Is the Russian Real Estate Market Attractive?

David Godchaux
NAI Becar

Was it ever attractive? If one judges by looking at the huge volume of foreign capital that flowed into Russian Real Estate in the 7 years until 2008, then the answer is definitely yes.

The level of net initial yields (NIY), which is roughly the ratio of the net operating income of an asset to its net price, can be considered as a measure of the risk reward for buying this asset. Historically, investors were logically asking for higher yields in Russia than in Eastern Europe, and higher yields in Eastern Europe than in Western Europe or the United States. In 2007, at the peak of the market, when yields were at their lowest point, investors could expect a 4 percent NIY for every prime and well-let office building in Manhattan, compared to 7 percent in Moscow.

In 2007, the market was very bullish, and there is no surprise in the fact that investors tended to underestimate the risk and overestimate potential return. Yields had been compressing for years in every markets, and differences in risk rewards expectations between different regions of the world had been compressing as well: None of the foreign investors in Russia were able to see that a 3 percent premium for coming to Moscow instead of New York was an insanely low level of risk reward.

Nowadays, prime office or retail yields in Russia are around 11 percent, compared with the West End or Manhattan at 7 percent. In other words, over the last two years prime yields have increased by 75 percent in major Western markets, while they have increased only by 57 percent in Russia. This statement is certainly slightly biased as it is easier to increase by 75 percent starting from a low level than from a higher one. But it is also true that whereas the bullish market tended to underestimate risks 2 years ago, the bearish trend since 2007 should have had an opposite effect. Yields in Russia should have jumped by a much more significant level than 57 percent in comparison to the 75 percent increase in US prime yields. This paradoxically indicates that for investors, the level of risk in Russia has increased relatively less than in mature economies, which are normally considered safer.

There are actually now two distinct real estate markets in Russia: local buyers who believe that 12 percent is a good deal and who are looking for volumes of investment that do not exceed $50 million, and foreign buyers awaiting 14 percent to 15 percent NIY to come back on larger projects. Owners of these larger projects should now realize that the rest of the world has awoken and that investors who were seeing no risk coming to Russia 2 years ago, or were ready to accept low risk reward, no longer exist. Psychology remains a key factor in investment, and it takes time to change the risk appreciation of buyers. In this respect, rather than waiting for foreign investors to review their appreciation of Russia, it makes better sense to monitor the level of yields abroad: at a certain point they will start compressing again as the world economies recover from the crisis and Russia will mechanically become more attractive.

There is another reason to remain very optimistic: Moscow, St Petersburg and large regional cities are still largely under-supplied in high quality real estate assets, and the corporate demand for those will come back as Russia and the rest of the world recovers. In this respect high vacancy rates in Russia are a very valuable asset, providing investors with huge upsides potential. A 20 percent vacant property selling at 12 percent today will actually provide around 13 percent if the vacancy decreases to 10 percent, and will provide 14.4 percent return when fully leased.