Galt & Taggart -

Ukraine's real estate market is currently defined by a severe shortage of quality commercial and residential property. Rising income and growing wealth, on the one hand, and a simultaneous difficulty in procuring development sites on the other, allow developers to keep prices artificially high and capitalise on the shortage of supply.

The market also lacks true nationwide developers, with the largest companies just starting to branch out of Kyiv and the Kyiv region, and target the so-called "millionaire" cities: Donetsk, Kharkiv, Dnipropetrovs'k, Odessa, Lviv, and towns with populations of over 200,000 inhabitants.

XXI Century and TMM were the first Ukrainian developers to go public in 2005 and 2007, respectively. The placement of TMM showed that there is significant interest from foreign investors in the Ukrainian real estate sector, which gives us confidence that the planned secondary offering on the Warsaw Stock Exchange, planned for later this year, will be successful as well.

We initiate our coverage of XXI on Warsaw with a 'Buy' recommendation and 'Hold' recommendation for TMM.

Considerable long-term growth

The average vacancy rates for class-A and class-B office space in Ukraine are below 5%. This explains higher rent rates (35-40% higher on average) in the office sector than throughout the rest of Central and Eastern Europe.

Over 80% of existing warehousing facilities do not meet international standards.

The average occupancy of Ukrainian retail space is 95% - 5% above the European average. The payback period in this sector is 4-5 years compared with over 10 years in Europe.

Out of 1,280 total Ukrainian hotels, only three have 5-star status (two in Kyiv and one in Donetsk) and about 30 have 4-star status. Just five hotels in Kyiv accommodate 90% of all foreign guests in Kyiv. Most hotels are refurbished Soviet-era buildings so more modern hotel complexes are needed. Stable and robust economic growth and declining interest rates on consumer loans should help keep retail demand.

These factors, in our view, will contribute to the considerable long-term growth of real estate development firms who are positioning themselves to meet this surge in demand.

Possible setbacks

Housing prices increased 46% per square metre (sqm) on average in 2006, but since the beginning of 2007 growth has slowed; low-end residential property is going through a period of price stagnation as potential buyers are both unwilling and unable to pay the current market prices. There are no such problems at the high-end of the market.

The market is heavily regulated by local authorities - a factor which tends to increase development time. Therefore, companies with an established reputation and solid track record have a distinct advantage over new market entrants and small developers.

Ukraine also faces a shortage of building brick as Ukrainian brick manufacturers struggle to meet demand. This demand translates into higher prices, which grew by an average of 27% in 2006. Other materials, such as mortar and steel rod, are also rising in price, which means higher costs for developers and, in turn, higher retail prices. The situation is not likely to change in the next 7-8 years, when the market will approach saturation.

General Background

After the spectacular 12% GDP growth seen in 2004, the Ukrainian economy slowed to a more modest 2.7% in 2005. In 2006, the country's GDP reached $106.5bn, posting an impressive 7.1% growth despite the surge in natural gas prices from $45 to $95 per 1,000 cubic metres. Over January-August of this year, GDP growth was 7.5% on year. We expect lower growth for the rest of the year - 5.9% by year-end.

Ukraine's economy has enormous growth potential, as GDP per capita is still far below its CEE peers.

Likewise, Ukraine's official average monthly salary lags behind the CEE average - $712.12 in 2006. However, by various estimates the portion of Ukraine's "shadow" economy is roughly 50% so the purchasing power is greater than the official statistics would have us believe.

Office sector: growth in major cities

Ukrainian office space is comprised mostly of refurbished Soviet-era buildings and apartments turned into offices. New office space is not being built fast enough, which is explained by a scarcity of suitable land and the difficulty in obtaining land for development. In 2006, vacancy rates of quality office space (class-A and class-B) were below 5% throughout Ukraine; in Kyiv they were even lower.

Furthermore, in comparison with other European capitals, Kyiv has by far the lowest quantity of office space and, as a result, the highest yields in the region.

The above factors make office development in Ukraine an attractive investment.

Construction of quality office space, however, has been limited by land issues, which is why the situation on the market is unlikely to change before 2010, when the previously announced office development projects are completed.

Key facts of Ukrainian office real estate in 2006:

--The market in Ukraine's "millionaire" cities and major business centres (Kyiv, Odessa, Kharkiv, Donetsk, Dnipropetrovs'k, Zaporizhzhia, Vinnytsia and Lviv) entered an active growth phase; activity in other regional centres was virtually non-existent;

--Total office space throughout Ukraine, excluding Kyiv, amounted to approximately 200,000 sqm of class-B facilities; in Kyiv, the total office space of class-A and class-B facilities reached 574,000 sqm;

--Approximately 77,000 sqm (60,000 in 2005) of office space was developed throughout Ukraine in 2006; in Kyiv - 100,000 sqm (150,000 in 2005);

--Average office space in Kyiv increased from 70 sqm to 90 sqm.

Retail sector - regions starting to catch up

Until 2006, Kyiv was Ukraine's only major city with an actively developing retail chain sector; however, the situation reversed last year as developers began paying more attention to regional centres with a population of 200,000-500,000 people.

The total number of completed retail locations that can be designated as trade centres reached 170 throughout Ukraine in 2006; the total area - 1.2m sqm (increase in number - 23%, in total area - 28%). A number of developers have announced plans to open up retail centres in Kyiv and in other regions. Retail concentration reached 100 sqm per 1,000 persons in the largest cities and 50-70 sqm per 1,000 in the smaller ones; in Kyiv, concentration was the highest with approximately 124 sqm per 1,000 persons. This contrasts starkly with other European cities.

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This means that demand for quality retail space will remain high as Ukraine's GDP per capita and consumer spending increase. Rental rates will continue to increase and yields will remain high According to the Ukrainian Trade Guild, construction of 80 trade centres comprising a total area of 1.7mn sqm was planned for 2007. The main trends include: moving away from city centres and into suburbs, increasing trading floor space, improving the quality of trade facilities, an increase in rental rates, and the continued expansion of big retailers to regional centres.

Warehousing and logistics - worth the effort

The Ukrainian warehousing and logistics sectors mainly consist of refurbished Soviet-era warehouses or of new warehouses built-to-suit, generally developed by companies to meet their own bespoke needs. The number of speculative warehouses built by developers to be leased or rented out and logistics complexes is low, as investors prefer more profitable office and retail sectors.

Until recently, most developers concentrated on facilities with total warehouse space of roughly 20,000 sqm as larger projects were deemed more risky (most developers in this sector, thus far, have been Ukrainian). As a result, demand for quality warehouse space far exceeds supply. Kyiv remains by far the most popular market in this sector with the highest yields in the country. However, the so-called "millionaire" cities also provide attractive opportunities going forward.

The situation, however, is changing as a number of domestic and foreign investors have announced plans to build large modern logistics centres in Kyiv, Odessa, and several other large industrial regional centres. High yields are the primary drivers for these developments. The payback period for the retail or office sectors at 4-5 years is still significantly shorter than the payback period in Europe (up to 15 years), which means the sector will continue to draw more investors.

Kyiv:

The total quality warehousing space in Kyiv at the beginning of 2007 was estimated at 150,000-160,000 sqm, while demand was estimated at close to 400,000 sqm. Demand is driven by a growing number of international companies on the Ukrainian market. In 2006, only two class-A warehouses (9,700 sqm and 27,000 sqm) were built in Kyiv (population about 3m), or 0.013 sqm per person. In Moscow (population 10m), over 280,000 sqm of class-A warehouse space was built over the same period, or 0.028 sqm per person. This means a great deal more warehouse space needs to be built before Kyiv catches up with Moscow and the market approaches saturation, which implies that there are still plenty of opportunities for willing investors.

The highest demand for warehousing facilities has traditionally been on the right bank of the Dnieper River (close to the business district). However, high land prices and a scarcity of suitable land have forced developers to consider the left bank, which, while further from the business district, has suitable land lots at lower prices.

Odessa:

Odessa has become the second most attractive area for developing logistics projects. This is explained by the fact that Odessa is the largest Ukrainian seaport with a population of over 1.0m. Rapid development of the retail sector and a severe shortage of quality warehousing facilities (total space of class-A to class-D warehouses is estimated at 70,000-80,000 sqm at the end of 2006; class-A and class-B facilities accounted for less than 10%).

Another plus for Odessa is the availability of relatively good connections to Kyiv via the Odessa-Kyiv motorway. As a result, a number of companies have announced plans to build large modern logistics centres with a total declared space of close to 200,000 sqm in and around Odessa.

Other regions:

Other potentially attractive areas for developing logistics centres include Kharkiv, Donetsk, Dnipropetrovs'k (all with a population over 1.0m), and Lviv (proximity to the western border and western-bound transportation routes). Quality warehousing facilities are scarce in these regions.

Residential property - opportunities still there

There are two contrary opinions as to the current state of Ukraine's housing market: 1) it is a price bubble about to burst; 2) housing prices will continue growing but at a slower pace. In our view, there are still plenty of opportunities in the residential sector for developers.

Last year, average housing prices across the country increased by 49.7% from $922 to $1,382 per sqm. The highest growth was observed in the northern region (64%), which is, of course, driven by Kyiv. The average cost of housing in this region reached $2,187 per sqm. The lowest growth (26.4%) was observed in the western region as the average cost there reached $1,019 per sqm.

The key factors that lead the charge were:

1) low levels of housing construction;

2) lack of alternative investment options;

3) an increase in mortgage lending;

4) parliamentary elections in September 2007.

1) Average construction per person increased to 0.19 sqm per person in 2006, up from 0.16 sqm a year earlier. Average area per person remained almost unchanged at 22.3 sqm per person (22 sqm in 2005). The lowest growth (0.1 sqm per person) was seen in Ukraine's eastern region; the highest (0.3 sqm per person) in the northern region.

2) Most Ukrainians view real estate as the safest investment option, which has led to speculation on the housing market; as a result, the housing market in Kyiv has been mostly stagnant as a result of the low number of deals in the new housing sector. In the regions, prices increased by over 50% in several regions.

3) The popularity of mortgages in Ukraine is growing in line with growing levels of disposable income. Thus, demand for mortgages increased by 40% in 2006 compared with 16% in 2004 and 25% in 2005. Average mortgage loans increased by 15% in 2006 to approximately $20,600, while mortgage rates remained stable at 12.5-13.5% in foreign currencies and 17.5% in Ukrainian Hryvnia.

4) By various estimates, the spring 2006 parliamentary elections cost Ukraine $1.0bn-3.0bn, which helped push consumer spending up, including spending on real estate.

Average consumer prices increased by 130% over 2005-2006. At the same time, average wages across Ukraine in 2006 were just slightly above $200, according to the State Statistics Committee. This means only a small portion of the population can actually afford to buy or expand housing, which is the main reason why most developers are focusing on so-called "elite" housing targeted at Ukraine's wealthiest classes.

Most opportunities in the housing sector lie in developing high-end apartments and suburban communities. Medium and low-end housing will have to wait for further developments in the banking sector and lower mortgage rates.

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