Moscow shakes off ‘wild East’ reputation

Copyright: David Lawson – Property Week 2000


Michael Lange won’t get off the phone. ‘I’ve three more points,’ he insists. The trouble is, he said that half an hour ago and has listed 12 already.  Moscow is fuelling that kind of enthusiasm nowadays. A couple of years ago one top fund manager dismissed the Russian capital as the ‘wild, wild East’ – hardly worthy of  the last dregs left in opportunity funds sweeping through Europe. Today, he is among the crowds sniffing around what many consider the next big opportunity.

  Anonymously, of course. It’s not quite time to tell investors in Ohio and Alabama that their dollars could be feeding the regeneration of  a former lifelong enemy dubbed the ‘Evil Empire’ by their hero, Ronald Reagan. But it will be soon, says Lange, managing director in Russia for Jones Lang LaSalle.  ‘Everyone is here, looking at opportunities,’ he says. ‘Around half a billion dollars of equity will be raised over the next 12 months.’

  What has changed? Ironically, the secret lies in the mantra of another US president diametrically opposed to Reagan’s world view.  ‘It’s the economy, stupid,’ was the endlessly repeated chant Bill Clinton used to batter Bush Senior from power.  Russia has transformed into one of the world’s most rapidly developing markets, according to DTZ, another top investment consultant pinpointing Moscow for an impending explosion. Barely four years after a catastrophic financial crisis, the economy has been  growing by more than 5% a year and while this is expected to slow in 2002, it still looks attractive compared with the rest of the world.

  Politics is still a huge issue, as Moscow remains in the iron grip of local government.  ‘You obviously don’t have the same freedoms as elsewhere,’ says Peter Wislocki, a director of architect Aukett Europe. ‘You can’t just buy and build. Schemes have to be joint ventures.’

  That can suite both sides. Locals are desperate for western know-how and funds while foreign investors need insiders to negotiate through the power politics. And corruption, although no-one mentions the c-word – at least not on the record. Partnership is a far more respectable concept. The ‘wild East’ is not that far below the surface but new entrepreneurs who trampled their way to success now yearn for respectability.

    They back measures like the new Land Code which,  DTZ  calls ‘revolutionary’. Perhaps a better term would be counter-revolutionary, as it will sweep away controls on direct foreign ownership and enable leases beyond the traditional 49 years. This could take years, however. In the meantime, caution is the watchword. Grosvenor Land chairman Phil Edmonds showed the same swashbuckling style he displayed as an England cricketer by boasting he could buy two Moscow office blocks with the £1.7m inherited by taking a controlling stake in  UK cash shell Property Internet. It was left to his chief executive Douglas Blausten, to put this in perspective.

  ‘Due diligence is the key. On the face of it there are a lot of good buildings but you have to take a good look at the documentation and get good local advice.’ It obviously helps enormously that while wearing his other hat as a partner in Cyril Leonard, he  built a network of contacts advising Russian firms in the Yeltsin era. 

   But he admits that Moscow is still a possible rather than a definite target – one of many emerging markets. And the competition could be stiff. The hotels are full of developers and investors, according to Lange,  talking, listening and sniffing around land deals. ‘The one thing we are not short of is land,’ he laughs. ‘A lot will happen very soon.’

  TK Development, the giant Danish company which has built an international reputation pioneering new markets like Warsaw, is among the sniffers, says Wislocki, who is working up several schemes. ‘It is understandable that developers are so interested when pay-back periods could be as short as 18 months,’ he says.

  The main interest is coming from Germany and the US, with the UK lagging at around 10% of investment, says Lange. Russians themselves are climbing the list as they regain confidence in the economy and the political system. Despite looming local and national elections,  few expect any return to the bad old days.

  A combination of indigenous growth and greater overseas interest has increased pressure on Moscow’s tiny pool of quality offices. Analysts Anders Aslund and Peter Boone  pointed out in a recent Financial Times article that Russian firms have travelled so far from the old regime that they are making US productivity growth appear ‘positively lethargic’.

   Huge demands are coming from the telecoms and banking sectors as they revel in the joys of capitalism. ‘In the last few years foreign companies were making the running and deal sizes have tripled. Now around 60% of demand is from Russians,’ says Lange.

  This quart is being squeezed into a pint pot of a mere 500,000 sq metres of grade A space, pushing rents to among the highest in the world. Vacancy rates are less than 5% and will be down to 2% by the end of the year, says Lange. Values will continue to rise by up to 3% pa for three years because supply has not matched this upsurge.

  DTZ Research takes a more optimistic view of supply, going beyond the usual definition of Grade A space to suggest a total of 1.8m sq metres of ‘international quality’ accommodation, with another 500,000 sq metres in the pipeline up to 2004. But despite greater access to finance, uncertainty remains over how much of this will be completed in that time.

  Rents have grown steadily to $570/sq metre [including operating expenses but excluding VAT] compared with $550 last year. ‘If projected supply materialises only in part, then rents will possibly soften in the next 18 months to two years,’ says DTZ. But  ‘realistic’ projected new supply to the end of next year is unlikely to have a ‘major negative impact’ because finance continues to be an obstacle for many developers with part-completed schemes.

  Lange is more upbeat, forecasting that the bankers and investors crowding Moscow’s hotels are ready to draw a line under the 1998 crash, when huge amounts of space were offloaded and rents crashed from  a high of as much as $800.. ‘We estimate there will be half a billion dollars worth of equity raised in the next 12 months,’ he says.

  European funds in particular are attracted to yields of 15%-plus in a rapidly steadying political and economic environment.  The latest growth phase is also likely to be more controlled than the first flush of post-communist activity that burned out in the Nineties. ‘Development will be less spectacular but more   sustained,’ says DTZ.

   It would be hard to apply that kind of sentiment to retailing. An enduring image of the old regime was not just the food queues in Moscow but tourists stocking up with jeans and sweaters in London, Paris and New York. Now both are a fading memory as international food and fashion retailers swarm into the Russian capital. At the end of last year they had helped create 430,000 sq metres of quality space, says DTZ. That will double this year alone.

  Atrium, the first true western-style retail and leisure centre, opened in May next to Kursky Station, the first two of six Metro cash-and-carry outlets are under siege from customers, SPAR has launched four supermarkets, IKEA is about to extend its second scheme incorporating a Auchan store, 11-screen Cineplex and 10,000 parking spaces.  Yet still there is unsated demand, with pre-leasing common.

  How is this feasible when average incomes run at a mere $7,000 a year? Lange cautions against using taking this at face value. ‘People pay very little for things like transport, accommodation and utilities because of subsidies.’ That means 85% of income is available for shopping compared with around 45% in London. Multiply almost 12m by that kind of figure and the potential market soars over $50bn – five times that in Warsaw and 16 times in Prague.

  Some analysts fear that even this cannot sustain such a vast supply but again the crude figures can be misleading. The new space is not an addition but a replacement for  a large amount of traditional shopping. Since 1996 the authorities have closed 50,000 of the kiosks which supplied much of the everyday needs of Muscovites. Even more drastic was the elimination of 1.6m sq ft of open markets driven largely by the black economy

   ‘Current stock provides 43 sq metres of retail space per 1000 people,’ says Lange. ‘That compares with an average of 325 sq metres for Central Europe. Even with eight or nine big new centres coming on stream, that increases to only 110 sq metres per 1000 – which is still a third of the level in Warsaw.’ A western city like Paris has something like 400 sq metres of retailing per 1000.

    Moscow’s government would like to go much further, doubling the total retail space to 16m sq metres through 300 new centres. Eight zones of up to 400,000 sq metres would be created close to major highways.  DTZ calls this ‘somewhat unrealistic’ – probably a diplomatic understatement considering  the uncertainty over land supply and finances.

  But current plans alone will put a firecracker under the most underdeveloped sector -  distribution. Supplying the new generation of retailing would be hard enough for a western country. Considering Russia’s creaking infrastructure, not to mention  winters that defeated Napoleon and Hitler, the task could be Herculean. Which is why all the top logistics operators are also jostling for space in Moscow’s hotels.

  JLL has analysed land supply for the regional government and identified 25 sites of up to 150 hectares which will flow onto the market. Warehousing may not have demonstrated the punch and glamour to attract investors half way across the world but it could be the sector which yields biggest returns over the next decade. Distribution is not just in its infancy but barely embryonic, so schemes are currently being slowly created on a build-to-suite basis, says DTZ.  But with only 150,000 sq metres of international quality space around the city, pressure will grow quickly. Some companies may even seek to overcome the long haul and hard weather by producing locally, which will spread activity into development of manufacturing  facilities.

  And still Lange has not exhausted his points. But a dozen or so are enough to be getting on with. The main one is probably not whether investors will work through the list but when. Moscow suddenly appears a lot closer, as European and US economies falter and intervening states merge into the EU.  The wild, wild east could be about to be finally tamed.