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With one of the highest and fastest-growing occupancy costs, Moscow is now considered the second most expensive city in the world. But what is it like to find commercial property in the Russian capital? Andrew Burt, International Director, Real Estate at Johnson Controls, Global WorkPlace Solutions EMEA, shares his knowledge of the Moscow market.

The space race

Since the 90s with globalisation and perestroika, interest from western companies to do business in Russia and access the 140 million population has increased. Following the commodities boom that started around 2002, domestic and foreign companies have significantly increased the level of demand for premises.

But due to the limited supply of good quality modern office buildings, rents continue to increase year on year.

In 2007, according to local real estate experts, the total stock of Class A and B office space stood at around 7.34 million square metres (sq m), with Class A space estimated at around 1.13 million sq m and Class B space of 6.21 million sq m. Demand for office space was around 2.09 million sq m last year and in the first quarter of 2008 this trend continued with 560,000 sq m of office space being leased.

This level of demand was 1½ times that recorded in London for the same period and second only to Paris across all European markets. Over the next two years demand is expected to continue at current levels.

Whilst overall vacancy rates are expected to increase as more supply comes to the market in the next two years, vacancy rates in modern Class A buildings are expected to remain below 7-8%. Coupled with the expected high levels of demand it will maintain upward pressure on rents in the city.

With supply tight for quality office buildings it is not surprising that over 50% of all transactions – whether lease or sale – are agreed prior to completion of the building (+20% compared to some other European markets). However, this high level of pre-leasing/pre-selling does present challenges and risks to foreign companies under Russian leasing practices.

Premium rates

Current rents for Class A office space within one of the major Moscow central transport arteries, the Garden Ring, are now $1,500-2,500 per sq m/year. Whilst Class B space in the same area commands rents of $850-$1,500 per sq m/year. Outside the Garden Ring rents tail off to levels of $700-1,000 per sq m/year.

In nominal terms:

  • Class A office rents grew by 40–50% in 2007 and have already grown by at least 30% in 2008
  • In Class B+ and Class B– properties, growth of almost 30% was witnessed in 2007 and another 40-50% in 2008

When you add in operating expenses ($95-150/sq m/year), parking charges ($3,000- 6,600/space/year), depreciation on office fit out and facilities costs, then Moscow easily become the most expensive location in the world.

Leasing practice

Length of leases in Moscow are now falling in line with most European markets, with five year leases commonplace on the majority of new or refurbished buildings. However new entrants to the market should be aware that there is generally little flexibility shown by local landlords when it comes to negotiating the detailed heads of terms and lease agreements. In addition the high level of demand means there are normally several companies interested in the same space and hence decisions have to be made quickly in order to secure the space.

In order for the tenant to be protected under the Russian Civil Code the lease should be registered. But this can only be done once the landlord has obtained his ownership certificate. This requires the prior issuance by the local government of an occupation permit, the so-called State Commissioning, confirming that the building has been constructed in accordance with the plans submitted and is fit for occupation. This can be complicated and potentially risky when negotiating a pre-lease/sale.

Under Russian Law parties are not permitted to enter into a full lease agreement for a building or premises that is still under construction. To document the terms and conditions of the lease deal in such circumstances, some landlords employ a contractual framework comprising:
  • A Preliminary Lease Agreement (PLA) that sets out the parties’ mutual obligations to enter into the full lease agreement at a later date
  • A Short Term Lease Agreement (STA), an interim agreement governing the parties’ lease relations during the period between the time the landlord is granted legal ownership of the building and the date the tenant’s lease is State registered
  • A Long Term Lease Agreement (LTA), the full lease agreement that will take effect on the date it is State registered

This proposed contractual framework presents a number of risks which need to be assessed on a case by case basis in conjunction with a qualified lawyer. Some examples of risks include:

  • The extent to which entitlements and obligations under the PLA-LTA-STA framework can be enforced is uncertain because the framework has not been tested in the Russian Courts. If the tenant occupies the Premises by relying on the PLA, it may face administrative offences and fines, eviction from the Premises by state authorities or by the landlord, and loss of the tenant fit-out
  • Delays in State Commissioning of the building could delay the tenant’s fit-out work and its move-in date. It is advisable not to start tenant’s fit out before State Commissioning as this can cause complications when there are issues around finalising the Facility Operation Permit
  • Delays in the landlord’s ownership registration could prevent the tenant from obtaining full legal protection of its leasehold interests


Lease

Class A – 5 to 7 years
Class B+/B- – 3 to 5 years

Payment basis

Rents denominated mainly in USD but paid in Russian roubles. Increasingly common for rents to be denominated in Euros.
Rents and operating expenses plus utilities paid quarterly in advance.
VAT - 18% added to rent and operating expenses.

Rental deposit

Generally 3 months rent and operating expenses.

Rent increases

Indexed to CPI or other common indices.
Increasing occurrence of fixed annual increases of between 3-7%.

Repairs

Landlord: responsible for external/structural works and common areas.
Tenant: space usually delivered shell & core so tenant responsible for all internal works. On Class B+/B- space sometimes landlord will be responsible for providing finished space.

Renewal rights

There is no automatic statutory right to renewal at lease expiry.

Rentable area

Calculated as net usable area of leased space plus loss factor 8-15% but can be fixed %age.

Leasing fees

7-10% of first year’s rent payable by landlord and/or tenant.


Building specification and fit out

New developments in Moscow are typically delivered to tenants in ‘shell and core’ condition with common areas (reception areas, lifts and circulation space) fully finished. Definition of ‘shell and core’ finish differs building by building and it is difficult to obtain a definitive base building technical specification from the landlord during negotiations. Any description provided in a brochure should be considered as a guide only and not be relied upon when it comes to actual delivery of the space. Where possible an agreed minimum delivery specification should be defined in the PLA and penalties contemplated (extension of rent free period) if the specified space is not delivered. Landlords will usually offer a small fit out allowance to the tenant.

Special attention needs to be paid to power availability per building as most buildings have a limit on the amount of Kilo Volt-Amps (KVA) they provide, so consider including a minimum guaranteed KVA supply to cover office equipment, lighting and air conditioning. Typically buildings are designed to a lower level of occupancy compared to other European cities.

Most buildings now have full 24 hour security systems with CCTV, a central security centre with controlled access via swipe cards into lifts, office floors and car park areas.

With typical annual temperatures in Moscow ranging from -13ºC in winter up to 35ºC in summer, there is a large heating and cooling demands on air conditioning systems which need to be carefully reviewed before accepting the building.

Branch versus representative office?

Many investors confuse the concept of a branch and an accredited representative office, ignoring that they have certain fundamental differences. An accredited representative office is not a Russian legal entity but an officially recognised extension of a foreign legal entity. Russian law restricts the scope of an accredited representative office’s activities to certain types of representational functions. Whilst under Russian law, a registered branch of a foreign legal entity is treated as an enterprise with foreign investment. Therefore, while a registered branch can hold a licence to conduct regulated activities (such as oil field development), a representative office or unregistered branch may not. Whether a foreign company creates a permanent establishment in Russia depends on the scope and nature of its activities, not its legal form.

What of the future?

In 2009 the Moscow office market is expected to continue its rapid development with supply continuing to lag behind demand for space, which will generate further rental growth with predicted rents of over €3,000 per sq m. Stock of Class A and B premises will continue to grow and by the end of 2009 is predicted to exceed 10 million sq m - a 50% increase compared to 2007. Vacancy rates for Class A and B premises are likely to remain around 5-6% within the Garden Ring.

The high rental levels will drive companies to consider decentralised locations outside the Garden Ring, including business park locations, in order to satisfy their demand for space at a reasonable level of cost. The practice of leasing premises larger than required is likely to continue as companies still feel confident about economic growth within Russia generally. Although with the world economic difficulties and continued financial market uncertainty we are likely to see future growth projections scaled back.

Significant changes have taken place in all aspects of Russian life since the collapse of the Soviet Union. Corruption, high tariffs, and poor infrastructures may discourage some potential investors. However without doubt Russia is a key growth market and forward thinking corporations need to find ways to embrace the political, social and economic challenges that this region presents.

Moscow – quick facts

  • Population 10 million people
  • World’s most expensive city for ex-pats for the 3rd consecutive year (Mercer 2008)
  • Domodedovo International Airport 22 km south east of Moscow city centre
  • Average cost per night for 5 star hotel room $500 - compared to New York $374 and London $300
  • Security still a major concern - most ex-pats and senior Russian colleagues hire personal drivers
  • Class A office rents grew by 40–50% in 2007 and have already grown by at least 30% in 2008
Contact:
Andrew Burt, International Director of Real Estate, EMEA at Johnson Controls Global Workplace Solutions, on +44 (0) 20 7606 8197 or email Andrew Burt.
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