The sun is not always shining

Earlier this year Knight Frank Russia teamed up with three other well-known organizations – Rutley Capital Partners, GVA Sawyer, and Duet Private Equity Limited – to create Rutley Russia Property Asset Management Company (RRPAM,) a new fund management company that is managing the Rutley Russia Property Fund. RRPF has attracted several international institutional investors to the fund and has already managed to conclude a number of deals in the short time it has been operating. Heiko Davids, Chief Investment Officer of RRPAM and one of the principals, recently spoke with CRE about the misunderstandings that most international investors have regarding the Russian market, and how RRPF will work around them.

The four organizations involved in your new fund management company have played a variety of different roles on the commercial real estate market, both internationally and in Russia. Why have they come together now to form RRPAM, and who initiated this project?

The initial idea in putting this fund together was Knight Frank’s. Our goal was to structure the fund and the fund management company in a way that would give to foreign investors the opportunity for attractive financial returns and, at the same time, provide them with a maximum level of comfort by taking a western-style, transparent and disciplined investment management approach, focusing on corporate governance and protecting the investor’s interest to the highest extent possible.

We had realized that before the establishment of RRPAM there were many purely international fund management companies coming to Russia who had on one side a good track record as asset managers in their home countries but which, on the other side, had little or no experience on the Russian market. They therefore faced serious problems successfully investing the money in Russia.

We also saw a lot of interest from foreign investors in Russian development companies who seem attractive due to their local expertise/connections and the existence of a deal pipeline. However, in the view of certain investors, many of these companies lack longstanding real estate track record and experience in institutional quality corporate governance. Many of these groups are also perceived as trying to bring their own projects into the funds or the companies they offered to investors.

With the creation and composition of RRPAM we wanted to combine the best of both worlds – professional Western fund management with strong local experience and expertise on the ground.

So how will your organization’s four member organizations function? How did you ultimately settle on this composition?

We have brought together the international fund structuring and management experience of RCP and Duet, as well as the local real estate skill sets of Knight Frank and GVA Sawyer. GVA came to this project because of its experience in development and development consulting. We felt that it would be inappropriate – given the lack of quality products and the tight competition among investors for such standing assets - to establish a fund focusing only on existing properties and therefore decided to create a fund that could invest in development projects as well.

RCP and Duet were brought into the fund management company because we understood that we needed foreign and an asset management track record and expertise to structure and manage the fund properly. In addition, both RCP and Duet have excellent relations with international investors that were instrumental in successfully doing our first fund raise. Both RCP and Duet’s experience will also be incredibly helpful to make the right strategic decisions for the further development of the Rutley Russia Proeprty Fund, e.g. with regards to topics such as additional fund raising, going public etc.

I strongly believe that we have very effective and well-balanced skills set compared to other funds here in Russia.

What sort of results have you and your partners begun to see?

We successfully closed our first fundraising for the Rutley Russia Property Fund in the form of a private placement at the end of February this year. After about half a year of operation, we closed our first deal – a sale-and leaseback for a automobile dealership center - at the end of October. In addition, to acquiring this first property, we have agreed with the vendor on the sale-and leaseback of two additional dealership centers and a pipeline of development projects with a total investment volume of up to 200 million US dollars.

In addition, we have a couple of other deals currently under exclusivity and due diligence and we are expecting to sign these deals within the next 6 to 8 weeks. By only doing these deals we will already have deployed a majority of the equity that we raised in February. That’s why we are already planning to do a second fund raising early next year, where we intend to raise additional $200 – 300 million.

The majority of other foreign funds that came to Russia have been struggling investing their money and needed in some cases up to two years closing their first transaction.

In the light of this, I would say that Rutley had a successful start and the composition of the management team has already proven to be right one.

Why did you decide to use these private placements instead of an IPO?

We had the initial plan to do an IPO, but when we were getting prepared last year in June we faced a temporary crunch on the stock markets globally and in Russia as well. As a result some of our competitors had issues when raising funds through an IPO, so we decided to go for a private placement initially and postpone the idea of going public to a later stage. As I already said, we will go for our second placement at the beginning of next year, and may then consider a public listing at a later date. It should be also noted, that our long-term goal is not to manage only the Rutley Russia Property Fund, which focuses exclusively on commercial property. Our intention is to grow and position Rutley Russia Property Asset Management as a strong, professional fund management team that may eventually establish and manage additional funds with different targets and strategies.

Which are the negative factors influencing investors and investment deals in Russia? Why do so many deals ultimately fail here?

One of the main reasons for the slow progress on most transactions and the high rate of non-completion is that most foreign investors had little or no experience working in this market before. It takes them considerable amount of time to understand the real problems inherent in real estate investment transactions in Russia.

Vendors usually don’t sell properties but entities holding properties. Thus, information about the corporate structure of the entity to be acquired is equally important to the information about the property itself. The impact of taxation on the net returns for example strongly depends on the chosen legal set-up and key financial parameters. Theoretically, there can be two identical properties in terms of quality, location, size, tenants, rent roll etc. But with a different underlying structure (asset vs. share deal, local entity vs. branch of a foreign entity) and financial parameters (book value, debt/equity structure, leverage) of the deal, the net return of the investments at the shareholder level might differ by more than 20%. Similarly, there might be also completely different legal risks inherited in each deal.

In most cases, it is very difficult to get initially full information from the sellers to make a thorough and detailed financial and legal analysis. For a variety of reasons, sellers are not willing to disclose sensitive information immediately.

Therefore we usually have to look at the property first and decide that it is attractive, and then once there is already a certain understanding with the seller about commercial terms, we can get more information. But the situation might change. Once we learn more about the company itself, we might see the tax issues and we may find that the project is really not so interesting. We need a lot of information to make a proper offer to sellers though they have a tendency to be rather unwilling to give it. The next problem is that foreign buyers have differing perceptions about risks. Foreigners have to understand that they live with a different risk profile here in Russia. You cannot expect to see a net initial yield of 8% or 10% here, as opposed to 5% in Germany or 4% in the UK, without a certain amount of risk involved. Also, the Russian seller who thinks that his legal structure has no risks should give investors the appropriate warranties and indemnities so that if these same risks come up, he will reimburse us for our losses.

The final point is that, frankly, the terms are not always clear or used the same way here as they are in the West. In the UK and Germany the phrase, Net Initial Yield, for example, refers to income on a property after certain deductions have been made. For example, even if a landlord currently hasn’t got any vacancies on his property, there is the potential risk every year that tenants simply won’t be able to pay the rent and he will have a vacancy. In the West, he would normally deduct 2% of his income just as a precaution against the potential vacancy. So there is a lack of information both on the sellers’ and on the investors’ side. In the UK we talk about a 4% net initial yield after theoretical deductions for vacancies, maintenance, and other theoretical problems. In Russia, they do the same net initial yield calculation but don’t do those deductions. Investors generally think the yields in Russia are higher than they actually are.

In your view, then, is it all simply a myth that yields are higher in Russia than in the West?

The net initial yield is still higher, unquestionably. But most investors work on a leveraged basis – that is, based on the amount of return they can get calculated against the equity they receive from their bank. On a leveraged basis, certain investments in Russia are less attractive than certain investments in Western Europe. It’s not such a simple question, despite the perceptions in the market. In some cases, it is not really attractive for some investors to buy standing properties with lower yields here any longer.

In your view, are there other opportunities still available for investors in Russia? You have only just now formed your fund management company, so you must think there is some sort of future in the Russian market. What form will this take?

There are still many opportunities in Russia. There is still so much to do here. There’s a lot that needs to be torn down and rebuilt in the next 20 or 30 years, and this makes Russia attractive for investors. If it comes back to smart investments, however, we don’t want our investors to come in when the market is overheated. It is imprudent to only rely on yield compression. Investors are currently buying properties at rental rates that in our view might not be sustainable in five years time. These investors might face a similar situation like in CEE – e.g. in Poland – 6 or 7 years ago, when rental compression was outweighing yield compression and thus resulting in falling capital values for properties. Maybe this won’t happen in Russia – but there will certainly be corrections. Much of what we see in Moscow office real estate is based entirely on the huge discrepancy between supply and demand. Somehow this situation in Russia is going to be stabilized in the next period.

Will your new portfolio at RRPF include more assets in Moscow or in the regions?

We are investing in commercial property – office, warehousing, and retail – with a strong focus both in Moscow and in Saint Petersburg. We are currently not planning to invest more than approximately 25% of our portfolio in the regions. It’s mainly a question of managing our resources properly. To move into the regions, you need to be present there, establish new contacts and spend a significant amount of time for research and supervision. A real issue is also to get sophisticated research information and comparable data, in order to show investors that it’s worth the trouble to buy in a new location.

Do you see a lot of competition between the existing funds because of the lack of investment product?

We do, absolutely. In particular with regards to existing properties of international investment quality, there is still very little supply and, therefore, extremely strong competition from all kinds of investors for such properties. As a result, foreign institutional buyers have recently been very aggressive in terms of pricing and sometimes make offers that in our view were unsophisticated and not justifiable given the risk-return profile. In most cases, these investors have realized their mistakes when taking a closer look at the deal and seeking professional advice from their consultants during due diligence and, consequently, refused to proceed with the deal. However, these investors have raised high expectations - mainly with inexperienced vendors - that are difficult to bridge for more experienced buyers in the market.

Most vendors are still very much focused on the “cap rate” an investor is willing to pay for his property in sales negotiations and assume that the cap rate is an objective figure to determine/compare the price of an income producing property. When taking a closer look at this it should become obvious though that the cap rate can be barely more than a rough indicator in an immature property market like Russia as one must have answers to a myriad of questions before making a judgment about a “fair” cap rate. How is the underlying NOI defined? Are capital expenses and vacancy/credit losses deducted for purposes of NOI calculations? Is the income fixed/indexed? Is the property leased at market rates, is it under or over-rented? As already mentioned before, even more important is the underlying tax structure. Is it an asset or share deal? In case of a share deal, do I buy a local entity or foreign entity with a local branch? What is the latent capital gain risk determined by the ratio between book value and purchase price? Are there any tax leakages/trapped cash issues when the deal is leveraged?

A serious investor will take all these questions into consideration and evaluate them professionally before coming up with a specific “cap rate” or total price for a deal. Unfortunately, the majority of buyers and vendors are not acting accordingly and are later on disappointed when they fail to agree or complete a deal. We have indeed seen this year countless offers and many negotiations but very few deals that were actually signed and closed. But the situation is slowly changing now. The credit crunch is also having some impact. Lots of sellers now see that things might change. Yields might go up again. That’s what is happening in Europe.

What direct consequences have you seen as a result of the international credit crunch in Russia, and what sorts of predictions are you making?

In particular developers are now having trouble getting financing from banks and some need to sell their existing properties to finance their development projects. I would say that the credit crunch will actually make forward funding/forward purchase structures more interesting for local developers who face problems financing their developments with bank debt. With few exceptions, Russian banks and in particular Kazakh banks have severe issues with liquidity and their ability to refinance themselves. This has strongly limited their overall ability to provide debt and increased the costs for capital significantly. What makes it worse is that nobody knows how long the impact of the credit crunch will last. It might take only a couple of months, it might take a year, but it might even last much longer if banks try to take advantage of the situation and recover part of their losses suffered by keeping in particular margins high for a longer period.

Those international banks who have not yet temporarily withdrawn from doing real estate lending in Russia have become very selective in terms of the projects and the borrowers they are still going to finance. In general, these banks focus now on financing low-risk, existing quality properties and on clients with whom they have an existing, long-standing relationship. Even for these borrowers, financing terms have been worsening over the last weeks: margins have gone up, loan-to-value (LTV) and loan-to-costs (LTC) ratios have come down, terms and amortization schedules have been becoming shorter. For new clients – in particular if they are looking for development finance – it will be very difficult to obtain from foreign banks any finance at all in the nearest future and will have to look for alternatives, perhaps by doing forward funding deals with Funds like ourselves. In addition, I strongly believe that we will see more properties coming to the market for sale and price corrections for non-prime properties.