For REQ

Over much of the last decade, a number of key changes to Russian real estate law, especially in mortgaging, have helped to increase the attractiveness of the country internationally. Yet, in spite of Russia’s openness to outside involvement, big obstacles to transactions remain, such as the state registration of buildings, which has also helped intensify the crisis in the real estate sector. Steven Shone, the former head of real estate at CMS Russia, who worked in the country for seven years before moving recently to develop the firm’s real estate operations in China, recounted his experiences to Alexander Teddy.

Have there been any positive changes in real estate legislation over the last seven years in Russia?

Steven Shone: There have been some positive changes. The most important one for the market was the change in the mortgage law. When I first arrived, for a lender to take security over a development project, the developer first had to mortgage the land, then when it was complete the building. The bank’s security was incomplete until the building was state registered. The changed law means the land mortgage applies to the completed building without any further action. That helped a lot and was the result of lobbying by the German mortgage banks. Without it, many lenders would never have been able to enter the market.

Did this have a knock-on effect for consumers?

SS: Yes, it made more finance available and a lot of the projects of the last five years possible, so it improved the market. It had a big effect on behavior in the real estate market, because when international banks came in before the crisis they would only lend with good security over a proper title. The old wild days, when it didn’t matter if your titles were imperfect as long as you had the right contacts, changed because foreign money, although much cheaper, had stricter requirements. Their arrival professionalized the market dramatically.

So it was outside lobbying, rather than a top-down initiative that brought about this change — the little people, rather than the power?

SS: Well, I wouldn’t call the German mortgage banks a group of little people, but it wasn’t a top-down initiative. It was something the market demanded and got. But they didn’t go far enough, because there is still the problem that until a building is state registered, it cannot be bought or sold and pre-lease agreements are not legally binding. This still makes financing development more difficult than in most countries. That would be the single reform I would propose, if I had one choice. I’ve repeatedly offered at conferences and public places to write this for the government for free.

Most real estate markets have some equivalent of an occupancy permit. This means that until a building has been signed off by the authorities as having been built in accordance with the regulations, it cannot be used. That is enough of an incentive to comply with the law, because if the tenants cannot use it, then the owner cannot make any money.

In Russia, until it has been signed off legally, it cannot be bought or sold. So owners cannot lease the property out; you cannot buy and sell it. Normally owners are able to buy and sell buildings during the course of construction, which adds more flexibility and brings more investors into the market. The lawyers in the market were still able to make it happen by creating offshore structures and doing it that way. It should be possible to do it using Russian law, but it is not yet, because of this state registration anomaly.

This has created further problems and probably intensified the crisis in Russia because owners cannot guarantee to bind tenants to forward-leasing obligations. For example, if you’re building a shopping center, normally to get your bank comfortable to finance it you would show them the pre-lease agreements the tenants had entered into, which committed them to paying rent, provided you deliver their premises on time. Those contracts are legally enforceable everywhere else in the world but not in Russia. Effectively Russian law says, ‘this building doesn’t exist yet’ because it hasn’t been state registered and you can’t create a contract for what doesn’t exist. When the market fell, tenants walked away from their forward commitments. That intensified the crisis; it has created a worse problem for Russia. This is the only country in our network where there is not already a substantial recovery in the real estate market. This is partly the reason for it. Because banks can’t rely on tenants’ forward commitments, they have to be more conservative.

It’s a pointless law and it reduces the available financing — both debt and equity — for development. Nobody lawfully benefits from it, but it destroys value. Russia’s land would be worth more if the system of state registration were abolished!

How might the dual tax agreements recently confirmed by the Russian government and offshore jurisdictions affect the real estate market inside the country?

SS: To the extent that the treaties make it harder to structure offshore deals with assets inside the Russian Federation, I think that they will slow the market down. On the other hand, so much offshore structuring involves agreements under foreign laws and dispute resolution in foreign arbitration courts.  So the judges here do not get the experience that they need to build confidence in the legal system. That damages Russia’s reputation and increases the perception of investment risk. It is in Russia’s interests to make things work as well as they can, so that people become comfortable with onshore deals. They will not be until the local courts have good experience in dealing with complex commercial questions.

How much farther has Russia got to go in terms of establishing a stable and coherent system of land law?

SS: The government has improved the Planning Code. There was no proper system before, and although it is still not perfect, there is now better guidance for what buildings and construction require. They have removed some of the uncertainties at the border between federal and regional law to avoid conflict. Moscow, for most of my time here, as a subject of the Russian Federation, was technically in rebellion for not complying with a Supreme Court ruling regarding the application of the law on implementing the Land Code. This dealt with state companies that were occupying land without legal title. In the Soviet days, the title was never an issue as the company and the land both belonged to the state. There was a law stating that the company was entitled to call for the freehold of their land, and there was a valuation basis for it. Moscow refused and, although the case went all the way to the Supreme Court and the City authorities lost, it still refused to comply.

Those were the kind of uncertainties that were quite fun for a lawyer — people would ask for legal advice and I would tell them, “the legal process is over; the Federal Government should send the tanks in because Moscow is essentially in rebellion”. But those issues have now been resolved, and freeholds are becoming available in Moscow for the first time.

What is going to be really interesting now, as those freeholds come onto the market, is to see the effect that they have on the market for the 49-year leases that they granted previously. It could reduce their value, especially if it ever became easy to obtain freeholds. This is theory, of course, at the moment.

Across all laws, there is change, but I do not have a lot of sympathy when things are not progressing as fast as they should. Again on the topic of the state registration of buildings, for example, I actually met the then-chairman of the Duma’s real estate committee at a conference and explained my concerns to him. He replied, “We have everything to fix, but have not got around to it yet, and in the mean time you guys seem to be very clever at figuring out ways of getting around it.” He has a point. It takes a long time to catch up after 80 years of arrested development in commercial law. This is especially true in a continental civil-code system where the judges cannot develop the law themselves and must wait for parliament to get around to it. I do not think the authorities are deliberately creating difficulties. I believe they are sincerely trying to make progress, but it is a big job and will take a long time.

Some people seem to think that most business contracts in this country are modeled using ‘Western law’...

SS: There’s no such thing as ‘Western law’. There is a much bigger ideological and philosophical difference between common law and civil law than there is between Christianity and Islam! English law and French law cannot be lumped together: they are far more different from one another than Russian law is from French law. Russia is part of the civil law family so ‘Western law’ versus Russian law is a mistaken distinction.

In legal terms, Russia is a very conventional, civil-law country. The only real difference is that commercial law was not updated for a very long time because of the Soviet Union. Russia’s legislators must work hard to catch up, because the Commercial Code and the Land Code have evolved in other European countries but not here. The Russian Land Code itself is only a few years old and the concepts are not embedded in people’s thinking yet. In Russia, local authorities often behave as though the land is theirs really, even if it is not. They are still adapting, because this is all so new. Conceptually, I’m not sure that the Russian establishment has fully adapted to the idea of private ownership yet.

When people point fingers at the courts and say they are unfair, is this because there is a lack of experience among some judges, a blend of old and new, or straightforward corruption?

SS: Well, there’s a variety of things. I saw all the same concerns in Central European countries in the early 1990s. People would ask me if they would get a fair hearing, and the only honest answer would be, “I do not know, let’s try to avoid going to court.” But given time, experience builds up and eventually people get more confident about it and stop asking the question. We have not got there in Russia yet. I would be surprised if the Russian courts turn out to be as bad as people fear, but I don’t want to experiment on our clients to find out!

What can Russia learn from China?

SS: I think it is the other way round, actually. I don’t know the Chinese market that well, so I will not say much about it until I have learned more. Russia is very liberal about the professions. Every major international firm of valuers is here, for example. If you want valuations of real estate assets, all the best professionals can help you, and there have been no obstacles placed in their way. The major international law firms are here now — obviously we are too modest to think we are important, but we do in fact contribute a lot to building investor confidence. I think that opening up to international professionals is one thing that China could learn from Russia. If people come to a new market and they can get advice from the same law firm or accountant that they know and trust and a valuation from the valuer that they use throughout the world, that helps; in fact it helps a lot when entering new markets.

Russia has placed no obstacles in the way, but China has. If I employ lawyers in China, their license is suspended while they work for me. So technically we cannot be a law firm in China — we are international legal consultants, because we cannot advise on Chinese law. That is protectionism. Russia is much more relaxed about that, I’m not sure why particularly, but it is much easier to get things done in that way. They’ve recently deregulated the architecture profession, for instance.

Is the market likely to recover more quickly in Russia because fewer people have taken out mortgages for real estate?

SS: If they can succeed in developing the mortgage market, then yes it will. The value of assets depends on the available universe of buyers. If more people are in a position to raise funds and buy something, demand will increase. Supply will then increase as will activity. The logical answer is yes, although we have done very little residential work as most of our clients are either commercial developers or commercial investors. Still, the residential market can have the same problem as the commercial in that it too has to be state registered.

In Moscow you specialized in the hotel sector. Is there anyway that legislation can be introduced to ease the city’s mid-range hotel deficit?

SS: The authorities do not need to legislate, because they own the land. If they want more mid-range hotels developed, they can make it happen because the demand is certainly there. But they only make land available at prices that work for high-end hotel development. So, guess what? People only build high-end hotels, because they cannot make cheaper ones work. Even when developers plan to build more affordable hotels, they are pushed into a position where they end up trying to move them up the market. If the Moscow government wants cheap hotels, then let it make land available at a price that is right for cheap hotels and be very strict about planning requirements — stipulating that this is all it can be used for. What will happen in the end is that three-star hotels will begin to appear simply because some five-star ones will fail and be downgraded. And that will undermine investor confidence for all levels.

Local authorities sometimes try to steer the market by giving permission for mixed-use developments on the condition that they include hotels. This is very difficult for investors because hotels are a very different proposition from shops or offices. Investors specialize, and the range of people who will buy the whole of a mixed-use development is vanishingly small — some do not do this aspect, while others do not do that. If you mix the development enough, there is something to put everyone off. The solution is to ensure the different uses are on different plots so they can be separately sold, but that then complicates the design.

International hotels do not seem to use franchising here. Why is that?

SS: You don’t grant a franchise to an inexperienced operator. When more Russian companies can show a successful track record, famous brands may become more relaxed about franchising. Right now their choice is between ownership, leasing and management contracts. It used to be that hotel companies actually owned their hotels: Intercontinental used to own many around the world, for example, but sold most of them off years ago. Very few major companies work that way any more. Owning hotels consumes a lot of capital that could better be used to develop the business. It makes sense for specialized investors to hold the real estate and make it available for hoteliers to use. If a hotel company can make more money from owning the land than from running the hotel, then it is in the wrong business! Still, the investment institutions have not really developed here yet — which is a problem. The normal management contracts in the hotel industry are also novel in the Russian market. Owners would often prefer the simplicity of a lease, whereas hoteliers would prefer a management contract.

Has the investment climate changed since your arrival in Russia?

SS: The change has been amazing since I arrived. When I first came there were no foreign banks, very few foreign investors — it was not a very international market; it was all done in a specifically Russian way. That is not to say it was not done intelligently, but it was not part of the global market.

But it changed dramatically, particularly with the arrival of foreign mortgage banks. They cleaned up the top end of the Russian real estate market. I remember in 2004 talking to somebody from one of the major funds. He asked, “When should I come and look at Russia?” and I said about 18 months after I have closed my first international financing deal. If a project is good enough for a German mortgage bank, then it is good enough for a major investment fund. After about 18 months those projects will be stable and income producing, so they would be able to get comfortable with what they were buying. He said that sounded about right. Oddly that was about when they showed up. Not because he told all his competitors what I had said of course, but because it was logical.

So, perfecting your title began to matter, because developers could not draw down funding without it. We found extraordinary things in this process. For example, acting for a lending bank, we had to tell one shopping center developer, “Sorry, but you don’t actually own this project.” It is not always very clear — because the land was allocated as a matter of law to either the federal or the regional level — whichever authority is entitled to grant a lease. In this case, the local authority had tried to grant a lease over federal land. This was done in all innocence though — they believed that they were doing the right thing. It was a genuine mistake.

I do not tell it as a horror story, as it is actually a very positive for Russia. The developer went back to the local authority and explained the mistake that had been made. They then went to the federal authorities and the lease was re-granted, correctly.

There is some good thinking going on now too. I’m involved in the Urban Land Institute, an organization that I love. We have great conferences that are not just marketing exercises; there are intelligent, off-the-record discussions between experienced participants. One of the unique things about the ULI is that it brings together everyone involved in the real estate sector, including the local authorities, although we have not managed to get them involved very much in Russia. It is an international group, founded in America in the 1930s and now it is global. We’ve been trying to develop it in Russia and have established a ULI district council here, chaired by my enthusiastic, hard-working friend Arnaud Dubois. There is a lot of discussion in the ULI about standards. In general, Russians are very well educated and open-minded and look at things, asking, “Why is it done this way?” They do not just reject ideas outright because they come from elsewhere in the world.

What is the most exciting deal you’ve been involved in?

SS: I have worked on more exotic projects, but the most exciting for me was a warehouse project financing, because it was the first cross-border deal of its kind in Russia. For me it was the culmination of two years of effort, because I had been helping my contacts in some German banks with their preparations for entering the market. That work, most of it unpaid, was an investment in a way because that led to our acting on the first of those deals. All the advice we had given about how to structure such a transaction in Russia was tested for the first time.

If you’re a lawyer in England, you do not often get to test new structures for the first time, except new tax structures. The basic concepts of real estate law have been settled for some time. That’s what I love about emerging markets and why I have enjoyed working in Russia so much for the last seven years.