Real Estate Market in Danger Becoming Disconnected Again

David Godchaux
NAI Becar

During 2009, the Russian real estate market was impacted faster and more violently than many Western markets. Sale and rental prices in London or New York did not drop as fast and as much in two years as they did in Moscow in just four months.

One of the reasons is that while Western real estate markets had a long and painful crisis that lasted from mid-2007 until now, the Russian real estate market was disconnected from the rest of the world for almost a year and a half, between mid-2007 and Oct. 2008, creating the potential for a very painful and sudden drop when it adjusted in early 2009. The financial crisis was the trigger of the real estate crisis in Russia, not its cause: Rent and prices in Russia in 2008 were too high, and yields too low compared with other emerging markets, or even with developed economies. They would have seen a correction sooner or later, even without the global crisis.

Because of good macroeconomic fundamentals and the relative isolation of Russian banks — no toxic assets in their balance sheets, contrary to what was seen in the United States — the Russian real estate market remained in good shape until September 2008. In Europe and in the United States, rent and prices had already significantly dropped during this 2007-08 period, and Russia, together with Latin America, was one of very few markets in the world to see no price or rent drops. But the Russian real estate market had two major weaknesses:

• The market was extremely expensive: Prices and rent in absolute value were among the highest in the world at that time;

• Yields were insanely low, almost at Western Europe or U.S. levels.

After the international real estate crisis of 2007-08 turned into a major financial crisis in September 2008, real estate in Russia was impacted by significant drops in both the demand for office and retail premises, and offers of financing.

When demand for office space suddenly dropped, rents that were at levels comparable to those in London or Manhattan also dropped sharply. Risk rewards (yields) expected by investors were multiplied by two. Higher yields and lower rents (yield is calculated as the ratio of rental rate to price) mechanically pulled prices down to a 10-year low.

At the same time, many developers started having difficulties finding financing for the completion of projects that had been designed with an exit strategy at 2007-08 price levels. Not being able to finance their project and hold it until things went better, they started looking at an anticipated exit, which provoked an overflow of unfinished projects for sale on the market, and finally pulled the prices down even lower. In this situation many developers went bankrupt, even while a select few remaining equity investors had great successes.

From June to December 2009, the investment market that had been silent for more than half a year started to take off slowly, because of some rising interest from local investors. But this created a dramatic gap between its foreign and domestic legs: While local investors in offices were considering initial yields of about 11 percent to 13 percent, foreign investors would not even look at Russian properties for yields lower than 15 percent to 16 percent.

The last two months of 2009 finally saw a significant increase in rental rates. This situation was very specific to Russia and can be seen mainly as a technical rebound because of the overreaction in the first part of the year. After dropping from $2000/sq.m. to $600/sq.m. in the first six months of the year, prime office rents increased to $900-1000/sq.m. between October and the present day.

This was probably a technical rebound, and we should now see rents growing at a much slower pace.

However, if on the contrary the market keeps increasing fast and within the next three years rents in Russia increase to the level of early 2008, the real estate market will face a very dangerous situation: Better availability of financing and the rising appetite of local investors, coupled with rents that are increasing faster than in Europe and the U.S., will trigger an increase in prices. This would prevent yields from reaching higher levels (14 percent to 16 percent) that could attract foreign investors. Russian real estate would then become again, like in 2008, an exclusively domestic market disconnected from the rest of the world — high rents, high prices, and nonattractive yields in Russia versus lower rents, lower prices, and more attractive risk reward in Western Europe and the U.S.

The year 2009 taught us how fast and deeply the Russian real estate market, disconnected from the rest of the world, could crash because of a combination of exogenous macroeconomic factors — the next three years will show us whether we have learned something from these lessons.