Looking Beyond the Current Cycle

As the Russian economy approaches the end of the current cycle, the onset of the new cycle will have interesting implications for the real estate sector.

Vladimir Pantyushin, Head of Research, JLL, Russia & CIS

Slow economic rebound awaits

When thinking about the new cycle in Russia, one naturally refers to the period following the 2008-09 recession. That last recovery was solid and quick, with GDP growth reaching 5 percent in 2010 and lingering at the 4-5 percent level for two years. Admittedly, the initial bounce was helped by a strong base effect: GDP decelerated to -11.2% YoY in Q2 2009. The V-shape bounce that followed was assisted by a quick rise of oil prices, which remained high until mid-2014. This time, the bottom of the cycle is more shallow (-3.8% YoY in Q4 2015), oil prices recover slowly and unevenly, so the exit out of the recession will certainly be less remarkable. The initial bounce will likely produce GDP figures below 3% YoY. Growth forecasts of market analyst for the next two-three years cluster in the range of 1-2% per annum. To the expected moderate nature of oil price recovery we add such internal factors as substantial underinvestment over the last four years, shrinking labor force and certain restrictions on imports of advanced technology. Attempts to lift growth rates will require jumpstarting investments. This looks unlikely, particularly when adding the fiscal situation to the mix.

Gradual rental recovery

On the commercial real estate market, the exit out of the 2008-2009 recession was equally impressive. Moscow prime office rents rose by 30% in 2010 after a 50% decline in 2009. Note that this happened in the market with the overall vacancy rate above 15%.

Ekaterina Andreeva, Investment Market Analyst, JLL, Russia & CIS

Current Moscow office market vacancy levels are similar (15.6% in June). Still active supply of new projects is balanced by dynamic rental activity. The likely scenario is that rents begin to recover shortly after the economy turns to positive growth. The arguments for slow economic recovery are applicable to the real estate sector as well. Therefore, the sharp turnaround of 2010 is likely to be replaced by a gradual recovery in 2017.

Real estate segments: new leader, maybe

Comparing the range of rental changes in Moscow offices, the sector benchmark, with that in the previous crisis also shows more moderate swings. Prime rents declined 22% this time versus 50% at the trough of the 2008-2009 recession. We expect a more gradual rental recovery as well. Low GDP growth makes this a likely scenario. Real estate specific factors supporting this are high vacancy rates and still high completion volumes.

We also find more uncertainty in the potential sequence of the recovery of real estate segments this time. In the previous cycle, the industrial segment confirmed its status of the first to react. Construction volumes, vacancies, rental levels adjusted ahead of those in offices and shopping centers. This time, however, we may witness a change of the leader. While vacancies in the other two segments have already dipped lower, in Moscow warehouses they continue to rise. Struggling consumers will curtail the recovery of retailers, the principal warehouse sector customer group.

Admittedly, some large local retail chains (Magnit, X5 Retail Group) have been performing well recently, mainly in the regions. However, real personal incomes are lagging; higher consumer debt weighs on family budgets. Both factors will likely be amplified by a weak consumer confidence and will postpone the recovery of retail turnover. In turn, this indicates that Moscow shopping centers may go through a longer rental trough.

Domestic capital drives investment recovery

The economic downturn, the currency devaluation in particular, led to a sharp contraction of real estate investment activity. Investment volumes in 2015 were at the lowest level since 2006, when the market was still at a formative stage. As the economy began showing signs of improvement, investor interest in Russian assets increased.

In relative terms, the fall in investment volumes in 2009 and in 2015 was comparable, at about 35%. The recovery in 2010 lifted them by 70%. The recent stability encourages investors to return to the negotiation table, with the activity in H1 2016 serving as a testament. According to our forecast, the bounce in 2016 is expected to be similar to that six years ago, with the annual volume reaching $4 billion versus $2.3 billion in 2015 (+74%). The bulk of deals that come to completion are those suspended amid high market volatility in 2014-2015. Further rise in investment volumes is likely in 2017, although the levels above $8 billion registered in 2011-2013 look unattainable in the medium term.

The office segment maintains the leading position, with a 40% share in H1 2016. Russian investors traditionally set the tone in tough time. Their share in total deals in 2015 (80%) matches the 2009-2010 split. Foreign capital remains flighty and traditionally returns to the market when the recovery is well under way. The experience of 2011-2013 indicates a potential for large acquisitions by non-resident investors in the medium term. Several investors have already begun "testing the water" recently, and the market looks attractive offering double-digit yields. What looks likely to change is the investor origin, as traditional Western market players give way to Asian investors.

Rouble as preferred leasing currency

Prime rents are traditionally nominated in US dollars. Therefore, one of the factors that can potentially raise them is the currency. In fact, rouble strengthening has already contributed to rental recovery this year. This has also served as a reminder of the two-sided nature of the currency risk. One of the features of the down cycle was a massive switch out of currency rental contracts into roubles triggered by the rouble devaluation. Understandably, the experience of 2014-2015 created a strong bias towards rouble weakening.

A question of currency denomination of rental contracts still remains valid. In the current tenant market, the prevailing opinion will be that of the tenant. As a consequence, we believe the ruble will remain the preferred leasing currency. Retail and industrial segments service the rouble economy, so their reluctance to take currency risks is natural. Class B offices also appear unlikely to return to FX contracts.

A significant number of exceptions will remain though in higher grade offices and shopping centers, particularly if the rouble continues to recover. In this scenario, FX contracts will turn out to be cheaper for tenants: the currency discount will supplement lower annual indexation levels.