The Appraisal Journal, Spring 2009 – “Market Prices and Capitalization Rates for Commercial Real Estate in Ukraine”
Beginning in late 2006 and continuing into early 2008, IRE (Ukraine) LLC, appraised approximately 3,000 parcels of commercial real estate owned by four of Ukraine’s largest banks. The purpose of the appraisals was to determine fair value for financial statements as part of the banks’ international audits conducted by two of the Big 4 international auditing firms. These real estate parcels are located in a large number of cities and towns throughout Ukraine, but are concentrated in Kiev and 25 regional cities. The assets include general administrative office facilities as well as more specialized facilities required for operating a bank. To determine fair value of each real estate parcel, between 5 and 15 sale and rent comparables were selected and adjusted for factors such as size, location, age, and condition. Each comparable was visited to ensure similarity to the object of appraisal and photos were taken as documentation. By employing a consistent methodology for comparable selection and adjustment, a relatively large and unique database became available for determining capitalization rates for commercial real estate in Ukraine. Since 2006, real gross domestic product (GDP) growth1 has been in a range of around 5%–7%, with data through mid-2008 showing growth of around 6%. Capital investment during this period remained very strong, with growth of 19% in 2006, 30% in 2007, and around 10% during the first half of 2008. Most tellingly, retail turnover since 2001, in real terms, has grown between 15% and 30% per year; real wages have also risen between 10% and 20% since 2001. Real wage growth, however, was stagnant during the first half of 2008. Inflation has ranged between 10% and 17% since 2004, but has accelerated to over 20% during 2008. Since mid-2008, preliminary economic data indicates that the first half of the year may have been a high-water mark for real estate development, price increases and general market activity, and turnover. This indicates that Ukraine’s real estate market remained buoyant at least 12–18 months longer than in some other markets that peaked in late 2006 or early 2007. This lag reflects the fact that since 2001, there has been historically high growth in personal income and sales, along with strong GDP growth supported by rising domestic and foreign capital investment (especially in industry, banking, and real estate). Looking past a potential one- or two-year world recession, these past trends bode well for the macro economy and should serve to support rising long-term land and real estate values, particularly for commercial real estate in the next business cycle. Demand for new commercial real estate in Ukraine has been very strong for the last several years and has led to historically high prices, particularly in Kiev and major regional cities. Construction of new commercial space continues to grow, and although prices have increased to historically high levels during the last few years, and there is significant risk that current price levels cannot be sustained, real estate remains by far the preferred investment alternative for domestic capital within Ukraine. Relative to an underdeveloped stock market offering low returns and high risk, as well as current rates of interest on bank deposits or government securities, real estate in general and commercial real estate in particular continues to offer the greatest returns for the associated levels of risk.
Prices and Capitalization Rates
There are two major factors driving the continuing growth of prices in the commercial real estate market in Ukraine. First, although the supply of new commercial real estate has increased significantly in recent years, total supply remains far below its potential and continues to lag demand owing to a host of artificial constraints inherent in Ukraine’s system of land use. There is no open market per se for buying and selling land in Ukraine. Most land is still owned by the government or leased to private companies that also hold development rights for the use of leased land. The owners of these companies are most often not developers. Rather, developers purchase these shell companies to obtain land lease and development rights for prices approximating the market value of land; the land market is therefore neither easily accessible nor transparent. In addition, there are a vast number of official permits that must be secured to obtain development rights for building on leased land and these costs are reflected in the prices paid for companies holding land lease and land use rights. The lack of ease of access to the land development market has worked to constrict the supply of new commercial real estate even in the presence of strong demand. This in turn has contributed to large price rises that may not prove to be sustainable over the longer term. Second, the authors estimate that approximately one-half of all new commercial office space has been purchased by speculators at discounted prices and held for future sale. The carrying cost of this investment is quite low because Ukraine does not have a property tax and monthly utility rates and maintenance costs are well below world market levels. Therefore, speculators can afford to hold onto investment property. The incentive to do so has been strengthened by the rapid and substantial rise in commercial real estate prices, which in turn have been driven by continuing high demand from both domestic and foreign investors. From 2000 through the end of 2006, prices increased the most in Kiev owing to a high rate of inmigration from other regions of the country. By the end of 2006, average commercial real estate prices in the city center had grown to $5,000 per square meter.2 During 2007, prices increased by 15%. During the first quarter of 2008, average prices of commercial real estate in Kiev increased another 25%. Kiev also has by far the highest concentration of foreign-owned companies and a large governmental sector. Owing to rapid economic growth in recent years, driven in part by active growth in real estate development, Kiev now accounts for probably half of total Ukrainian GDP. During 2007, significant amounts of capital were invested into regional capital cities where growth rates in prices were even higher. Table 1 shows changes in average prices of commercial real estate in 25 cities in Ukraine by quarter during 2007 and the first quarter of 2008, for each respective city center and for the city as a whole.3 Owing to its large size, complexity, and highly variable prices within the greater metropolitan area, a citywide average for Kiev would have little meaning and therefore Kiev is not included in Table 1 for direct comparison with other regional cities.
Table 1 Change in Commercial Real Estate Prices in 25 Cities of Ukraine, 2007-2008
Table 1 Change in Commercial Real Estate Prices in 25 Cities of Ukraine, 2007-2008 (continued)
Average prices for almost all 25 regional cities in Ukraine increased significantly since 2007. Price increases for commercial real estate in the largest cities, such as Dnipropetrovsk, Donetsk, Lvov, Odessa, and Kharkov, reflect strong economic activity in their respective regions. There are exceptions, such as Ternopol and Lutsk in western Ukraine, where a significant percentage of the workforce has been employed outside the country and repatriated earnings have driven real estate price increases in these cities even as overall economic activity in their regions have remained low. Price increases have been erratic, with often large fluctuations between quarters. The highest price increases occurred during the fourth quarter of 2007 in Odessa (102%) and Yalta (116%). However, for most cities, price increases have slowed since the fourth quarter of 2007. In a few cities, large percentage increases or decreases in average prices merely reflect the very small size of the local market. Regional cities with the highest prices for commercial real estate based on data for the first quarter of 2008 are given in Table 2. Average prices in the city center are substantially higher than for the average of the city as a whole. As sale prices have increased, capitalization rates have decreased.4 This is because rental price increases have not kept pace with sale price increases. Whereas sale prices for new commercial space are strongly affected by speculative investments, rental rates are driven by the underlying growth and profitability of thebusiness sector in each region. As capitalization rates decline, new capital investment is redirected away from areas where capitalization rates are lower and toward areas where capitalization rates are higher.
Table 2 Ranking Cities by Price of Commercial Real Estate, First Quarter 2008
Table 3 shows changes in capitalization rates from October 1, 2006, to April 1, 2008, for 14 regional cities. In 12 cities, capitalization rates declined and in 2 cities the rate was unchanged. Several major cities show very clearly the interaction of increasing sale prices and decreasing capitalization rates. For Donetsk (the major southeastern city of Ukraine with large mining and metallurgical industries), prices rose 16%, 26%, and 19% respectively during the first three quarters of 2007. During both the fourth quarter of 2007 and the first quarter of 2008, however, prices remained flat. As a result, capitalization rates have declined from 16% in late 2006 to 11% in early 2008. The market has now reached a point where further price increases are becoming constrained by a softening in existing demand as well as the cost and availability of credit. In Kiev, a capitalization rate of 13% in late 2006 was already relatively low, declining further to 9% by early 2008 as prices rose very substantially. In other major regional cities such as Dnipropetrovsk, Odessa, and Kharkov, the same trend is apparent, with capitalization rates declining from 16% to 7%. The commercial real estate market in Ukraine during the last few years, particularly in its largest cities, can be characterized as a hot market, where pent up demand is released and sale prices rise rapidly while rent-price increases lag behind, thereby affecting the stability of capitalization rates.
Table 3 Changes in Capitalization Rates in Commercial Real Estate by City*, October 2006 to April 2008
Ukraine’s market for new commercial real estate has been very strong through mid-2008. Prices areexpected to continue to increase, although probably not at the rate as recent years as demand continues to exceed supply. Declining capitalization rates reflect a maturing of the market as capital investment has first followed price increases and then shifted in response to declining capitalization rates. The recent slowdown in price growth since the fourth quarter of 2007 in some cities reflects an increasing balance between new supply and demand, and especially the effect that such rapidly rising prices have recently had on constraining demand. However, real estate investment remains the preferred investment alternative in Ukraine given the relatively low risk-adjusted returns in other sectors. At the same time, the system of land use continues to constrain overall supply growth, while speculative investments can be carried at lower cost in anticipation of higher prices in the future, and relatively high rates of inflation make investment in real property more attractive. These factors should contribute somewhat to maintaining current prices or moderating declines near- to medium-term. Looking beyond a three to five year period, the economic growth in Ukraine is expected to recover along with the world economy. The commercial real estate market is expected to remain strong, the currency to remain relatively stable, and inflationary trends to moderate. Demand for new commercial real estate built to international standards should continue to exceed supply, particularly in the larger regional cities. Price growth is expected to moderate, but continue. expected to continue to increase, although probably not at the rate as recent years as demand continues to exceed supply. Declining capitalization rates reflect a maturing of the market as capital investment has first followed price increases and then shifted in response to declining capitalization rates. The recent slowdown in price growth since the fourth quarter of 2007 in some cities reflects an increasing balance between new supply and demand, and especially the effect that such rapidly rising prices have recently had on constraining demand. However, real estate investment remains the preferred investment alternative in Ukraine given the relatively low risk-adjusted returns in other sectors. At the same time, the system of land use continues to constrain overall supply growth, while speculative investments can be carried at lower cost in anticipation of higher prices in the future, and relatively high rates of inflation make investment in real property more attractive. These factors should contribute somewhat to maintaining current prices or moderating declines near- to medium-term. Looking beyond a three to five year period, the economic growth in Ukraine is expected to recover along with the world economy. The commercial real estate market is expected to remain strong, the currency to remain relatively stable, and inflationary trends to moderate. Demand for new commercial real estate built to international standards should continue to exceed supply, particularly in the larger regional cities. Price growth is expected to moderate, but continue. – Sources include the National Bank of Ukraine, and the Ministry of Finance of Ukraine. – Prices are reported in U.S. dollars per square meter of net usable space. To convert from price per square meter (herein sq. m.) to price per square foot, divide by 10.764 square foot per square meter. This article uses the metric system since original data is quoted as such in Ukraine. – Data is obtained from a large variety of publicly available sources, including established real estate agencies, associations, and data acquisition firms with reliable track records. A map of Ukraine is shown in the Appendix. – Capitalization rate equals the ratio of average rental price to average sale price, after adjustments for size, location, age, quality, etc.