Signs that the global economic downturn was going to derail the development of Russia’s industrial real estate market started to appear late in 2007, but it was not until the third quarter of 2008 that the market both in Moscow and Russia’s regional centers really started to feel its effect.

In recent years windfalls from oil and gas exports drove consumption, which, in turn, fueled huge investments in production and transportation and created a huge demand for warehouse facilities nationwide. “There was this romantic idea that the real sector was insulated against the onslaught of the economic crisis,” said Denis Sokolov, head of research at Cushman & Wakefield Stiles & Riabokobylko. “Because Russia’s economy was backed by spiraling oil prices, the only consideration behind most real estate development projects was that things would keep on improving,” he added.

The first signs of trouble in the warehouse segment came in October 2008 when potential lessees began to shy away from signing contracts at the beginning of negotiations, said Olga Yasko, regional director of the analytical department at Colliers Inter national. “By December many lessees had either frozen development plans or put off considering rental projects indefinitely,” she said.

Owing to the continuing growth in supply and flagging demand, only 500,000 square meters of quality warehouse space were released onto Moscow region’s property market in 2008. Another 300,000 to 400,000 square meters of announced developments were delayed because of the crisis.

Three large logistics complexes — the Tomilino Techno-Logistical Complex, Espro Group’s Istra Logistic Park and the Pokrov Logistics Park — accounted for 63 percent of the total space brought into operation in the Moscow region during 2008, Knight Frank said in its first quarter report.

Rental rates have experienced a dramatic rise and fall over the last year. At the start of 2008, annual rates for quality Class A warehouse premises fluctuated between $127 and $145 per square meter excluding VAT, operating expenses and utilities costs. The upper limit for some Class B properties that are located closer to Moscow than the newer Class A facilities reached $160 per square meter.

By the third quarter last year a combination of shrinking supply and high demand had pushed up annual rates for Class A properties to between $140 and $165 per square meter. That put the Moscow market a notch higher than Madrid with $130, Amsterdam, $116, and Frankfurt, $104.

However, rates have significantly dropped off since, returning to levels close to those of January 2007. Rents for Class A premises fell by an average of 11 percent over the first quarter, while Class B rates dropped by 16 percent, according to an analysis from Knight Frank.

Current prices of $115 to $125 for Class A facilities and $100 to $115 for Class B will probably remain steady for the rest of the year, predicted Vyacheslav Kholopov, director of the industrial, warehouse and land department at Knight Frank. “However, in 2010 the situation may change as there are no new developments planned,” he said. “Depending on the global situation at some point we may even experience a shortage of quality space, which could lead to growth in rental rates.”

Beyond the capital

In addition to Moscow and St. Petersburg, the most promising warehousing markets before the economic downturn were Yekaterinburg, Novosibirsk, Krasnodar and Rostov-on-Don. “These cities are exceptional for their intensive transit flow, b industrial activity and large consumer markets,” said Kholopov. The average price of a lease on the regional markets is nearly equal to that in Moscow and St. Petersburg, reaching $120 to $145 per square meter, according to the company’s data.

One trend in the regional market that appeared prior to the onset of the current economic crisis was the emergence of warehouse networks. Large companies, such as GreenGate, Megalogix, MLP, PNK and Espro, began constructing networks of Class A warehouse complexes in locations that serve as important transportation and logistics hubs. Cities that lie on major transport corridors, such as those mentioned above plus St. Petersburg, Nizhny Novgorod, Omsk, Samara, Ufa and Perm, are natural choice locations for such projects.

A range of factors affect where to situate these logistics hubs. “In the case of the automobile industry, the choice of location has always been influenced by the proximity to manufacturing centers,” said Anna Sorokina, senior consultant at Jones Lang LaSalle’s industrial and warehousing department. “However, in the Asian part of Russia, access to good transportation and the possibility of a rail connection to the site are the primary considerations,” she added.

Sorokina said the new Russian warehouse networks were neither conceived nor designed to dovetail with European distribution networks. However, their location at the major transportation junctions and their proximity to infrastructure hubs such as airports, ports and railroad stations provides for the smooth and efficient transit of goods to and from Europe and Asia, she said.

The rapid development of such warehouse networks may also pose an imminent threat to the real estate market in the regions, industry experts said. “Intensive activity by big developers could easily lead to an over-saturation of certain regional markets, as forecasts for regional market dynamics are often quite ambiguous,” Kholopov said.

However, Megalogix, a joint venture between the Avalon Group and Raven Russia Limited, has been executing a large-scale plan to develop Class A warehouses and logistics complexes totaling 1.5 million square meters nationwide in towns, including Khabarovsk, Omsk, Yekaterinburg, Ufa, Chelyabinsk, Saratov, Krasnodar and Nizhny Novgorod.

The company has completed two of three buildings in the first phase of its Rostov-on-Don warehouse project and opened another $135 million, 121,000-square-meter warehouse and logistics center in Novosibirsk in late February. The complex was partly financed with a $95 million loan, which the company secured from International Finance Corporation in October.

Eurasia Logistics, a subsidiary of a Kazakhstan-based investment and manufacturing group, Eurasia, has also stepped up the development of storage facilities and logistics centers in an area that spans CIS countries and stretches into Turkey.

At the beginning of 2008 the firm, which operates under the GreenGate brand, reported that it already had around 2.5 million square meters under development in Russia. Most of them are located along the rapidly developing East-West international transport corridor from China through Russia to Europe.

GreenGate’s latest developments include a 300,000-square-meter industrial park with Class A warehouses and container terminals in Druzhino, in the Omsk region, and the $213 million, 60,000-square-meter Tatischevo industrial-logistics park in the Saratov region.

Eurasia Logistics is also focusing on the construction of the Mezhdurechiye logistics center in the Volgograd region as well as its 50-hectare GreenGate Park in Volgograd which is expected to be completed in 2010.

Currently, Eurasia Logistics has five construction projects nearing completion, including the 800,000-square-meter Class A Tolmachevo warehouse in the Novosibirsk region, according to a survey by Knight Frank. The company, which said it controls a 15-percent share of Russia’s Class A warehouse property market, is the first operator to construct container terminals at logistics parks. “Adding container terminals will enable the management company to cut logistics expenses by an average of 10 percent,” Yegor Dorofeyev, head of the warehouse and industrial department at Cushman & Wakefield Stiles & Riabokobylko said. However, the Moscow-based logistics operator announced in April that it would shelve its 790,000 square-meter Kolpino project in St. Petersburg, citing the declining health of the warehousing sector in north-western Russia, Cushman & Wakefield said in its market report on the first quarter of 2009.

In February, Multinational Logistics Partnership, or MLP, which also specializes in developing and managing Class A warehouse facilities, completed its $150 million, Class A Utkina Zavod in the Vsevolozhsk district of the Leningrad region. The complex’s total area reaches 210,000 square meters.

Trends and tendencies

A tight credit market has almost completely ruled out speculative developments, which have been a defining feature of Russia’s warehousing market in the years leading up to the present economic situation. Virtually all new industrial developments and other business parks are now being targeted at companies willing to sign contracts for specific buildings on the developers’ land. “The bane of speculative developments is that developers don’t know where to draw the line,” said Robert Aubrey, head of the warehouse and industrial department at CB Richard Ellis.

“Groups were speculatively leasing premises with an expectation that there was still huge unmet demand. There was never an understanding of where the equilibrium point was,” he added.
There is likely to be no speculative developments in the segment in the next few years, at least until there is clarity about where the vacancy and rental rates are, Aubrey said. As a formula for minimizing risk there might still be some prelease commitments and developers may consider built-to-suit deals, which are expected to be prevalent as developers become more flexible.

As companies struggle with shrinking production and slumping demand, the pool of vacant spaces continues to swell. Prior to the final quarter of 2008 the official vacancy rate was virtually zero and the majority of projects were leased out before official commissioning. However, by the end of the year, the vacancy rate was 3.5 percent, spiraling to 4.7 percent in the first quarter of this year, as demand shrank and companies put expansion plans on hold, CB Richard Ellis noted in its first quarter report.

In the regions the vacancy rate was as high as 50 percent in some facilities, according to data from Knight Frank. Nationwide, the vacancy rate currently stands at 12.7 percent for direct lease, according to a survey by CB Richard Ellis.

What’s more the situation could deteriorate further. “The figures are substantially higher if we are to add sublease space and underutilized premises within those spaces,” Aubrey said. “Underutilized premises are important because they can officially return to the market and swell the volume of vacant space especially if tenants in existing schemes experience financial problems,” he added.

In the final quarter of 2008 there was an upward trend in subleasing and safe custody services for cargos as separate segments in the market. Fearful of poor growth prospects, many companies were forced to sublet space acquired earlier for expansion purposes, sometimes at a rate close to the initial rental rate.

More than 110,000 square meters of warehouse space was sublet in 2008, representing about 20 percent of total transaction volumes on the market, according to estimates by Knight Frank. As of April this year, about 350,000 to 400,000 square meters of sublease and direct-lease space at large Class A complexes had entered the market, the firm reported. However, the market for sublease space remains highly volatile, as companies constantly re-negotiate lease terms or struggle to reduce already leased space, Kholopov said.

Sublease space has become popular because it is much more liquid than direct lease and is usually offered in turn-key condition. Sublessors are very flexible about the duration of the sublease agreement and other conditions.

The safe-custody services for cargoes have also proved highly convenient in conditions of tight credit, as they allow companies to make quick adjustments to their business strategy without being tied to long-term lease agreements.

Rapidly changing market conditions may result in the further growth of Russia’s third party logistics segment, as more companies strive to concentrate on their core activities by outsourcing more and more logistics services. Logistics outsourcing is also becoming popular as the best way for companies to reduce logistics expenses in a tight credit situation, analysts from Knight Frank said.

Though a major breakthrough is hardly expected in the next few years, the absence of an alternative supply of small premises in the 1,000- to 2,000-square-meter range with all necessary equipment for short-term lease could boost growth in this segment.

Similarly, the built-to-suit sector may fare well in the current situation. Until very recently domestic warehouse developers tended to see the built-to-suit models as generally having more potential for loss than speculative developments. While vacancy rates were at almost zero, it made no economic sense to give up huge profits in favor of the less prospective and glacial built-to-suit market.

The peculiarity of land ownership and availability also affects the built-to-suit market model. Most of the land for warehouse developments in Russia was agricultural plots several hectares in size that used to belong to various collective farms. “Their location in specific areas and the sheer size of the plots make them unsuitable for specific development projects such as the built-to-suit format,” Aubrey said.

There is also a need to create infrastructure from scratch, requiring both a complicated master plan and economics of scale that could eventually generate ownership problems. However, industry experts and analysts see a local version of the built-to-suit model evolving from the present crisis. “The built-to-suit model will become more prevalent as the crisis hits harder,” Aubrey said. “The pattern that would emerge is most likely to be minor alterations to existing developments and not a standard European model,” he added.

Outlook

Although the b growth enjoyed by the economy over the past several years has generated the need for modern industrial facilities and boosted the potential for growth in the segment, the outlook for the warehouse market in 2009 and beyond remains bleak.

As the situation in the domestic economy worsens, with diminishing production and transport-related activities, investors are more likely to reevaluate all projects on the drawing boards, cautiously selecting the most viable.

Various estimates by real estate firms put the total number of warehouse space that could be delivered this year at around 500,000 square meters. “Compared to 2008, the area of warehouse projects slated for construction this year has shrunk by one million square meters,” Kholopov said. However, real delivery figures could be as low as 250,000 square meters, Aubrey said.

Cutbacks on development projects and logistics expenses, prompted by the financial crisis, have triggered high demand for low-quality – Class C and D – warehouse premises, especially in the Moscow region.

Putting further downward pressure on land prices and rental rates are new arrivals such as Lemcon, a Finnish firm, and Trimo, a Slovenian developer, which are clustering around the Moscow region. Last year Lemcon purchased 135 hectares of land for the construction of a 500,000-square-meter industrial park for the automotive industry and cluster assembly in the Kaluga region. Meanwhile, Trimo announced it would develop a 150,000-square-meter built-to-suit technology park in the Vladimir region.

The outlook for warehousing and logistics services in the regions is extremely poor. “Most regional warehouse projects have been frozen and only about 200,000 square meters of warehouse space is currently under construction,” Kholopov said. Yug Development has stopped development at the ProLogica Park Takhtamukai complex in Krasnodar in order to focus on residential real estate development and Parkridge has frozen its project development in Yekaterinburg and postponed the delivery of a warehouse project in Krasnodar. Meanwhile, Viktor and Co., a Samara-based developer, said it would redesign part of its Class A warehousing premises for use as automobile and food markets.

Other large developers including MLP and Eurasia Logistics have revised their regional strategies. Sergei Vereschagin, commercial director of Eurasia Logistics, said the company would focus on the development of its industrial parks in Moscow, Novosibirsk, St. Petersburg, Kazan, Yekaterinburg and Odessa while deferring construction on those scheduled to start in autumn.

MLP’s CEO, Michelle Paskalis, said his company intends to complete its four ongoing projects in St. Petersburg, Podolsk and Kiev totaling 723,000 square meters of Class A warehouse space, but would not embark on the construction of new sites for the time being.

Sluggish demand from logistic operators is also expected to drive prices down on the regional warehouse market where they had provided up to 50 percent of total take-up volume between 2006 and 2008.
However, because of its less volatile nature compared with offices and portfolio diversification, the logistics sector would continue to be of interest to investors, said Chris Staveley, head of the pan-European office and industrial capital markets at Jones Lang LaSalle in a report.

On a positive note, project development costs are falling as prices for key construction materials plummet: the price of cement is down by 50 percent compared with prices in summer, 2008, while metal prices have tumbled by 40 percent. “The price changes could bring down the cost of building storage facilities by as much as 20 percent,” Kholopov said.

Andrew Bushin, general director of MIEL Commercial Real Estate, predicted that, if current conditions hold, rental rates could fall by as much as 50 percent before the end of the second quarter of 2009. “Even now, developers could only retain existing tenants by greatly reducing lease rates,” he said.

However it is difficult to accurately assess the situation. “Behind the curtains, individually negotiated prices tended to differ from official proposals by as much as 35 percent, which is barely sufficient to maintain a margin of profitability,” Bushin said. The present crisis, coupled with the exit of Western institutional investors, will lead to a significant reduction in the supply of quality storage facilities in the coming years, he added.

But while high levels of systemic risk in the market and continued global financial uncertainty would reduce delivery in 2009, market forces would dictate which direction the real estate market goes, Aubrey said. “What we are going to see is a flight to quality — a stratification of the market where good projects command a high price and lease easily, and poor ones only go at a discount,” he added.

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