Cold Shower for a Once-Hot Property Market

	To Our Readers
	The Moscow Times welcomes letters to the editor. Letters for publication should be signed and bear the signatory's address and telephone number. Letters to the editor should be sent by fax to (7-495) 232-6529, by e-mail to [email protected], or by post. The Moscow Times reserves the right to edit letters. Email the Opinion Page Editor

We are now months along in Russia's painful readjustment to a new economic reality. This is courtesy of the global economic meltdown, lower commodity prices and the credit market liquidity crunch.Russia appears to be in the middle innings of this humbling downsizing. The country's core metropolitan commercial real estate markets have already been significantly repriced and are about to be restructured.

Property developers' pre-crash boom stories were suspiciously uniform. All were based on severe supply shortages, endless growth in demand and high barriers to entry. These points have now been turned on their heads. The investment story lost its underpinnings to market fundamentals when commercial rents effectively doubled over 18 months in 2007 and 2008, far outstripping growth in underlying demand measured by a host of proxies including growth in per capita gross domestic product, household consumption and investment.

In the last four months, market rents have fallen by about 50 percent in the office and retail sector, with the Moscow market leading the pack. What is clear is that pre-crisis demand was exaggerated by overly optimistic growth plans of both office occupiers and retail operators, impervious to the extraordinary rent increases. These high-growth, 10-year business plans have now come unhinged. As a result, we see floor after floor of shiny, new and unoccupied office space. According to CB Richard Ellis real estate services, vacancies rates in the office sector have gone from about 7.5 percent in summer 2008 to 17.5 percent at the end of the first quarter 2009, and they are expected to go even higher over the next couple of quarters. Similarly, distressed retailers and vacant units along the high streets and malls are proliferating.

Developers, property owners and most investors failed to see this rapid expansion in pricing and demand as speculative and susceptible to a sharp correction.It was quite clearly a case of too much money chasing too few deals. As Robert Shiller of Yale University reminds us in his book "Irrational Exuberance," market participants in aggregate have a vested interest in maintaining a feel-good, high-margin investment narrative.

In Russia's case, exuberant investors were abetted by seemingly price-insensitive end-users of real estate, collectively underestimating the country's macroeconomic vulnerability.

For good measure, here are some anecdotal references to the magnitude of rental declines. Currently on the market are modern high-quality offices near Moscow's Third Ring Road for $400 per square meter including fit-out, operating expenses and valued-added tax.That's equivalent to a net rent of about $250. Rents in Moskva-City have gone from upward of $2,000 per square meter to about $700 per square meter, including fit-out.Additionally, several developers in Moskva-City have lowered asking rents and are also offering the first year of a lease term free to compensate for tenants fit-out.The corrections are equally severe in the retail sector.

Meanwhile, on the investment side of the market, property yields have skyrocketed as investor interest has dwindled to a trickle. Investors cannot adequately underwrite future rent levels and cash flow, the return of the debt markets, currency risk, country risk or the cost of their capital in home markets.Reason would dictate that until yields and markets stabilize in investors' home markets, the risk premium to buy in Russia will hover as high as the international space station.

This post-crash investor demand for higher compensation for higher risk, together with the 50 percent fall in market rents from peak levels, have had a severe impact on property valuations, driving asset prices down 50 percent to 75 percent from their former peak levels.

This represents a massive destruction of value -- especially for those investors who bought into the market late at inflated price levels."Bought in" includes investment either through acquiring income producing assets or funding development.It is clear that upon completion, the future market value of most development projects currently under construction are likely to be worth less than the cost to develop -- commonly called replacement cost. Many of these projects are now stalled and looking for new equity to refinance and complete.

What is obvious is that many project sponsors and or their lenders will have to take substantial losses on their project investment to date in order to entice new equity to come in at lowered valuations.A lot of these developers are in for haircuts. This is especially painful for market participants who have only seen asset values rise over the past 10 years. Additionally, we should expect to see many of these projects foreclosed upon and wind up on the balance sheets of banks as Russia's banking system goes through its first round of nonperforming loans in commercial real estate.

This destruction of value is one reason for the value decapitation of Russia's publicly listed property stocks, which fell over 90 percent from last summer's price levels.These listed developers presumably understand much of the devastating repricing as their bankers are now demanding tough refinance conditions and starting to foreclose on their projects, notably with VTB Capital and Sberbank recently taking over collateralized assets. Smaller private developers are still holding out hope and have been much slower to recognize the new market reality.

One can appreciate why Sberbank head German Gref announced last week that he expects the bank's bad loans to reach 9 percent of its portfolio by the end of the year.Other senior bankers see nonperforming loans reaching 20 percent of the Russian banking system's total loan portfolio.

Unfortunately, most small and midsize banks believed that real estate was one asset class they could really understand. Renaissance Capital estimates that the Russian banking system has an aggregate real estate loan portfolio of about $80 billion. It is likely that the overreach was widespread and the contraction will be broad and painful.Given the opacity of the country's banking system, the shift in the government's refinance policy and its list of "strategic companies," the workout of nonperforming real estate loans could be messy.

While 2009 may be the first year of the workout in property, it will not be the last, as restructuring insolvent projects and waiting for demand to take up the supply overhang will likely be a multiyear effort.In fact, much of 2009 will likely amount to a standoff between lenders and borrowers -- with both clinging to the hope that a market rebound will bail them out. Hope is not the most secure thing to bank on, but as the Russian proverb says hope dies last.

Jack Kelleher, formerly a managing director of Alfa Capital Partners, advises an institutional real estate private equity fund in the former Soviet Union.