their share of the commercial real estate market."

Of course, it's not just developers and investors that are set to reap the rewards. As Renaissance Capital points out, the construction sector also offers strong opportunities, especially on the back of the government's push on housing.

"Although it often takes longer to find its way down into the market, the numbers we see for public-sector spending are huge," the bank says. "For example, the government aims to double the construction of residential housing in the next five years, and has allocated about $9.7bn to special housing and a utilities reform plan. A further $45bn is to be spent on infrastructure improvement - mostly roads, bridges and tunnels.

As a result Renaissance expects a wave of construction-company IPOs in the near future. "Poland, with a population of just over one-quarter of Russia's, has 345,000 construction enterprises; while in Russia, a mere 130,000 construction companies are trying to accommodate the needs of the country's 143m population," it says.

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