July 24, 1994
International Business: RUSSIA
When Liggett Group Inc., maker of Chesterfields and L&M cigarettes, invested in Ducat, owner of a Moscow cigarette factory, it seemed like a big gamble: Ducat’s 100-year-old plant contained ancient equipment. That was four years ago. Today, the partners are gearing up to produce cigarettes at a new plant in the suburbs, while the old city site is being redone as a gleaming financial center for foreigners. Called Ducat Place, the 2.5 acre project is one of Moscow’s hottest properties, thanks to its central location near Mayakovsky Square. “Sure, there is solid value in the cigarette business,” says Ducat Place Director David Geovanis, “but the real estate business is a terrific bonus for us.”
Liggett is one of many Western companies jumping into Russia’s high-yield, high-risk real estate market. Since 1990, rental fees have skyrocketed as Western businesses have competed for scarce office space in such key cities as Moscow, St. Petersburg, and Ekaterinburg. These cities have cheap, dilapidated buildings in prime locations that can be renovated or rebuilt and rented at huge profit. “Distributors or exporters come to town with an idea to develop a particular product but fall into property development and say: `Maybe we should get into this business instead,”‘ says Alison M. Driezen, resident partner of White & Case, a New York law firm.
But the wild world of Russian real estate is filled with pitfalls. Russia’s emerging legal codes don’t give clear title to either property or land. While Boris Yeltsin‘s new constitution lets foreigners purchase land, the State Duma recently prohibited it. To get around that, foreign businesses often use local partners. Other hazards for foreigners include organized crime, corrupt officials, and red tape. Building Ducat Place required approvals from 130 different city committees.
Lining up financing is tricky. Liggett provided its own equity for the renovation. Banks turned the company down because it wasn’t clear whether they could repossess the land if the deal failed. Some big projects, such as the 19-story business center proposed by First Voucher Fund, a Russian investment company, may never get completed because of a lack of funds.
But the potential profits are too good to pass up. Annual rents for prime space in central Moscow run from $84 to $93 per square foot, with one or two years prepaid. In contrast, similar space goes for $60 in Tokyo and $47 in London.
Faced with such high rents, many foreign companies are developing properties themselves. One example is fast-food giant McDonald’s Corp., which has three highly successful outlets in downtown Moscow. Rather than worry about repatriating ruble profits, McDonald’s plows them into local real estate, including a gleaming mirrored tower it rents to Western companies. “It turned out to make a lot of sense,” says McDonald’s General Manager Mark Weiner.
In Liggett’s case, the company has already recouped the $5.3 million cost of the first building in Ducat Place. That happened last October, when Citibank signed a five-year lease for the entire building, paying two years up front. Citi has since subleased space to other banks. Similarly, Berlin-based developer S&T Handels, in partnership with the government, renovated a building that now houses Exxon Corp. and the International Monetary Fund.
GANGS. But many Russians aren’t happy with the Western deals. Factory bosses resist moving operations to make way for foreign offices. Officials, led by Moscow Mayor Yuri Luzhkov, fret that foreigners are getting steals. “Many officials have an inflated view of property values; some think Moscow is being sold for a song,” says Oleg Myshkin, development director for Haskel International Brokerage.
Another troubling aspect of the boom is organized crime. Gangs have been pushing out babushkas from apartments and turning the buildings over to foreigners at enormous profit. To escape high commercial rents, smaller companies have been using apartments. Now, those companies are panicking after a ruling from the Moscow City government making it illegal for apartments to be used as offices. That means smaller companies are out on the street, thus pushing up demand.
Certainly there’s plenty of opportunity in Russian real estate. “Most developers are under the euphoria that this is the Wild West,” says Myshkin. It may be for now. But all real estate bubbles burst. Some experts see that happening in Russia within 18 months.