Russia offers growth potential, but can institutional investors feel comfortable with the risks? Shayla Walmsley investigates

A Welsh entrepreneur who took on emerging market firms by buying steel from them, then selling it back to them after treating it, offered the following advice to would-be investors in Russia: stay sober, say nothing, and leave.

For institutional real estate investors, Russia is often seen as too opaque and risky. With a renewed focus on due diligence, Russian property has fallen off the radar screen for these investors.

Yet capital is being ploughed into the Russian market, according to a report published in May by Colliers International. The study found that Russia accounted for 40% of the €13.2bn transacted in central and eastern Europe last year - higher than Poland, which accounted for €2.6bn.

Despite the evident appetite, there is limited availability of investable assets. Back in 2007, Aberdeen launched a target €500m Russian property fund with the aim of investing up to €1.5bn primarily in Moscow and St Petersburg. “It was a big trend at the time of the bull market - to establish a Russian property fund,” says Pertti Vanhanen, head of property fund management at Aberdeen Finland. “We did establish a fund but we couldn’t buy anything. Now institutions are more risk-averse. Of course we’ll keep our eyes open, but there isn’t one in the pipeline.”

Caisse de dépôt et placement du Québec subsidiary Ivanhoe Cambridge entered the Russian retail market in 2008 with the acquisition of Moscow shopping centre Vremena Goda via a 60:40 joint venture with Austrian fund manager Europolis. But it has acquired nothing in the market since. This is in contrast to its continued activity in Brazil, for instance, where it has acquired more than 10 assets since 2008. Hines has raised €390m in global institutional capital for a fund targeting real estate in Russia and Poland with a view to deploying 80% of capital in the former. It has already made a number of retail development investments in Moscow and St Petersburg.

While plenty of investors see more value in second and third-tier cities in China than in Beijing or Shanghai, in Russia the market effectively comprises Moscow and St Petersburg. In other words, Russia has a significant landmass but a very limited market. CBRE figures indicate that last year the regions accounted for only 4% of total real estate investment in Russia. These regional markets offer a running yield 100-200bps higher than the two major cities, which account for just 20% of the population.

Another typical example of the two-city approach is that of Finnish property investor Sponda, which has a business unit dedicated to office, logistics and retail in Moscow and St Petersburg. The firm, whose shareholders include pension insurers Varma, Ilmarinen and Fennia, the State Pension Fund (VER) and the Landskapet Ålands (local government) pension scheme, plans to increase the percentage of Russian property in its portfolio up to 20%.

Kari Inkinen, chief executive at Sponda, expects to see supply constraints once current projects reach completion in 2012 and 2013. Despite a 13% vacancy rate for prime office, a lack of quality assets will result in higher rents. In contrast, rents are not rising in Saint Petersburg and they are less likely to because demand is lower there than in Moscow, and there is greater supply.

“We’re interested in St Petersburg but it’s a smaller market and it changes more slowly,” Inkinen says. “There’s fairly low demand and more new construction [than in the capital]. That’s our main reason for liking Moscow.”

Konstantin Lysenko, associate director for capital markets at CBRE Russia, has pointed to projects coming to market - such as Karnaval in Chekhov and Victory Plaza in Ryazan - as indicators of the potential for liquidity and retail yield compression in regional markets. If international capital has initially targeted Moscow and St Petersburg, he predicts that the next the geography will be cities with relatively modest populations (of between 300,000 and 700,000) within driving distance.

Moscow via Helsinki
The problem with investing in a growth story is that in reality it is not possible; investors invest in a market. The question with Russia is how to gain access without finding yourself exposed to significant commercial, sectoral, counterparty and political risks.
One way is to invest in Finland. Russia was tied with Nigeria in 143rd place in Transparency International’s most recent corruption perception index; Finland ranked among the top three least corrupt markets.

Russia has an effect on the Finnish property market in a couple of ways. First, Russia is Finland’s third largest export market after Sweden and Germany. In the first two months of 2012, Finnish exports to Russia increased 10% as its other export markets suffered. As a result, Finnish companies are in good shape and growing, which has a positive if indirect impact on the country’s domestic real estate market.

Second, Russian investors have recently been buying smaller-scale assets in small and mid-sized office and residential markets. These are not major deals. In total, Russian investors have only spent between €20 and €50m so far, but it is a trend. “It is difficult to say whether bigger investors will follow,” says Vanhanen. “This isn’t London, with tycoons doing big deals. That won’t happen in Finland because it’s just not a target market for them.”

As a solution to the problem of Russian risk, investing in Finland has its limits. Although the country can bask in the peripheral glow of Russian (and for that matter Nordic) macro economics, despite its euro-zone membership, it has a small real estate market dominated by domestic pension fund and insurance investors.

Despite acquiring two distressed central business district assets - one in Helsinki and the other in Tampere - for €38.5m earlier this year, the real estate subsidiary of Finnish insurance firm Tapiola acknowledged that it was struggling to achieve a prime allocation of 13-20%. Other domestic pension funds have targeted development projects. They include pension provider Etera, which has invested €300m in offices as part of Helsinki’s Töölönlahti bay development.

Even if you move outside Helsinki - and Aberdeen has, targeting smaller cities with yields on prime assets above 5%, especially university cities - the asset pool is limited. Volumes in the Finnish market total approximately €2bn, of which a third of involves international capital.

The economic imperative
Helsinki has one major advantage over a Russia, though - transparency. Even if some of the charges made against its investment environment could have come out of a vintage James Bond film script, it would not do to underestimate the complexity (and opacity) of the Russian market.

There have been improvements. Recently introduced reforms will increase the financial reporting required of state-owned companies, which account for around 10% of GDP. In February Russia became a signatory to the OECD anti-bribery convention after introducing its own anti-corruption legislation last May.

Russia ranked 28th on Transparency International’s Bribe Payers index last year, although that index only measures the likelihood of Russian companies paying bribes abroad, rather than overseas investors paying bribes in Russia.

Guy Barker, managing director at Palmer Capital, who has been investing in Russian real estate for more than a decade, believes the market risks have been overplayed. For investors looking to hire existing assets, he says, it is a predictable market.

“There is a process,” Barker says. “If you’re buying an existing building with financing from an international bank, the legal risks are no different than in a western country. You have secure title. You’ll have a mortgage registered with Raiffeisen or Sberbank. Knight Frank would have done the valuation, and an international firm the due diligence. International accountants will advise on the tax structure.”

The primarily British view of the Russian market is based on a lack of knowledge, he argues. “Brits would say the Russian market is dangerous, scary and corrupt. Germans would call it bureaucratic. It isn’t scary. Ukraine is scary, but not Russia, which is a functioning state. It is seen as the wild East by many, but you can’t go in like a cowboy. If you cut corners, it will backfire on you,” he says.

In any case, as Barker points out, “Size and potential can make up for a multitude of sins.”

The potential is primarily macro. Matthias Siller, equities fund manager at Baring Asset Management, is bullish for the Russian market’s long-term prospects and expects GDP growth this year to exceed the 3.3% consensus forecast. With emerging markets out of favour and investors in risk-off mode, he believes investors will compare Russian macro growth favourably with negative forecasts for developed Europe, seeing its strong performance this year as a means of reducing emerging market exposure.

In its most recent interim report, East Capital compared Russia favourably with the similarly oil-dependent Brazilian market, which is 40% more expensive.

A drop in Russian private consumption and investment in the first few months of the year could reflect a more moderate growth trend but that is “not a big concern”, says Inkinen. “The growth is still mainly driven by the oil price - that’s the biggest factor you should look at, and it will keep consumer confidence up.”

In the meantime, the cautious will go to Helsinki. For the bold, Barker offers a couple of secrets to investing in Russian real estate: common courtesy - and due diligence.