Katen Bakhytbek. Kazakhstan Real Estate Market: Expecting Changes.// February 2008

http://www.investkz.com/journals/55/544.html

Editorial

Today, the real estate market in Kazakhstan is experiencing uncertain times. Practically all the players – developers, realtors, investors and speculators – have firsthand knowledge of the meaning of the current liquidity crisis. They are having to adapt to a tougher market in which it is increasingly difficult to raise funds, find mortgage instruments and optimise costs and business processes. All this, coupled with reduced purchasing power, is seen as likely to lead to a fall in property prices. However, the fact that two big international real estate conferences were held in Almaty this spring, only one month apart, clearly demonstrates that interest in this sector has not yet been exhausted. Moreover, according to expert opinion, the current situation gives foreign investors a good chance to fish in troubled waters, at least in the commercial real estate market…

Do you remember how it began?

Not so very long ago, in the late 90s, the opportunities for development of Kazakhstan’s real estate market were vague. In those days, the price of a one-room apartment in Almaty, the largest city in the country, was equal to the price of a second hand car. But since 2000, the situation has begun to change rapidly. This period coincided with the upward trends in the world raw materials market due to a big boost in the economic growth of several large developing countries. Kazakhstan has parlayed its huge oil and raw material resources into profitable sectors of the economy, turning out to be a very attractive country for foreign investment. Kazakhstan’s economy has achieved steady growth and local banks have gained access to sources of low-cost overseas funding. As a result they have been able to extend widespread credit to the building sector, at the same time developing real estate mortgages that have become more and more available to the citizens of Kazakhstan.

Against a background of continuous financial injections, both in terms of demand and supply, the amount of newly-built housing soared. Real estate prices also rose dramatically first in Almaty and Astana, and later on all over Kazakhstan. According to statistical data, investment in the building sector in 2007 increased almost fivefold compared with 2000 (from 407.3 billion tenge in 2005 to 2,074.6 billion tenge in 2007). The annual construction increased 8.6 times, developers doubled in number (up to 6,184) and the total floor area of new apartments increased 6.7 times (up to 8.1 million square metres of new housing). No wonder that the building sector has recently been called "the locomotive of the domestic economy." According to expert estimates, this sector (taking into account the multiplier effect) provided half of Kazakhstan’s annual GDP growth. However, in the middle of last year, the system suddenly failed, for the same reason as seven years ago – world market trends.

The mortgage crisis which accelerated in the U.S.A. in early 2007 undoubtedly affected global financial markets, and in the middle of the year the largest investment banks in the U.S.A., Europe and Japan (the main creditors of the second-tier banks in Kazakhstan) suffered liquidity problems. Kazakhstan’s banks lost access to foreign low-cost sources of refinancing, and sharply raised interest rates both for legal entities and individuals. The real estate market has suffered most seriously, because it directly depended on banking resources. As a result, mortgage loans were halted and real estate prices started sliding for the first time in the last five or seven years.

Mistakes of growth and hardships of transformation

A year has passed since the first signs of crisis appeared, but there are no indications of improvement yet. Kazakhstan’s developers and building owners were not ready to operate under new conditions. Bakhyt Katen, Director of NAI Kazakhstan Aristan consulting company, speaking at the First International Investment Forum Investment Opportunities in Real Estate in Kazakhstan, said today’s problems were rooted in easy access to loan resources during the pre-crisis period. The terms were extremely profitable: loans were provided with a substantial ‘comfort factor’, so that a developer was required to provide only 10% of the total amount of financing and did not need to own the plot of land in question. Investors were queuing up, valuations were carried out quickly and sometimes with no proper basis, international standards and local rules were ignored during real estate negotiations. Concluding deals with domestic banks, a developer had no need to spend time and money on business plans and market research. There was no strategic financial planning or qualitative project research, let alone any risk management. As a result, a sophisticated system of financing the real estate sector failed to develop during the economic boom.

Today, when developers cannot rely on "easy loans" to complete their projects, most experts agree that individual purchasers will be replaced by institutional investors. Generally, these are foreign financial operations and real estate funds, which have their own rules of the game. International investors provide loans only to the 'right' teams and for the 'right' projects.

According to Mark Lerh, Vice-President of CAB Investment Germany, in order to attract foreign partners, local developers should pay much more attention to such issues as quality, deadlines, standards, transparency, profitability, return on investment and cost optimisation. The effectiveness of business processes, the speed of decision-making, and the provision of information, as well as the qualifications of the management team, will play a key role. Normally, a foreign investor prefers to enter a new market through establishing a joint enterprise, where a local developer possesses the relevant experience and communication skills to make deals with its partner and bears a defined share of the risks. And finally, one of the necessary conditions for deciding to take part in a project must be the existence of a clear exit strategy.

Bakhytbek Katen said that according to a review of investment projects currently offered by local developers, most of them do not comply with such requirements.

Real estate affairs

According to Peter Goranov, Senior Project Director of Scot Holland, the global crisis affected all the economic sectors, but the impact was diverse. The middle and lower sectors of the real estate market suffered the most negative effect from the reduction of prices. In the course of the International Forum Real Estate and Construction in Kazakhstan, held by the Adam Smith Institute, Mr Goranov said that more than 50% of transactions in these sectors had been financed by mortgage. Today these were virtually unavailable. At the same time, developers in the elite sector of the real estate market did not reduce prices, because the purchasers who had money to invest before the crisis still had funds available today. The same situation occurs in the first and second tiers of the real estate markets: while apartments in new buildings scarcely went down in value, the prices for old and dilapidated housing fell by 20–50%.

Oleg Alferov, Vice-President of the National Association of Realtors of Kazakhstan, said that speculators have a great downward impact on prices. A study of the current situation shows that private investors who purchased apartments from developers in the initial stages of construction were now being forced to offer these assets 20–30% cheaper than their original prices. But developers were trying to maintain prices because "they understand that reducing the current prices of their real estate might cause the market to become overloaded… which may damage the business environment; of course they are not interested in such a scenario". Meanwhile, the direct reduction of prices is typical of 'occasional players', who have single estates and do not associate their future business with the building sector.

As a general rule, when prices are continuously reducing in the real estate market, a ‘pending’ mood sets in, with both buyers and sellers waiting for a "bottom price" followed by growth recovery. At the present time there are no transactions underway, and the index of Krysha newspaper, indicating the state of the real estate market, cannot be regarded as accurate or relevant. According a survey carried out in February 2008 by the National Association of Realtors of Kazakhstan, 44.3% of the market experts believe the "bottom price" will be achieved in the 3rd quarter of the current year, while 22.3% forecast it in the 4th quarter and only 3.9% do not expect it until the first half of 2009. However, asked to predict the minimum price per square metre of usable floor area in housing construction, the respondents forecast a wide range of increases: 25% said $1,500 to $1,000; 28.6% said $2,000 to $1,500; 21.4% said $2,300 to $2,000; and 17.9% said $2,500 to $2,300. Only 3.4% of the respondents expected the price to fall below $1,000 per square metre. The experts identified several factors as having an impact on the reduction of housing prices, including the tightening of mortgage loan conditions, the difference between the average growth rate of personal income and the real estate price evolution, negative public opinion about the price growth, as well as a possible imposition of a new tax for maintaining and selling real estate. At the same time, a gradual slowdown of the price reduction trend indicates the proximity of the "bottom price". Additionally, there are several factors that point to price growth recovery, such as the accumulated volume of deferred demand and a supply deficit. On the one hand experts believe that the real estate market remains the most durable sector for long-term investment, given predictable levels of inflation and securities market risks due to recessionary trends in the international and domestic economy. On the other hand, no expert speaks about a return of annual price growth in the 50% to 100% range; they forecast modest figures.

Today, there are hundreds of ‘frozen’ buildings in Almaty and Astana, developers are laying off staff and cutting salaries, while investors facing losses are actively besieging their offices. Recognising the social importance of the real estate sector, the authorities decided to step in. In November 2007, the government announced a stabilization plan for national social and economic development. In accordance with this plan, 48.8 billion tenge ($400 million) were allocated from the state budget to complete the construction of 112 projects in Astana, as approved by the state commission on modernisation of the economy. An additional amount of 122 billion tenge ($1 billion) is planned to be provided during the current year. The main criterion for the selection of projects is the existence of individual investors. The Kazyna Sustainable Development Fund distributes the funds to the second-tier banks in the form of loans and 5- and 7-years fixed-term deposits. In this regard, the Kazyna Fund assumes 85% of the total financing, while the balance will be provided by second-tier banks (10%) and by developers (5%). In accordance with the programme, the funds will be deposited with the participating banks at 11–11.35% annual interest rate. This rate is based on the refinancing rate of the National Bank and is linked to the rating of the particular second-tier bank. If the refinancing rate or the ratings change, the annual interest rates will be adjusted accordingly. Second-tier banks will bear all the credit risks in terms of construction projects. The government has granted second-tier banks the right to set a final deposit interest rate taking into consideration the risks represented by each particular borrower.

Sayat Nurbek, Senior Manager of the Department of International Cooperation of the Kazyna Sustainable Development Fund, said this scheme had immediately failed, because banks were examining and estimating projects very slowly and meticulously. In recent times, second-tier banks had provided loans for building operations "as a matter of course", but today the building sector is not among the most attractive and reliable borrowers. The second-tier banks have a strong need for "reassurance", as they are expected to bear all the actual risks. As a result, from November 2007 to May 2008, builders from Astana received only $79 million from the first tranche totalling $400 million, and the interest rate reached 18%. Moreover, several banks refused to participate in the allocation of funds, which the government has provided to developers. "In this scheme we are only the intermediary between banks and the government. This mechanism is not all-inclusive and needs to be improved. I believe it is possible to create a large national construction holding, which may repurchase projects under construction at their prime cost and complete the construction using its own resources," Sayat Nurbek said at the First International Investment Forum on Investment opportunities in real estate in Kazakhstan.

Now the developers in Almaty should also be provided with funds. During the current year construction companies in the southern capital are due to receive 58.3 billion tenge, including the first tranche of 22.4 billion tenge. Unfortunately, the mechanism of allocating funds has not undergone any serious alterations, so this financial aid will most probably prove to be as inadequate as it was in Astana.

However, it is clearly unrealistic to expect construction sites to be ‘unfrozen’ without adequate funding. Today, there are 49,000 flats under construction in the capital of Kazakhstan, and at least 8,000 of them are to be bought by the government for the staff of state-financed organisations, the personnel of central institutions, national companies and holdings. The developers in Almaty refused the offer of the Almaty Akimat (administration) to buy part of the housing under construction at a price of $600 per square metre. Nevertheless, such measures, even if they are successfully implemented, can hardly create fresh demand in the real estate market. According to experts, only mortgage programmes can improve the situation.

Commercial interest

The outlook for the commercial sector of the real estate market are more positive. This sphere is able to provide a guaranteed and stable volume of real estate leasing business, which is attractive for professional institutional investors. Generally, they specialise in long-term investment and are not interested in speculative purchase and sale transactions. According to Charles Reuter, Head of Jones Lang LaSalle in Kazakhstan, the number of requests from western banks, funds and developers has sharply increased during the first quarter of the current year, based on a consensus that annual returns of 13–20% sound quite realistic for Kazakhstan’s sector of the commercial real estate market.

Peter Goranov said that traditional investment funds specialising in office, trade and hotel real estate came to Kazakhstan two years ago. Today, other players attracted by the crisis are joining them. Typically these are European specialists who monitor national economies in tough times and then launch big crash projects. According to Mr Goranov, the fact that this type of western investor is entering the Kazakhstan market is an indicator that the ‘bottom price’ and therefore the recovery are at hand.

Olga Arkhangelskaya, Head of the Real Estate Consulting Department in the CIS countries (Ernst & Young), believes that the domestic real estate market will experience firsthand the transition in foreign investment from different parts of the world. US funds are still seriously restricted in their financing capability due to the mortgage crisis, so nobody is expecting substantial investment from the U.S.A. The European and Russian investment will also probably decrease significantly because investors will want to have a deep analysis of the market. The first players will be investors from Asia and the Middle East, from regions whose economies have not been involved with the global financial turbulence. While Asian investors are specialised in medium-sized commercial real estate projects, Arab investors are interested in large-scale projects which require substantial investment.

What can foreign investors expect from the office and trade sectors of Kazakhstan’s real estate market? And how big is their current potential?

All the experts agree that today Kazakhstan faces a shortage of high quality office buildings. For example, Almaty falls seriously behind comparable European cities in terms of office floor area per 1,000 citizens: the figure is 300 square metres in Almaty. compared with 1,700 square metres in Prague or 1,500 square metres in Warsaw. Meanwhile, Almaty’s rental levels ($60-85 per square metre for class A office floor area and $30-60 per square metre for B class office floor area) are ahead of European cities such as Warsaw, Madrid, Brussels and Amsterdam, giving way only to London, Paris and Moscow. According to estimates, the total office space in Almaty in both A and classes B comes to 300,000-460,000 square metres. Less than 3% of it is unoccupied. The main office lessees are transnational corporations, financial and telecommunication companies, consulting, audit and law firms, as well as large Kazakhstan industrial operations. Citing the demographic forecast for Almaty, Dmitry Revin, Director of Finance and Business Development of Eurasia (RED), stated that approximately 1.5 million square meters of new office space should be constructed in Almaty by 2012 to satisfy demand. An equivalent area will be provided by projects due to be implemented within 4-5 years (including the largest ones, such as the Almaty Financial District, Rakhat Towers and Yesentai Park). However, according to Nursultan Kasenov, Director of the Commercial Real Estate Department (NAI Kazakhstan Aristan), the realisation of new projects under current liquidity crisis remains doubtful. It means that rental rates will stabilise for the next 3-4 years. The situation is different in Astana, where the market is overloaded with projects under construction. Mr Revin believes that the resulting oversupply may lead to a fall in rental rates for Astana’s office real estate in the next two years.

As for commercial real estate, experts say it is in the early stages of development. There are, however, several economic prerequisites for its rapid growth. Since 2000, the rate of increase of retail turnover in Kazakhstan has reached double digits. According to a survey carried out by A.T. Kearney in 2006, Kazakhstan was ranked among the 30 top developing retail markets, even though there are no global retail networks in Kazakhstan.

According to Peter Goranov, there are several factors which constrain big retail players from entering the local retail market, including a relatively young economy, low-level incomes and the low purchasing power of Kazakhstani people. In addition, the huge size of the country, its undeveloped infrastructure and very low population density may also be mentioned as negative factors. Today, however, the situation is starting to change for the better: the German Metro Retail Trade Group is opening an office in Kazakhstan, and IKEA has announced plans to open two big commercial centres in Almaty and Astana.

Obviously, such trends in the expansion of international retailers will require the construction of modern high quality commercial centres. This mainly concerns Almaty, which accounts for approximately 40% of the whole retail sales turnover. According to several estimates, the supply of high-quality commercial space totals from 133,000 to 260,000 square metres (or 100-200 square metres per one thousand citizens), and approximately 400,000 square metres more is due to be built in 2008-2011. Today, the weighted average monthly rental rates in Almaty’s commercial centres vary from $65 to $150 per square metre. Kazakh and Russian commercial operators together with foreign brands franchise holders make up the principal demand for high-quality trading areas. In addition, Nursultan Kasenov noted a new tendency for professional foreign developers and investors to move into the Kazakhstan market; these usually have their own pool of lessees.

Who knows what tomorrow holds?

Generally, both domestic and foreign experts estimate the current situation in the market as part of a cyclical wave, which may apply the law of natural selection to the participants. Continuous corrections will separate the long-term players from the short-term ones, looking only for speculative profits. Badly managed projects will fold, emphasizing the benefits of market stabilisation, professional standards and new conditions for sustainable development. Establishing new joint ventures with foreign developers, financial institutions and funds will facilitate the import of know-how, new technology and architectural concepts, and lead to the implementation of really high-quality projects. It all sounds rather optimistic! How it will be in actual practice? - Let's wait and see.

Katen Bakhytbek. Kazakhstan Real Estate Market: Expecting Changes.// February 2008