Getting A Feel For Moscow - A City That's Hard To Label

Glenn Rufrano

Cushman & Wakefield

Travelators and psychographics could hold the key to understanding the Russian market, according to one global CEO who should know. Glenn Rufrano, president and CEO of Cushman & Wakefield, has an executive background that ranges from compiling Class A portfolios to managing retail centers.

Now based in New York, he has has spent more than a year on a working tour of  the globe, getting a personal view of markets and their characteristics, from the factors influencing valuations to business and retail cultures. Mark Gay spoke to Glenn Rufrano during his visit to Moscow.

What is your view of the Russian market, from the perspective of Cushman & Wakefield's New York headquarters? What do you want from your team or expect from the market?

Glenn Rufrano: In my view, there's an abundance of capital in the world markets searching for yield. What we're finding around the globe is people are searching for yield and in 2011 and '12 they were more risk averse because of what had just happened in 2008, '09 and '10. But they became a little less risk averse in 2013. They are willing to take a little more risk, so the question is, where can we find these markets that will bring more yield, with the understanding that it will bring more risk? Could Moscow be one of those markets? But just like all investment markets, stocks, bonds or real estate, underwriting at comfortable levels needs to be set before you can understand the risk you are taking relative to yield. And my sense is that capital outside of Russia and maybe outside of the EMEA has not studied as well as it should the risks of investing in Moscow

How would you assess those risks?

Glenn Rufrano: Risk in real estate can be simple fundamentals. Everywhere in the world where you own real estate you could own it 100 percent but you are in a joint venture with whatever government you have. In the US the government says you own the title: you have all these laws that can protect you with foreclosure and if your tenants don't pay their rent, you can kick them out, but then I get taxed based upon what we're doing. There is always taxation, which is a joint venture between you and the municipality, and then sometimes those rules can change. You can own a building and a municipality can say there are new rules on disability so I want you to put in a different stairway, new elevators.

  Psychographics is the study of personalities, values, attitudes, inte- rests and lifestyles. You have less information than we would have in the US or Australia.

When we own real estate it is subject to four elements of government: taxation; police power such as zoning and the government's ability to come in and make you make changes; eminent domain meaning the government can take your property for public good but it has to pay you fair value; and escheat which means if you die and there are no heirs your real estate goes to the government. I know every time I buy I am subject to those four in the US. That's the joint venture. Now I need to understand that here. If I own a piece of real estate here, what are my obligations relative to the government? Can they make changes arbitrarily; can they take my property for any good reason? If they are understood people will deal with them.

From the outside looking in, there is lack of certainty between owning and what happens with government authorities. I'm not saying its negative or positive, it's just not as clear as it is in the US. That's the first issue: what is your level with government because you always work with government. The next is economic risks and these involve the growing economy and understanding what's growing and where. This is the positive part of Russia because there is a 3 to 4 percent GDP expectation and that is very good. The US is two, the UK is zero. There is economic growth driven by energy and other elements which is very positive for investing but it needs to be understood how long term it is, where's the upside, how do I know if I can get more rents and value from that growth, so, understanding that growth and how you participate in it. Our team here in Russia understands that but from the outside world looking in, that's not easily understood.

Some foreign investors say their number one concern is inflation. How do you see that from a real estate perspective?

Glenn Rufrano: First of all, GDP growth is a net of inflation number, so it's already been taken out but that is my major point when we talk about the cost of money. When I think about inflation — because I've separated that from growth and GDP — I now think about cost of funds. And that is an issue. That will be an issue that will keep values down in real estate because interest rates will be high. I look at Metropolis and it sold at about a 9 percent cap rate. Why would it sell at a 9 percent cap rate? Because the cost of money is high: 500 basis points over Libor plus a swap gets you an 8 or 9 percent interest rate, 400 or 500 basis points over the US. Why is that? Because you have 6 percent inflation and we are only talking about 1 or 2 percent in the US. Unless inflation comes down to a level that is understood and controllable — and I think world markets would like to see inflation at 2 or 3 percent plus or minus — there is a problem because long term capital will be expensive and that will keep the value of real estate down.

Looking at the different segments: residential, office or real estate, are you more protected from inflation in one or another?

Glenn Rufrano: In general inflation has never been bad for real estate because over the long term it has picked up the value. In the short term it may not. The one area that is more protected is retail because in retail rents there is a provision that increases percentage rent based on increases in turnover. That is a protection against inflation so if inflation occurs and goods and services cost more, and the retailer sells more, they will pay you more rent. So that is a form of real estate that normally everywhere around the globe has more inflation protection whereas in the office rents the annual increase is not related to inflation.

There is lots of talk in Moscow of building a financial center, although that is limited by the cost of capital and the dominance of energy, but how do you view the potential of the office market here compared to other large cities?

Glenn Rufrano: Moscow is a big city; it is a major city with a major economy. The office market size is subject to two variables: the growth of Russian companies and the external growth of companies who want to be here. That is the equation. When you add up the demand for those you get what the office market size should be. Russia is growing internally, what I'm unsure about is the external part: the companies who are migrating to Russia from outside who need more space.

Where does the growth come from? Russia has a limited small business sector which, in the US or Europe, is the sector that generates the future big companies over time?

Glenn Rufrano: If you look at markets and you compare how many square feet of office space they have, in New York we have 400 million square feet of offices. London is the next with 250 million. Look at these markets. New York is about the same size: it has about 10 million people in the city, 15 million including the suburbs, so there is a world market size that you think about.

The state sector is very big here. Does that factor into your analysis. Is the relatively smaller private sector a disadvantage?

Glenn Rufrano: It is a very important variable but in terms of demand for office it is not positive or negative, it just is. There are certain services that the private market could cater to, or the public market which is the government. I'm indifferent as to which one is doing it. I just want the productivity of either one. So I'm not sure that will increase or decrease the number of square feet I need. What I know is I need space for all those services regardless of who is providing them.

Unless inflation comes down to a level that is understood and controllable, there is a problem.

How do you assess the opportunities in Russia versus other emerging markets?

Glenn Rufrano: When we talk about emerging markets as a company, Brazil, China, India, Turkey, all those come to mind. Moscow isn't usually included for the following reasons: I think the market thinks of Moscow as a mature market. It is a market that has been here for a long time, it has culture, it has maturity, and it is a substantial society so it is not thought of as an emerging market but as a mature market. But on the other side it is a mature market that has the potential for a lot of growth so it is almost a marketing issue. It is not marketed as emerging because it is not truly emerging and it is not truly mature and because of that I don't think in the eyes of the investing public it is as clear.

Is it a disadvantage or a marketing problem? For example, Russia disappeared off the Afire list.

Glenn Rufrano: Russia is absolutely not in one camp. You would probably put it into a more mature category but clearly it has some of the characteristics of an emerging market. On the latest Afire list New York was number one, London was number two, San Francisco was three, Washington DC was four and Houston, Texas was number 5. Moscow was 25th. Then they give you the list to fill in for the top emerging markets you would invest in and no one would put it in that. If I were a marketing person here I would be spending time thinking about how I would describe Moscow to the investing world. I would want a nice phrase: we have education, maturity, sophistication and at the same time great growth potential. You need to put all that together.

What would solve the problem of the underdeveloped capital markets in Russia? Is that jut a result of the overdependence on energy, is it a lack of investor presence?

Glenn Rufrano: When you think of the cycle, when we were in 2011 and 2012, core was the phrase: safe investment. New York, London, Paris, all had pretty good pricing because you were coming out of tough years. As you move into 2013 it gets back to where we started: a little more risk, yield being important and now someone has to identify that risk versus yield for Moscow:

Morgan Stanley buying Metropolis is a really good thing because a major institution has said I'm doing this deal, I have priced Moscow this property in this way. What you need now is another institutional five to make some big transactions that will help put it on the map but you need to get those people here and that is the point about convincing people on the risk reward. I don't have any good answer for how to do that but I just know you do have the growth potential, you have to overcome inflation, you have to overcome general politics — is this a good long term market politically — I don't have a judgment on that but people will have to make a judgment on that.

You had a background in Australia looking after the retail sector there. What are the differences with the Russian market? What has to happen here to get the retail majors developing across the country?

Glenn Rufrano: I lived in Australia in 2008 and 2009, working with a company called Centro Properties. It owned 10 million square meters of retail in the US and 2 million square meters in Australia. It was way different from the US. In Australia a typical closed mall would have at least two grocers and a high-end department store and a low-end department store. Everyone would be in the same property. People would have shopping carts with food walking around the malls then they would go into Gap. So it took every demographic and let them come to the same shopping environment. That would never work in the US. All our grocers are at strip centers with a big parking lot. You go in and out with nothing else in between and your malls are separated into high end and low end. Very rarely will you see a low-end department store with a high-end department store. So we are very segregated; My guess is that you are closer in Russia to Australia; that your merchandise mix is going to have to be more integrated for a group of demographics. I saw that when I went to Metropolis. There is a big hypermarket, you have grocers in the shopping centers and you have travelators. I like the Australian model because your catchment area is a lot bigger, you didn't have to worry about capturing high end or low end.

One thing is that you are going to have to understand the market, to get information on the demographics: how many people within five miles, what are the income levels, because you have less information than we would have in the US or Australia. If you look in the eyes of the tenant, what does he care about? This is psychographics, which is the study of personalities, values, attitudes, interests and lifestyles: what are the income levels, how many people, what are their characteristics and what is my turnover. If you can understand those characteristics you will have a much better gathering of retail tenants instead of just experimenting.

You are going to have tenants who experiment, once you get a body of information to help retail understand profitability, your retail will get more perfected. As someone who owned and built retail I can tell you I only had to fill it once. I knew after I built the shopping center that probably 5 to 10 per cent of those tenants were not going to make it in the first 12 months and I would have to put new tenants in. If you don't understand whether your tenants are the right tenants, maybe it's 40 percent so you are going to be changing your mix until you figure out what works.