COMMENT: Something wicked this way comes?

By bne IntelliNews September 18, 2007

Michael Lange of Jones Lang LaSalle Russia & CIS -

Possibly one of Russia's strongest adversaries has been its own reputation. Separating fact from fiction could be regarded as the linchpin to a successful international investment strategy. From ex-ante oversubscription to an ex-post decline in share value, property company IPOs are offering an unbalanced view of what would otherwise be described as a stable and prosperous market.

Continued expansion across the country and a soaring demand for greater volumes of new capital are the clearest of indicators for a healthy IPO market. Yet market pundits continue to raise unfair questions about the market's future, suggesting everything from "developers cashing in their chips" to "the market's inability to deliver new product to the market."

The wave of Russian developers' IPOs has been one of the biggest real estate stories of the last year - a true milestone in the history of the country's property market. Russia's real estate is becoming increasingly global.

The crisis in US sub-prime mortgages and the consequent market insecurity across the globe this summer have left some investors worried about the mid-term prospects of the Russian property's investment market as well. However, with positive economic development trends and existing strong real estate fundamentals, this seems a purely psychological phenomenon.

The bigger picture

Being more transparent means gaining access to international sources of capital, but this also makes the market, which for over a decade had been developing as a "thing in itself," vulnerable to global economic events such as these – almost irregardless of its actual state of development.

With the recent multi-billion Rosneft and VTB offerings among many others, real estate IPOs are part of a bigger trend that has seen Russian companies increasingly going public both in Russia and abroad, chiefly in London.

On the back of a booming market, Russian property companies are now focusing on new ways to inject capital into their projects and more sophisticated ways of expansion. A clear indication of this has been the growth in equity raised through public offerings.

With rental rates now exceeding most of Western Europe's, capitalization rates hardening to single digits, and investment volumes reaching the previously unheard of heights, it's no wonder that public equity for real estate companies is flooding in.

In November 2006, developer Sistema Hals raised $432m on the London Stock Exchange (LSE). In December; Mirland Development, a Russian subsidiary of Israel's Fishman Group, raised $282m via offering 30% of its shares on London's AIM market; and RGI International, a developer of elite residential premises in Moscow, raised $192m in London the same month and had a successful additional offering in April this year, raising another $237m.

In the two biggest real estate IPOs so far, AFI Development, a subsidiary of Lev Levayev's Africa-Israel, raised $1.4bn in London this May, while PIK, one of the country's most ambitious developers with an impressive list of ongoing projects, sold 15% of its shares in June on the LSE for $1.85bn.

From the investors' side, however, a clear signal of rising interest has been significant oversubscription. Sistema-Hals for instance was oversubscribed five-fold; AFI Development was oversubscribed more than six-fold.

However, this summer brought nothing but disappointment to investors into Russian developers' IPOs, with an almost non-stop decline of their stock price. For example, AFI Development, sold its shares for $14 a piece during its much-hyped IPO in May. As of September 14, they were trading at less than $9.

While some market watchers blamed it on the negative influence that the liquidity crunch in the US was having on global markets, forcing hedge funds and other opportunistic investors to dispose of risky Russian stock irregardless of its long-term potential, the stock market bears saw it as a clear sign that Russian property shares were overvalued.

On the surface, there may be some element of truth to the second notion. For example, out of more than 400 projects listed in PIK's investment memorandum, nearly half only existed "on paper" at the moment of the IPO. Similarly, AFI Development is yet to get all the approvals for many of the projects it listed in its memorandum earlier this year.

Is that something that investors should be afraid of? It is true that the Russian real estate market has a reputation for construction delays, but it is more than offset by its tremendous growth potential and strong economic credentials of the Russian market. While the expectation that the market will continue growing is already priced in into the share price during an IPO, as the announced projects are delivered to the market a developer's market capitalization should skyrocket.

Appetite for real estate developers' shares remains very strong today, despite the negative publicity that their performance has been generating in the press recently. Yet, what is important to realize is that the very nature of the property market presumes a long-term investment. Those that see the big picture will be winners.

If we look strictly at market composition and dynamics, Russia is pretty different than the UK or France. At this point in its evolution, Russia has a developer's market – which means we expect to see intense construction and a large project pipelines. Western Europe has, by and large, already been through this and so their "investor" markets are more concerned today with carefully maintaining the balance between supply and demand. Therefore, coming to markets like Russia, the Western perspective is often skewed by Russia's irregular or occasional inability to deliver projects on time.

Property development in a market that exhibits a clear demand overhang across more than a dozen major urban centers has a bright future – that seems fairly evident. Investing in property companies tasked with navigating Russia's burgeoning property market requires an understanding of two things – an understanding that emerging markets often perform in less than predictable ways; and that the days of short term, "in-and-out" adventure capital in Russia are all but over. Investing in Russian property is quite simply, investing in the country's future.

Michael Lange is chairman at Jones Lang LaSalle Russia & CIS

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