Key Discrepancies in Deal Structuring: Approach Investing in Russia & CIS

  • 2006-09-27
  • By Kristine Kolosovska
With the active development of the economies of Russia and CIS, these countries have become an interesting investment target. Special interest is put on the development of the real estate market. As a rule these markets offer higher expected returns, transactions are made on yields twice as high as one would expect in mature markets. Investors perceive these markets as highly undersupplied, underpriced with huge development possibilities.

However, recently there were only a few transactions in investment real estate in Russia made by foreign real estate funds and private equity funds. Very few European banks, including local banks that have opened their branches in Moscow and other cities, are ready to finance these acquisitions. Gilad Regev, partner of Bridge Capital explains: "The primary reason why such great opportunities are not being explored to the full extent is that cultural differences in doing business and deal structuring are often diametrically different".

First of all, when the investors start looking at feasible acquisition targets, as a rule they look for Class A and B1 in all property segments, including trade, office, and logistic centres. In Russia, despite the huge volume of new construction in all segments, there are differences, for instance Class A buildings do not correspond to the basic requirements for class A properties according to European standards. Secondly, investors look for long term contracts with anchor tenants expecting key leases to be over 5-7 years long. However, in Russia, all lease contracts above 1 year need to undergo complicated state registration, thus it is rare that anchor tenants work under 11 month tenancy contracts.

When it comes to transaction structuring, the usual business practice in Europe is to acquire shares of special purpose company (SPC) that owns the asset. When doing business in Russia, investors usually face the fact that property is not spun off in a separate SPC. But as Gilad Regev asserts: "if it is, it is spun off at very low costs in comparison to the transaction price. The worst thing is, that this may be questioned by tax authorities even after the SPC gets a new owner".

Usually, the interest towards investment property in Russia and CIS is induced by much higher expected returns and yields. For example, in Western Europe transactions are made based on 5-6% yields, while in Russia similar properties are being traded at 10-12% yields. At the same time every investor is trying to win the so called "yield compression game", because even these 10-12% yields go down very fast making transaction timing crucial for the justification of higher risk in order to get expected returns. "Yield compression process comes with fierce competition for properties, - comments Mr. Regev - few investors have access to off-market projects, but those properties that are publicly available for sale are severely overpriced".

In commercial real estate transactions that involve share purchase in Russia such an acquisition is done using very complicated off-shore schemes, often using a separate company to finance project and a separate company that holds the shares of the Russian SPC. This practice was recently widespread in the Baltics as well. "However, as our practice shows, - states Mr. Regev - such schemes often become completely unbankable with large European banks that have sufficient lending capacity to finance such projects. According to the experience in property acquisition transaction the borrower has to come up with a strong international name and stainless reputation".

"In addition, - continues Gilad - if the construction of the asset was financed by the loans of local Russian banks, they usually require high exit penalties that the vendor is not always ready to cover all by himself".
Furthermore, real estate projects in Russia and CIS are not able to attract optimal loan-to-value bank financing. In Europe and, currently, in the Baltics as well, banks are ready to finance up to 80-85% of total project costs. But in Russia, obtaining 50% financing is considered to be pretty good.

Bridge Capital, corporate finance boutique, has been engaged in real estate transactions in Russia for two years. Recently, deals for a total $150 million (117 million euros) have been signed and about $750 million (587 million euros) deals are in the pipeline. Bridge Capital represents a number of high net worth private equity funds from the UK and Ireland.

Kristine Kolosovska is head analyst at Bridge Capital.