Pioneer in Russia says Market is Top Performer
- Mar. 11 2013 18:41
Hines is a developer, manager and investor whose presence since 1992 spans Russia's modern era of construction and economic development. A privately owned company, it has always pursued energy efficiency in buildings and built the country's first certified green office complex. Its latest project, the Kievsky outlet village and retail park near Vnukovo, is being built within the Moscow Agglomeration, after the city's extension to the south-west in 2012. Hines' executives in Russia are convinced the city government is tending towards residential development in the region, and away from the initial proposal to move government and financial services out of the center. The company invests in all major emerging markets. It has commercial real estate projects in Brazil and residential developments in China but Hines sees continued potential in Russia, which has been one of its most successful markets in the world. Hines recently raised a $500 million Russia Poland Fund, of which 80 percent is targeted at Russia. Mark Gay spoke to country manager and Senior Vice President Lee Timmins, and Aaron Smith, Managing Director.
The first question has to be financing: has the global financial crisis changed the rules? What innovation are we seeing in financing?
Lee Timmins: When we did our first two investments, like Prokovsky Hills in 1996, we did it all-equity with no debt and recently we have been using more debt and there is greater availability of debt at a more reasonable price. We have five or six lenders that we work with and that has been a big change. However the cost of finance declined significantly up to 2008 and then post crisis the interest rates have spiked up but at the same time the underlying base rate, Libor, has gone down. So apples to apples the cost of our financing is about the same in 2013 versus 2008. The difference is the base rate of Libor is much lower today and the bank spread is higher.
There are more international lenders involved, much greater appetite for high quality development and developers, and more interest from banks like Gazprombank, VTB, Sberbank and Alfa-Bank. So there are a lot more active participants in the real estate market. As a consequence you can do much bigger deals. Before when it was constrained by the amount of equity you were going to put in, today you'll have 60 percent debt.
The size of projects in Russia compared to, say, Poland can be much much bigger. Someone might sell an office building for $400 million and that's middle of the road, where in Poland that would be the top end. And you have billion dollar transactions like the Galeria mall in St. Petersburg.
As well as being a developer and a buildings management specialist, Hines raises finance through equity funds. What are the latest trends in your funds operation?
Lee Timmins: Hines is a private company which runs equity funds as a general partner, bringing in sovereign wealth funds or pension funds or other institutions. The typical fund size is between $400 and 500 million with six to 10 investors, normally fairly large pension funds investing $30 to 100 million alongside Hines as a general partner.
In 1997, $100 million dollars was a big number and there were few institutional players on the market. Russia was probably seen as a volatile place. Hines decided to take a fair amount of investment risk and it has proved one of the top locations for performance globally.
We are on our fifth fund now. We have made significant investments, in Ducat Place III and Belaya Dacha outlet village, in warehousing like Logopark (a logistics complex adjoining Belaya Dacha). We now have roughly $1 billion in assets in the Russian marketplace.
Before turning to the specifics of the Russian market, what are the rival markets. Is Turkey on the map and how does it compare?
Lee Timmins: As to Turkey we spent some time looking at a number of projects there. We love the demographics: it has a growing population; becoming wealthier; moving to the urban areas. We found there are some challenges unique to Turkey. I think it's probably a little more difficult to develop there but it provides some good opportunities for acquisitions. You've seen some major players make acquisitions, like Blackstone, but mostly they are buying completed assets.
Project costs, the construction costs are much lower in Turkey because they have well-developed infrastructure and you can get anything from façade to all sorts of materials. Now that's changing in Russia and costs are coming down. And though inflation is going up, generally speaking Turkey is cheaper. However, land in major metropolitan districts like Istanbul can be equal to or even greater than Russian costs. The dynamics of supply and demand are reasonably good but there is the potential for some sectors to be overbuilt like retail or residential because there is a broad domestic development market in Turkey that is pretty good and has a lot of experience. Financing is still relatively expensive in Turkey, equal to or more expensive than Russia. It's a market where there is not as much institutional ownership as there is in Russia so on balance I would say a good story would be buying stabilized retail assets but maybe it's a bigger risk to buy a piece of land and develop it.
How does Russia compare to Brazil and China?
Lee Timmins: These are the three most important countries for us. Brazil is definitely more favored by investors but as a result there is a lot of capital going in so the returns are going to be more subdued compared to Russia. Our business model is to do a lot of logistics and office projects in Brazil. China is seeing a lot of inward migration and so we are doing a lot of residential projects. The competitive landscape in China is becoming more acute because there are a lot of domestic and Hong Kong developers. Russia is not as favored but it has for us been one of our most successful markets in the world.
Some global rankings see Russia slipping down the charts, as a country providing opportunity for capital appreciation. What is your view?
Lee Timmins: We actually don't agree with that. We think the returns still are robust. One of the big stories globally is that the Russian consumer has low leverage, is educated, is desirous of better quality things both in their homes, such as furnishings, and as retail consumers. We think those dynamics are continuing to deliver a much better return from a real estate point of view.
My guess is that 70 per cent of the respondents have not done business here in the market and this is a perception gap versus the reality and the experience that we have on the ground. But the result of that generally negative perception of Russia is that there is a lot less capital competing as compared to Brazil which has generally a very good ranking around the world but I don't think their profits are going to be as good.
Turning to innovation, Hines has converted some of its buildings to green standards. Does it have a real impact on running cost of the building?
Aaron Smith: It is a mix of public relations, tenant relations and good economic decision-making. Since we opened Ducat Place III we have been able to reduce our energy usage by 25 percent. That's equivalent to about $130,000 per year in savings purely on how we operate the building.
We also have a full recycling program that is contracted to a recycling company and they actually pay us to remove the recyclable materials from the building. The numbers are not big but the program pays for itself and any revenue we get from that is passed on as a reduction of costs for the tenants. This includes paper, light bulbs, batteries, cartridges, metals, and glass. In our retail assets it is really dominated by paper products and packaging.
We did roughly 35 tons of recyclable materials at Ducat Place III in 2011 and we matched that at one of our retail outlet malls in less than three months. Retail assets generate potentially more recyclable waste than the office sector does.
There are no government incentives for environmental programs so do you see any other benefits?
Aaron Smith: As a landlord all the tenants both Russian and international have picked up the recycling program and actively participated which has given us a closer relationship with the tenancy and you have something good to talk about and a joint goal to aim towards. I think green programs are a big benefit to the tenant relationship and I think it's another good selling point and a way to diversify your asset.
Two years ago when we were certifying Ducat there were a handful of green projects. There are now close to 50 projects, which are either in the certification process or are intended to be certified. It is taking off but not to the extent in the West. It is a matter of awareness and competitive forces. You can get your employees trained here in Moscow by the Russian Green Building Council in BREEAM, LEED or DGNB certification standards. There are consultants who will take you though the entire certification process, such as Mott MacDonald or Drees and Sommer, so if you are serious about it you can execute in Russia.
New developments obviously give a greater opportunity to build more efficiently. But doesn't Russia's size, plus the legacy of Soviet planning in Moscow make that very costly?
Aaron Smith: As for materials there obviously is an improving picture to the extent that when we built Ducat Place III we probably imported the majority of the materials from outside of Russia but now on our Russian projects probably only 35 percent of the costs are imported materials, which are mostly mechanical systems, some aspects of your façade, and some of the nice stone finishing works. A lot more of the products can be sourced in Russia nowadays or the materials are brought in and then manufactured locally.
One of the myths is that Russian SNiP construction norms, which are based on old Soviet methodology, somehow restrict your ability to execute on BREEAM and green standards and that's not true. The real challenge we have is educating Russian contractors to implement green standards within their procedures. We can design the specifications and they will be green but the builder has to construct the building in a green fashion. There are two challenges to that: the recycling of the majority of materials on site and the other is a very significant amount of documentation that is required from the contractor, to be provided to the investor and owner in order to gain the certification.
There is a perception that it is harder to get a green rating in the center of the city compared with a greenfield site. What is your experience?
Aaron Smith: If you are doing something on a former industrial plant in the city center you can actually get more points under the BREEAM and LEED system for cleaning up a former polluted territory than you can on a greenfield site. From a location perspective there could be some upside, even.
The Moscow municipality is still struggling with the legacy of poor maintenance in the city center. What can they do to link up these modern business and retail developments which are isolated like islands?
Aaron Smith: The long term challenge is going to be the legal entitlement to existing infrastructure. The city is limited, because it does not own the assets to force a regeneration or unification of specific areas. Having said that a lot of the development was around Zastroika developments which were these one-off land plots that people were able to redevelop and that is how Moscow has developed to date: you have these nice sections and then the neighboring house may be a legacy of old Soviet infrastructure so it is quite eclectic in terms of the architecture and quality of construction. But the current city administration is taking much more of a broad view of Moscow and is working on implementing a real city master plan versus the system that we used to have which was one-off approval of construction on each of the sites.
It is true that all the utilities are owned by separate companies: Mosenergo power plants, vodakanal water services and Mos-teplo, which provides the heating, but that is not inherently different from New York City. Part of the problem is simply poor execution. But simply better city planning would help. The city is in the process of completing a new plan, which must be approved by the city Duma. Genplan does most of the planning for transportation. If you want to see wider sidewalks and green boulevards they need to design that into the larger plan
Talking of planning, we have the Moscow Agglomeration, which in 2012 doubled the size of the city and proposed a new suburb for federal employees and bureaucrats. Is it going to happen as originally planned?
Lee Timmins: The extension of Moscow, to the extent that it enforces a more rational planning for the suburban satellite towns, may be a good thing if you have good transportation. For example Kievskoe Shosse is an excellent route. Then there is the airport express and a nice hub at Vnukovo and then you've got a nice residential district out there. We are not so enthusiastic about the idea of moving broad portions of the government or the business community out to the suburban locations. There will of course be some edge-city developments as there are in any city but I would not say it would typically be your government or financial services. Those groups should stay in the center. You don't want a hollowing out of the center. You want a vibrant, energetic place. So we think the Agglomeration is more a question of residential development, in a proper organized fashion, properly served by public transport.
We have a big project in the Moscow Agglomeration district that is retail oriented and we are getting enthusiastic support from the city because it is supporting a significant amount of the residential development that is happening out there. The project is right next to Vnukovo, a 50-hectare site on Kievskoe Shosse. There will be Kievsky Outlet Village and a retail park with Cinnamon Entertainment, It will be about 85,000 square meters, and the total investment is about $380 million. We have had a very good experience working with the city and they are definitely focused on making it efficient so there is a growing view that picking up government or asking business to move out of the center is not a good idea.
We think it could worsen the traffic and it is far more rational — which appears to be the way the city is going — to develop public transportation as well as highways, and the proper servicing of districts to avoid the kind of hectic development that has happened in many cities around Moscow.
For those who want to shop at the outlet village, they can board the train at Kievsky railway and metro station and be out there in 30 minutes. It will be a short shuttle ride from the Vnukovo Aeroexpress airport station.
Looking back on your experience in Russia, what trends can you identify?
Lee Timmins: We opened our office in 1992 and did our first joint venture with a division of the Ministry of Foreign Affairs, UPDK, for a project, Park Place Moscow. It was just a couple of million dollars and managed the project for a cash flow participation for 20 years, After a second project with UPDK, we were an adviser for Ducat Place II then, in 1996, we part invested our real estate emerging markets fund in Prokosvky Hills, to the amount of $100 million of equity investment.
Since then, virtually every building that we have built has been almost immediately occupied so it has been a great experience.