I promised in my last blog (Decoding the Russian enigma) a further post dealing with my expectations for the Russian property markets. I have also been considering giving my thoughts on what to expect in general terms (i.e. they cannot be held against me in specific valuations!) for 2018 year end valuations. We are approaching that time of year! So I have decided to do both together, a once in a lifetime two for the price of one deal.
As our excellent JLL Russia research team has recently published their Q3 reports this is as good a time as any. However, as always a caveat: there are various external factors still playing out, but if I waited for everything to unfold I would never write anything!
The investment markets have certainly borne the brunt of the broader geopolitical uncertainty. Investment volumes for 2018 are down 28% from the same period last year and are now comparable to the levels seen in 2015. The usual Q4 uptick may not materialise to the full extent with investors unsure about how to price assets in the current environment and levels that are not appealing enough to tempt sellers into the market place. Improvement in sentiment is required for a meeting of the minds, so that potential buyers can get closer to owners’ expectations.
As things stand investment volumes may not even reach the 2009 level of $3.2 billion, which would make 2018 the second lowest year in the last decade.However, appetite remains amongst investors and the returns are attractive. There is the distinct possibility that this drought will be followed by a flood when the wider environment stabilises and pricing becomes clearer. For now, our view on cap rates for all sectors remains unchanged. This is a long way above the peak of the market in 2008 and there is a significant spread over investment yields in other European markets, not only the core ones.
Office take up for the first nine months of 2018 is 28% up on the same period last year and it looks likely that demand will be at the highest level since 2012. I.e. at the peak levels of the previous cycle.
With new supply still constrained, the vacancy level has fallen rapidly since it peaked in 2014 and is now at levels not seen since before the Global Financial Crisis in 2008. It has fallen 3.6 ppt in the last 12 months alone, and we forecast it to fall a further 0.5 ppt by the end of the year to 10.5%.
New deliveries are not really gathering pace and are likely to take some time to recover fully from the squeeze caused by the twin factors of low sentiment and expensive and scarce project financing. The supply that is coming is often in the wrong place and is increasingly in peripheral locations. The market is rapidly becoming very tight.
In this context it is perhaps surprising that rents have remained stubborn and have shown little inclination to rise (this will become a familiar theme as you read further). However, with supply being very inelastic and development cycles long this will have to change, and the market will switch, probably very rapidly, from being tenant favourable to landlord favourable. Tenants should be locking in space requirements now. Investors will soon benefit from rising rents and compressing capitalisation rates which will drive capital values upwards.
The vacancy rate in shopping centres in Moscow is 5% and has been on a downward trend for three years. The vacancy rate in prime shopping centres is less than 1%. Stop me if you have heard this before, but why then have rents hardly increased for the last two years? Retail sales have been growing for 15 months and real wages for 2.5 years, at an accelerating pace. Retailers have dusted off their expansion plans and are increasing the number of planned new store openings. There has been a clear switch during the last two to three years towards a greater focus on turnover rents, but nevertheless base rents simply must go up.
Although the recent uptick in inflation, the weakening rouble and the upcoming increase in VAT are all negatives for consumer sentiment, expect them to be short-lived and for retail spending to continue to grow.
Although Moscow already has the largest stock of shopping centre space of any city in Europe, its density remains low, particularly compared with cities in similar climates such as Helsinki and Stockholm. There is plenty of mileage left in the Moscow retail growth story.
Take up is forecast to be an all-time record this year at 1.54 million square metres! Take up for the first three quarters of 2018 is 1.2 million square metres, which is a whopping 48% increase over the same period on 2017. As a result the vacancy rate has decreased 3.7 ppt over the same timescale and now stands at 5.3%. The rental experience though mirrors those in offices and retail. There is anecdotal evidence that they are starting to drift upwards, but nothing like the major shift that I would expect to see based on how tight supply is now becoming.Much of the current supply pipeline is on a build -to-suit basis, and speculative space will be relatively low. Occupancy rates are therefore going to remain high and I project that there will be a significant increase in rents over the next couple of years.
Russian sheds have a lot going for them. Warehouses globally are becoming a more attractive asset class, there is growth in consumer spending, retailers are expanding, we are right at the bottom of the rental cycle with income poised for significant growth, there is pressure towards localisation of production as much as possible, e-commerce is in its infancy and there is going to be a large focus on infrastructure spending over the medium term.
Warehouses are the place to be for investors.
2018 year end valuations – what to expect?
At the risk of creating a rod for my own back I thought some comments on this topic would be useful. This is only in general terms and should not be interpreted by clients as giving them license to use these thoughts against me!
As outlined above, JLL Research has not changed its headline numbers for market rents or capitalisation rates in any sector. That having been said, in my view we are clearly at, or have recently passed, an inflection point in the market. At the very least I am expecting rental growth to kick in next year across the board. Compression of cap rates may take a little longer but is certainly in our future. The difficulty at this point in the cycle, as I continue to say, is to account for the expected growth in rents without giving way to unfounded optimism. It is a difficult balance to strike when rents are at historic lows.
For the year end it will perhaps be too early to adjust the baseline assumptions, particularly as there remains the potential for further external shocks, and I would therefore expect, ceteris paribus, that valuations will be at a similar level to where they were in the middle of the year on a rouble basis. Hard currency valuations are hostage to exchange rates
Barring external factors, I would expect capital values to start growing in 2019 and to accelerate beyond.