Thomas Mundy of Jones Lang LaSalle -
With €102bn invested in the European commercial real estate market in the first half of this year – 65% up on the same period two years ago – the disparity between lackluster Russia and booming Europe could not be greater. By comparison, volumes in the first six months of this year in Russia more than halved to €1bn versus two years ago. This divergence in performance has been driven by a combination of continued interest for developed market assets, supported by massive amounts of liquidity, contrasted with a rapid decline in the economic expectations that the market prices in for Russia and the decline in liquidity. Given this divergence in investor appetite and interest, we think it’s worth asking the question: is it time to the call the bottom of the Russian real estate market?
Q2 2015 investment confirms momentum – Direct real estate investment in EMEA (€bn)
Unfortunately, this question cannot be answered with a straightforward yes or no. Nonetheless, we would generalize that whilst EMEA is closing in on the top of the current cycle, Russia is closer to closing in on the trough. One prism through which to view the disparity between these two cycles is by looking through the three prisms of rents, pricing and debt.
Forecasting the direction of commercial real estate rents in Russia is particularly difficult when there is so little visibility on the economy. Nonetheless, in US dollar terms, Russia’s rental forecasts in the prime office sector are amongst the most bullish in the EMEA space with 4.3% per annum expected through to 2019 compared with the European average of 2.1% pa. These forecasts are predicated by two very different scenarios: one of weak demand and one of strong demand. To put some numbers behind that, a 14% fall in demand in the last 12 months versus the previous 12 months has made Moscow the least active market in Europe in terms of take-up. By comparison, the UK, Europe’s largest market by far, has seen a 16% growth in take-up.
Given the low base that Russia is working from, the obvious question, therefore, is not whether these rental forecast are aggressive, rather it is what they are predicated on. Much of the answer to this question rests on supply. Supply in Europe remains very tight, yet at the same time growth is modest, which implies reasonable rental growth in the medium term.
In Russia, the pace of economic deceleration has left a huge overhang of office space broadly across Moscow. However, supply in the centre of Moscow is much tighter, with some 15% vacancy in the prime segment, and even less in the most in-demand assets. In our view, and as is usual, this will drive a surprisingly quick recovery in the prime segment for the best assets, well before we see the same recovery in pricing for more average assets. This same principle of divergence between best and average assets will apply across all sectors, not just the office market.
The situation in terms of pricing is very different in Moscow than across Europe, where yields are hovering close to their pre-2008 crisis troughs. Indeed, in London shops on Bond Street are trading well below crisis levels at 2.5%. In London prime office yields at 3.5% are pretty much in line with the levels seen in 2007. There is room for compression, but it will be a challenge in a tighter monetary policy environment. In Russia, office yields at 10.5% contrast with 8% seen in 2007, implying that not only is Russia cheap, but that there is more than enough room for yield compression. It is not impossible, but Russia’s economic backdrop would have to deteriorate very aggressively from here for yields to widen out further and threaten the 12.5% level seen in 2009.
Major yield compression only to be found in EM – Prime yields across offices, unit shops and logistics in Q2 15 vs. last peak and trough (2007-09)
The relationship between equity and debt is another useful gauge of where Russia stands in the real estate cycle. Broadly speaking, the higher the loan/value (LTV) ratio and the lower the cost of finance then the closer the market gets to the top the cycle.
In Europe the trend post-crisis has been clear; quantitative easing driven by the US Federal Reserve and the European Central Bank has provided plenty of cheap liquidity to banks, which in turn has been invested in the real estate market. It is not unrealistic for example to expect a developer of a good quality prime office in London to acquire financing at below 3%, assuming an LTV ratio of around 60%.
In Russia LTV ratios are not dissimilar, in that they remain conservative relative to the levels seen pre-crisis (though they have been starting to creep back up). The difference is the availability and cost of debt. In Russia, 12 months ago, developers would have been able to secure dollar financing at around 7%. Today, however, the discussion is framed not about the cost of dollar debt, rather the availability, given that lending has almost entirely dried up. Therefore, the discussion in Russia is how long developers can continue to fund their existing debt, even with pretty conservative LTVs, given the fall in rents and the move to an increasingly ruble-denominated market. We would suggest, that it is now the prohibitive cost for developers to add further stock, which will tighten supply, combined with challenge of acquiring new financing that will open up opportunities for cash rich investors. Rather counterintuitively, it this challenging environment in the debt markets that may prove a driver a pick-up in investment volumes in 2016.
So in conclusion, whilst there is no straightforward answer to this concise question, it is safe to say that whereas the evidence points towards core European real estate markets approaching the top of the cycle, the Russian market lies at the other extreme. Rents look to be at a cyclical low, and certainly in the prime section are close to the lowest level that can be reasonably achieved. Yields are well above their historic trough and are providing some interesting opportunities for investors that can find them. We think the market will be become two-tier in 2016, with good quality assets trading at a marked premium to more average assets that will struggle in the debt markets. Smart investors will take their opportunities where they can and could provide a pillar for an improvement in overall investment volumes. Finally, debt markets in Russia are the very opposite of Europe. European markets will tighten eventually. This will probably happen at about the same time that Russian debt is becoming more available.
Thomas Mundy is Head of Research for Russia and the CIS at Jones Lang LaSalle
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