Tom Mundy of JLL -

One of the more surprising aspects of Russia’s current downturn has been the pace with which the commercial real estate market has responded to the dislocation in the rest of the economy. As the ruble has crashed and the cost of borrowing has soared, Moscow’s commercial real estate market has adjusted with impressive efficiency. Prices have moved without the lag that that one should expect in a market with such little transparency and which we experienced during the 2008-2009 crisis. In this short paper we look at why look at why this has been the case by considering the reaction of three important real estate indicators: the cyclical nature of rising vacancy rates; falling rents driven by economic downgrades and ruble volatility; and finally a slowdown in completions as developers adjust their expectations. In the residential market, which behaves quite separately to the commercial market, mortgage issuance (a common proxy for residential sales volumes) was driven up aggressively by rapidly worsening ruble assumptions before being strangled at the end of last year by intolerable lending rates.

The first indicator that has reacted has been vacancy rates. Vacant space, that is to say the amount of available stock in a building, had been building gradually through 2014 across all sectors, mostly due to the nature of the real estate cycle. Saying that, the collapse in demand towards the end of 2014 did exaggerate the pressure as vacancy rates soared in the last quarter. The current cycle has its roots four or five years back as developers with access to plenty of affordable FX financing took on, quite reasonably, ambitious expansion projects starting a new post-crisis real estate cycle. Across all sectors, record levels of stock came to the market. Given the expectations of economic growth at the time as well as the massive undersupply of quality commercial real estate space, there should have been sufficient demand to absorb the supply created by mega-projects such as Moscow City. As economic expectations ebbed away through 2014, it became abundantly clear that all this extra space could not be absorbed in the near term and vacancy rates moved out with alarming speed. From 18% at the end of 2013, the average vacancy rate for Class A office space had climbed to 29% by the end of 2014. In some areas, such as Moscow City, Class A vacancy rates have reached 45% already and could well climb further.

Moscow average Office Vacancy Rates. Source: JLL

The second area where the impact of the economic downturn is clear is through the rapid adjustment in the rents that tenants pay. Rents have been heavily impacted not just by the increase in vacant space, but also because development is financed almost exclusively in FX. This means that rents are denominated in FX as well. Hence companies that derive revenue in rubles and pay their costs in FX are absorbing a very painful currency mismatch and are seeking to reduce their costs by either renegotiating rents down in FX terms, or by switching to an effective ruble rental rate. The latter is, however, not a straightforward alternative for landlords with FX debt who will be limited by their lender’s willingness to accept rouble exposure. Furthermore, for an asset valued in FX a switch to ruble rent will have an impact on valuations given the slimmer income that the asset will generate. Thus, while it is clearly a tenant’s market right now, and many landlords are giving temporary respite by offering ruble terms, it is unlikely that this window for renegotiation will be open too long.

We would also assume that in many cases it is not the landlord that is setting the limit to what is tolerable, rather it’s the bank who will determine at what rental rate the landlord can service their interest payments. Rents across all sectors have already fallen a long way and we would suggest that with rates that are already below the worst point in the 2008-2009 crisis, they may not have much further that they can go. It is notoriously difficult and perhaps disingenuous to calculate an average rent given the individual circumstances of each landlord, but we would estimate that compared to the end of 2013, in dollar terms, Class A office rents were 20% lower by the end of 2014 and have fallen at least a further 10-15% since the start of the year.

Moscow Average Class A Rental Rates. Source: JLL
 

The third area that is already being affected is the level of completions. As suggested above, developers have to adjust their expectations to account for the fall in demand and the availability of debt. In the current environment, projects are increasingly likely to be either postponed or cancelled entirely if they are at an early stage. However, the good news for landlords is that quite quickly, assuming some improvement in demand as the economy levels out, as completions become more scarce vacancy rates will move down in turn, supporting an upward revision in rental rates. Thus, though we are well aware that the market looks gruesome at the moment, the structural undersupply of space across all real estate sectors (Moscow has less Class A office space per capita than Bucharest), will help landlords more quickly through the cycle as the demand supply equation comes into balance quicker than many casual observers would expect. Indeed, we anticipate office and industrial rents to level out through the middle of 2016 and given current oil price assumptions possibly be back to pre-crisis levels in dollar terms by the end of 2017.

Moscow Office Stock Dynamics. Source JLL

No home abroad

Finally, unsurprisingly, the weaker ruble has pushed Muscovites looking for the safe-haven of bricks and mortar to invest heavily in the residential market. According to central bank figures, the number of mortgage transactions increased in 2014 by 23% against the previous year. This dynamic built through the year until December, when central bank policy rate hikes effectively strangled the mortgage market. Given that the residential market, unlike the commercial market, is financed largely through pre-sales, as funding and financing dry up, completions will inevitably follow in turn. Like the commercial market, it will not be long before the residential market also finds its equilibrium.

One of the more surprising trends through 2014 was that contrary to popular belief there is little evidence to suggest that Russians have become more active in real estate purchases abroad. This may have its roots in the political environment where state officials have been reluctant to be seen moving assets out of Russia. It is more likely, though, that it has more to do with the pace with which the ruble moved. In a few short months last year, real estate in London doubled in price in ruble terms. As shocked Russians contemplated their next move, Asian and Middle Eastern buyers snapped up what little London stock there was.

Moscow Mortgage Transactions per month. Source JLL.