Russia’s residential real estate market is flourishing, driven by the boom in mortgage credits. But changes in the regulations have caused uncertainty, which has held down the share value of the leading developers. That should start to change this summer.

Demand for new apartments in Russia remains very strong. Last year saw record demand – registered deals surged by 18% in St Petersburg and 30% in Moscow, BCS Global Markets said in a report released at the start of March.

While real incomes have been falling slowly for the last five years, that is more than offset by the faster fall in the cost of borrowing, which has seen the stock of mortgages double every two years since 2013 when the mortgage business took off.

However, some big rule changes come into effect this summer that will, amongst other things, ban pre-selling apartments, which has been a favourite way to finance the construction of buildings. Now would be homeowners pay their money into escrow accounts that the developer can only tap once the building is complete. That is going to hurt smaller developers who don't have the clout to raise the hundreds of millions of dollars needed to build a large complex in one of Russia’s larger cities so the sector is expected to consolidate. Moreover, the cost of raising large scale project finances is also expected to drive up real estate prices by 15-20%, says BCS GM.

Unsaturated market

Russia’s residential real estate market remains very underdeveloped and should grow for years to come. Although real incomes in Russia fell again slightly in 2018, down for the fifth year in a row, demand for new housing is high.

The recovery in real disposable income expected this year will only pour fuel on the fire as Russia has just 25.2sqm housing space per capita, according to BCS, about half of the norm in western Europe.

As bne IntelliNews reported recently, mortgages have exploded in Russia as they become more affordable; in 2013 the monthly payments were equivalent to 80% of the borrower's wage, but since then the share of payments has fallen to 45% in 2018.

In the early days of the mortgage market, borrowers would often take out a mortgage and in effect use it as a bridge loan while they sold their old apartment to cover the cost of buying a new one. The credit was paid back very quickly. But increasingly Russians are taking out mortgages and keeping them to maturity in the traditional use of a housing credit.

​At the end of 2018 the total stock of outstanding mortgages topped RUB6.4 trillion ($97.4bn) with the number of deals closed in Moscow in 2018 up 30% and those in St Petersburg up 18%, according to BCS GM.

The government, keen to get people into their own homes, just launched a fresh round of initiatives to make mortgages cheaper and President Vladimir Putin called on the banks to lower interest rates from the current record low 10% by another two percentage points to 8%, which will make payments even more affordable. Today Russians with a mortgage pay up to half their income on meeting the payments, whereas in Western Europe those payments account for between 20% and 30% of incomes.

Escrow is coming

The uncertainty in the sector concerns the new rules that ban developers from pre-selling apartments, a move designed to improve consumer protection against scams and bankruptcies. Buyers will pay their contributons into an escrow account instead.

Initially the amendments suggested that projects with construction permits received before July 1, 2018 are able to avoid escrow, however, in December 2018 the Duma approved changes saying that from July 1, 2019 all projects are moving to the new scheme regardless of when the construction permit was received.

The criteria for exceptions are yet to be released, and, most likely, will be related to the percentage of completion and percentage of the project already sold, reports BCS GM. The recent rhetoric around the issue has been favourable and suggests that projects at 30%+ completion on costs, and 10%+ on sales will be able to avoid escrow – however, this is yet to be reflected in the government decrees.

BCS GM says that the new system will depress the earnings of the largest companies by 20-40% and they will need price rises of 15-20% to compensate.

Given construction projects in Russia can run into the billions of dollars, the new scheme favours the largest companies and so the sector is expected to consolidate in the coming years as the smaller companies either merge or get bought out. Knight Frank estimates that 40% of all Russia’s developers are at risk of going out of business.

And that process has already begun. PIK bought Morton, a smaller rival in the residential sector, in 2017. More recently Etalon bought Leader-Invest (aka Lider-Invest) from multi-industry conglomerate AFK Sistema, in a deal that saw Sistema buy out the founder of Etalon and beef up its holdings in the residential development business.

Stocks fall

bne IntelliNews profiled PIK, the biggest real estate developer in Russia, in an interview last year and it remains the clear leader in the sector, outperforming its rivals both in terms of earnings and stock price over the last year. The stocks of both Etalon and LSR have badly underperformed the RTS index this year, although Etalon shares have rallied more recently after multi-industry conglomerate AFK Sistema increased its stake in the company.

The difference in the companies can be seen in their price-to-earnings ratio (p/e): PIK currently trades at a high (for Russia) x12, while Etalon and LSR both trade at a lot more modest x5.7.

The fall in companies’ share prices has been driven by the impending changes to the regulations, but as the uncertainty fades from the middle of this year those prices should rise again, depending on the details of the new laws.

“Over the last two years, listed developers’ share prices have gone through a de-rating. LSR and Etalon underperformed the index by 17-34%, despite strong operating data and healthy margins. Ahead of regulatory changes the importance of financial results and operating data has diminished,” BCS GM said in its report.

The share prices are down despite a flourishing business that continues to grow on the back of strong demand and falling mortgage rates. Last year, Etalon and LSR sales were up 22% and 44%, respectively. PIK was intentionally behind with just 5.5%, as management is interested in cooling its growth after the Morton acquisition. Strong operating data translated into solid financials.

And like the other leading Russian companies, the real estate companies are paying handsome dividends: the benchmark MSCI EM has an average dividend yield of just under 4% but PIK offers twice this with a dividend yield of 7% while Etalon and LSR pay an even better 10% and 12% respectively.

The new system will almost certainly drive real estate prices up, which should also lift the stocks, as currently pre-sales fund 79% of all construction, according to Dom.Rf.

“At current construction volumes, pre-sale funds worth RUB3.7 trillion ($55.8bn) need to be replaced by project financing, adding 7% to the banking system loan book. Applying the average net interest margin (NIM) of 4-6% for the top 3 banks gives an insight into additional interest income for the banking sector. As this is not a win-win game, development businesses have quite a visible risk of comparable losses in the mid-term, should prices remain flat. In reality, the cash flow re-distribution will be less, as construction volumes will shrink during the transition period, and prices will adjust upwards,” says BCS.