I have been asked by a number of people over the last few days about the effect of recent events on property valuations in the Russian market. Therefore, three years on from the original blog, I thought I would give my brief comments on the topic, even though the situation is very fluid and fast moving at the moment.
There are a number of potential drivers of change of property valuations on the Russian market at the moment and I summarise these below, in no particular order:
International sentiment has certainly been rattled by recent events, which I do not intend to describe in detail. These can be broken down into longer-term effects, which tend to be part of an ongoing drip, drip, drip of negative coverage, particularly in the Western media, which plays to an audience already pre-disposed to think the worst of Russia; and shorter term effects, such as the recent and rather sudden US sanctions, which provoked a sharp, broad-based concern, which had significant immediate effects.
This second category seems to be unwinding as expected, and the US already seems to be rowing back from its previous position. For those with open minds, and interested in attractive returns, the effect on sentiment is likely to be minimal, even in the short term. However, they are likely to approach all opportunities with a little bit more caution.
Lower Economic Activity
Although I believe that much of the reaction to recent events has been overblown, there will certainly be a feed-through to economic activity this year. GDP growth for 2018 is now likely to be 0.1 pp or 0.2 pp lower than expected. Not huge but can have a knock on effect on, for example, consumer spending.
The most visible manifestation of recent ructions (besides the Rusal share price) has been the sharp weakening of the ruble. This was overdone and we are already seeing the ruble returning back towards where it was 2 to 3 weeks ago. However, the ruble will be weaker on average this year. This may push inflation up, reducing the CBR’s room for manoeuvre (see below) and may also be a drag on consumer spending.
I have heard concern that the weakening and volatility of the ruble is likely to have a negative effect on the values of properties where the leases are predominantly dominated in hard currencies. However, the number of these leases is now much smaller than previously, and as I believe the period of volatility has already passed, I do not see any effect here.
Cost & Availability of Debt
There are no clear indications, yet, if there will be an effect on property markets. However, whereas the debt markets were starting to be very competitive, with some great deals on offer, this tendency may go on hold for a while. Debt is likely to become more expensive, at least in the short term, and scarcer.
Inflation and Policy Rate
As outlined above, there may well be a short to medium term effect on inflation, which will now be higher than we originally expected for 2018 on average. More significantly the Central Bank of Russia (CBR) will now be more constrained in considering further cuts to the policy rate, particularly when the weaker ruble is taken into account.
We had expected further cuts this year of 75-100bps, but that is not now the case. I still expect to see cuts of 25 to 50bps, but the effect will be more muted.
This affects the cost of debt, consumer spending and the capitalisation rates for commercial property (although the link is weak and takes some time to feed through). However, I expect that the rate cuts are simply delayed and will still take place over the next 18-24 months. The expected cuts in the policy rate had not yet been priced into property valuations and I do not expect there to be any effect.
One of the major effects of uncertainty, both as regards Russia, but also in various parts of the Middle East, is that there has been a significant rally in the oil price. As I write it has just passed above $75 per barrel for Brent, compared with $67.5 just two weeks ago. An increase of 11% over that period.
With a weaker ruble this is a significant positive for the Russian budget, and also has a positive effect on sentiment. With extra revenues the government will be able to spend more freely towards some of the identified objectives. Government spending will offset, to an extent, other negative effects and will support real wage growth and consumer spending. Arguably this is the most important effect of all and the oil price is sanction proof.
What Does That All Mean
I believe that most of the recent upheaval is short term, and we may already be seeing the back of it. There will be some longer term effects, but nothing significant. I do not see any reason to change our approach to property valuations at this stage, or to change our view on cap rates, discount rates or ERVs. Unless there is a severe and sustained downturn in the broader economy I still believe that the property asset class represents a real buying opportunity and I will not, at this stage, be adjusting my approach to valuations.
As I said in my last blog – Don’t Panic! That is certainly what I am doing in our property valuations.