COMMENT: Ockham's Russia

By bne IntelliNews September 18, 2007

Michael Lange of Jones Lang LaSalle Russia & CIS -

I could say that since about the year 2000 a lot has changed on the Russian property market. Now, while this is true, it is also a colossal understatement and says little about the market's future. Scores of people, from analysts to managers, when asked the question about Russia's property future, will pontificate and theorize, often providing you with some of the most elaborate and complicated explanations. However, in my experience, like Ockham's Razor, all things being equal, often the simplest solution tends to be the right one.

In the past seven years change has happened so quickly that we can almost talk about two distinct markets, each with its own dynamics and characteristics. Today's market is fast-paced, more efficient, and more liquid. Today's market is flooding with both international and domestic capital, hardening Moscow's office yields almost to levels found on the CEE markets. Seven years ago, the story was quite different. International lending institutions were absent, only a handful of off-market investment deals were transacted, leaving the market as "dark and murky" as the Western press made it out to be. Today's market works. So what's next? What's the next phase of Russian real estate? Should we expect a clear and predictable path to maturity – efficiently traded properties resembling something on the order of London or Paris? Should we wait for Russia to follow the path of China or India, with continued development and uncertain market cycles for years to come? Or will the Russian market follow a distinct path, drawing on a little bit of both, East and West?

Russia and Chindia

One can do a complicated question justice only by providing a simple answer. My explanation of the future of Russia's commercial property market is as follows. Russian real estate has a very promising future (I'm sure few would argue this point). The Russian market will stand alongside the markets of Chindia (China and India) in terms of risk and returns, and investment opportunity. It will also be as accessible and familiar as the core markets of Western Europe (London, Frankfurt and Paris). So far, nothing too earth shattering, as we are simply saying things are going to get a lot better. There is however, the question of how this is going to happen. There is one feature of the Russian market that will make all the difference over the next few years, and our answer lies in that.

Over the medium term, the Russian property market will undergo the type of change that'll make the last seven years appear like a slow start. This "change" - a genuine "real estate renaissance," if you like - will be fueled and driven forward by Russia's seemingly endless flow of domestic capital. Russians have been able to establish themselves as a force to be reckoned with on a global scale - largely due to their capital reserves - and this will be the catalyst for the future of the property market. Gigantic institutional quality office complexes, world class shopping centers and strings of high grade logistics points are popping up all over the country. In short, development of investment grade assets is booming and it's in large part due to Russian capital. So now we get to the root of our explanation. Russian capital will continue to drive real estate development to the point where supply will finally catch up with demand and the market will reach equilibrium. Equilibrium isn't a novel idea, but the only force that continues to make significant ground in driving Russian supply forward has been Russian development fueled by Russian capital. International developers, while becoming more important to the market, still play a minor role. So with Russian capital driving supply, we can conclude that market equilibrium is also largely in the hands of Russian capital. This is a fiercely different situation than what occurred in the Central and Eastern European markets, where on the whole, the formation of the real estate markets was largely influenced by international developers and global capital.

Question: "how does having supply driven by domestic capital any different?"

Answer: "in most cases it probably doesn't."

But when we are talking about the current volumes of Russian capital - a market that gets lumped in with China, India and Brazil; an economy that is forecast to be one of the world's largest over the long term - you start thinking of market evolution in terms of months and years rather than decades. Reaching market equilibrium in the next few years, let's say by 2009, will immediately send out the right signals to the right investors. Currently we have billions upon billions of dollars of institutional capital standing at Russia's front door, waiting for a full and stable market to appear- in other words a market with the appropriate stock of investment grade assets. When this stock level appears (at equilibrium) not only will the investors get their assets, but they will also be faced with depreciated prices. What more could someone ask for?

This will trigger the largest inflow of capital in market history - total sums to date, multiplied several times over. Yearly investment volume records for 2006 were considered high when we topped $4.2bn. If we account for an "interim market," ie. the lean years when rents are low, vacancy high and capital values low, as being two to three years, the investment volumes by year four or five could easily be as high as $30bn by 2015. And what's more, the volumes will show a clearly international character. Today, investment is recorded as roughly half domestic, half international, with slightly more toward international. This "balance" will change dramatically. Russia will in effect go the way of the CEE markets, at least in terms of international exposure to capital. Development will still have a strong Russian influence. The country is notorious for bureaucracy - and as optimistic as I tend to be about the property market, some things will not be able to improve that quickly - at least not as fast as the investment market. As a result, the development process will continue to require "domestic assistance" and joint ventures will be around for some time to come.

The next phase

Returning to the initial question "what's next", our simple explanation gives us something to think about. The Russian market's "next phase" will be one of maturity, liquidity, and opportunity - something that we could have guessed right from the start. Will it be more like Western Europe, North America, or Asia? Russia being what it is, it will probably be some combination of all three. Investment volumes will look like Western Europe's core markets, in terms of who's investing and how much. Russians are surprisingly progressive. If they recognize a practical and profitable consequence to improving something as ethereal as corporate and market transparency, they will actively turn this around. Given the scale of future investment volumes we've mentioned and the increased number of transactions - especially from new investors such as South Korea, Singapore, the US, Australia and Hungary - market transparency could, in short order, begin to resemble the markets of North America.

What about Asia? In recent months it's been considered very fashionable to compare and contrast Russia with the Asian markets. Well, these comparisons are for good reason. Growth rates, both on the market and in the economy as a whole, are sizzling success stories. China has all the potential to mirror all the changes we're talking about for Russia. Its domestic capital is certainly comparable, and in some cases superior to, many international funds. If we are talking slightly longer terms, the Chinese market could go through a very similar process - domestically driven equilibrium, and a tidal wave of foreign capital. There will of course be differences. While most markets function essentially in similar ways, the Asian markets will retain a cultural and "business" component that will shape and control their level of international exposure. Clearly this will be the case for China.

Russia's risky, sure, especially if you believe the Western press. But the reality is that its not any more perilous than the Chinese or Indian markets - in fact in many cases it tends to be more investor friendly. The Russian property market is about to shift gears, and that's what we should pay attention to. It's set for market equilibrium in the very near future, and rather than interpreting this in a convoluted and overly complicated way - focusing on "a crash" and "bursting bubbles" and alike, we should use a level-headed, straightforward approach. The Russian market is about to undergo a change that will make it a core market for global investment. No more "Eastern Europe", "CEE" or "emerging markets" - Russia will simply be, Russia.

Michael Lange is an International Director and Chairman of the Board for Jones Lang LaSalle Russia & CIS

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