The Russian economy is becoming normal. Inflation has fallen from the double digits typical of an emerging market and is currently 2.7%, a normal country level. Unemployment is also at record lows of 5%, and incomes, while still well below potential, are on a par with many poorer European Union (EU) countries: per capita income is currently $22,540 per year.

The one exception is interest rates, which are still a high 8.25%, despite a string of cuts this year by the Central Bank of Russia (CBR). However, even this will fall to 4-5%, perhaps as soon as next year, almost a normal country’s cost of capital.

All this combines to give a rosy outlook for Russian real estate.

PIK group emerged last year as the real estate sector’s standout company. The acquisition of rival Morton for RUB11.7bn ($189mn) in 2016 left PIK as by far the largest and fastest growing Russian real estate company. In late 2016, it had a portfolio of 12.5mn square metres (sq m) of property. In the same year, its revenue was RUB60bn ($0.9bn). This year, the developer expects to total cash collections of between RUB190bn and RUB200bn.

In the first half of this year PIK’s revenues more than doubled, up 119% to RUB41.5bn (€716mn), while its closest competitor, LSR, saw a 30% decline. PIK sold 771,000 sq m of real estate in January-June, a 90.4% increase y/y. Still, the company posted a net loss of RUB2.5bn, compared with a net profit of RUB1.7bn in January-June of 2016, but that is a function of the fact that a project can take two years to complete, CEO Sergey Gordeev told bne IntelliNews in an exclusive interview, and doesn't reflect the state of the company since it took over Morton.

“[The loss] is because of the way real estate business is. These results reflect the state of the company two years ago as we book the revenues when we deliver to the customer not when we get the money from them,” Gordeev told bne in an interview in PIK’s headquarters in central Moscow. “So we will see the profits from the current activity in 2018 and 2019.”

The company’s financial results in this difficult market were given rousing support by international ratings agency Standard & Poor’s (S&P) at the start of November, which praised the company’s “sound performance” at time when many of PIK’s competitors are seeing sales fall, while PIK is enjoying “strong pre-sales and cash collection growth driven by robust demand for its apartments”.

“The stable outlook reflects our view that PIK's liquidity position is supported by large cash balances and our expectation of sound operating cash flow,” the agency concluded.

Boom to bust in retail and office

The real estate sector boomed in the noughties and profits could be made from buying a building on Monday and flipping it on Friday. But the real estate business has had a hard time in the years since the global financial crisis. Only one new business centre has been opened in Moscow this year. A flurry of old retail projects were completed in 2015-2016, but since the “silent crisis” that hit two years ago, no significant new projects have been completed.

“The retail business is changing fast and the old style of malls are not as relevant as they were. There is a lot more space than there was 10 years ago. There is an oversupply,” says Gordeev. “We don't see any change in office in the near future either, as this business is being disrupted by the co-working spaces. The way office space is being changed.”

Gordeev used to have an office development company called Horus Capital that developed office space but he sold it in 2010 because of the changing trends in the industry.

The disruption in retail is also starting to be visible: the latest Watcom shopping index, which tracks footfalls in Moscow’s leading malls in real time, is having its worst year since the index was established in 2014, which is surprising as real incomes have started to rise again, albeit modestly, and the economy is a lot healthier this year than it has been for most of the last two. Part of the fall in the index must be due to the stagnation of real disposable incomes, but part of it is also due to the increasing completion of online stores.

The growth of Russia's e-commerce is easily outpacing the development of traditional retail outlets: the online market grew by 22% year-on-year to RUB498bn ($8.6bn) in January-June 2017 and Russia’s e-commerce is predicted to account for 10% of the global total by 2025, according to  Russia’s Ministry of Industry and Trade. Clearly Russia’s booming e-commerce is already affecting the real estate sector.

“In malls you can clearly see the changing traffic as a new generation come to the fore – the millennials,” says Gordeev. “They don't like using cars and prefer the metro or buses. They want to be independent from cars. That means retail has to mingle with the metro stations. There has to be more entertainment and fewer shops as traditional retail is being disrupted by e-commerce. The food retail outlets – the big supermarkets – these will remain but the fashion stores will be diminished.”

Russian food retailers are better positioned than some Western European retailers for the changes resulting from disruptive e-commerce challenges and its attempt to adjust to consumers' increasing preference for shopping at smaller convenience stores rather than at hypermarkets, Fitch Ratings said on November 23.

The retail segment amongst Russia’s top 50 companies by revenue accounted for RUB606bn ($10bn), or more than half of the aggregate revenues of Russia’s top 50 companies, soaring from 18% of the total in the preceding year, but still lagging behind the RUB1.38 trillion grossed by the fastest growing retailers in pre-crisis 2014. Fitch said it sees consumer interest in hypermarkets continuing to decline globally as shoppers put more of a priority on speed and convenience.

As Russian hypermarkets tend to be smaller and closer to their customers than their Western counterparts, the trend will go slower in Russia, but Fitch expects the size of the average Russian hypermarket to fall by around 300 sq m to 4,200 sq m over the medium term, the ratings agency said in its report.

And the same sort of disruption is just getting underway in the office business. A number of co-work space hub companies have sprung up in the last year and already have a dozen locations in Moscow where established companies are moving in, due to their cheapness and convenience.

The one bit of the real estate business that is benefiting from these disruptions is warehousing, which saw the volume of new deals up 54% in the first half of this year to 362,000 sq m of acquired space on the back of soaring demand from e-commerce companies. A large chunk of the demand came just from the major online retailers Utkonos (groceries) and Wildberries (clothes & shoes), two of Russia’s largest e-commerce companies.

Safe as houses

But none of this has stopped residential projects from going forward. Prices on the primary residential market have been flat or even fallen a little, but a government sponsored mortgage-subsidy programme for loans with interest rates over 12% has been supporting sales in this subsector.

Demand for residential property remains huge and not just in Moscow where the demand is so great you could build a second Moscow alongside the existing one. As mortgage rates have now fallen below 12% the government has ended the subsidy programme, and rates continue to fall: in November Russia’s leading bank Sberbank cut its rates to their lowest ever level of 8.6%-9.7% and the central bank is expected to cut rates to 4-5% in the next year or so. Mortgage sales already account for 57% of PIK’s sales, up from 7% in 2010.

“The CBR could go faster, but I don't think it will. It is being very cautious, as it fears the return of inflation. However, if rates were to fall to 4-5% we would probably see acceleration in mortgage sales. But rates falling to 4% could happen in the next two to three years,” says Gordeev, who adds he is relying more on cost cutting than rate cuts to make his profits.

The takeover of Morton transformed PIK into a market leader almost overnight. There were significant cost savings as all Morton’s properties and land bank of 4.6mn sq m worth RUB53.6bn was taken under the control of the PIK management; more than 6,000 staff were let go as a result.

“There was a huge administrative cost saving and at the same time the cost of loans fell significantly,” says Gordeev. “We sold the non-standard properties and concentrated on controlling costs and boosting the returns.”

However, one of the more valuable assets that PIK picked up from the acquisition was a state-of-the-art plant built by Morton that makes prefabricated construction panels for high-rise buildings. Gordeev has a bee in his bonnet about technological advances in the construction business and carried on investing in the panel plant.

“With this tech we can reduce the time to put a 25-story building up down to two months. Morton didn't make full use of this capacity and it is an important driver of cost reductions,” says Gordeev. “We have created a lot of different plants and we should be able to create all the elements for an apartment by the end of this year. We have a small plant where all the elements of the bathroom are made and can be delivered to the site. It is already producing 5,000 units, which will grow to 15,000. It is modular, robotic and cheap. We are also thinking about exporting these elements, but that is in the future.”

LSE stock flop

Along with the changes in the business have been changes in the ownership of PIK. In August Gordeev bought out two significant minority investors – legendary Russian financier Alexander Mamut and the owner of failed bank Binbank (aka B&N Bank) Mikhail Shishkhanov – to bring his stake up to just over 50%. Since then he has increased it further to 74.6% by the middle of October.

At the same time the company has delisted its GDRs from the London Stock Exchange and all trading is now only available on Moscow Exchange (MOEX). As part of this deal Russian state-owned bank VTB bought a 7.57% stake, leaving another 25.41% as the free float.

“Mamut and Shishkhanov were independent investors. Today Mamut’s main investment is in [Russian online company] Rambler and Shishkhanov was invested as a private individual. There was no connection between us and Binbank,” Gordeev said, who argues that the strength of a real estate company, like a tech company, is in the quality of its management. 

The decision to delist from London is part of a growing trend. In the boom years the LSE representatives were constantly in Moscow hoping to lure leading blue chips to IPO on its exchange.

But Gordeev voices a recurring complaint. “We delisted from London as we didn't see any action in our stock there by investors on the exchange,” says Gordeev.

Now MOEX is connected to the international clearing system Euroclear it makes no difference if the stock is listed in Moscow or London and so Russian companies are increasingly moving their shares home.

On top of this PIK is planning to come back to the market when the current transformation stemming from its merger with Morton is complete.

“We are targeting making an SPO in the future but we want to start from a white page,” says Gordeev.

The company is also reworking its financials. The company reported that net debt increased slightly in the first half of this year to RUB43.6bn from RUB40.7bn as of late 2016, but Gordeev says the company could try to reduce the debt to zero by early next year.

S&P is a little more cautious on the debt pay down, forecasting a deleveraging to about 2x Ebidta in 2018 and 1x in 2019, from 4x in 2017, “on the back of continued growth in buildings completion, recognised revenues, and better profitability,” the agency said in its November note.

Gordeev has also committed himself to paying a generous 30% of operating cash flow as dividends semi-annually starting with the 2017 financial year. The company last paid dividends in 2014 and they “were not very much”, says Gordeev, but that should change next year.

“If we stick to our business plan and there is free cash flow left, then we will share it with shareholders. There are only two good things to spend money on: shareholders and land,” says Gordeev.

The attitude of Russian business owners to their shareholders has changed dramatically in the last decade. In the Yeltsin era the key was to “privatise the cash-flows” as oligarch Boris Berezovsky once described it. Today owners see their equity as a valuable source of capital and are investing into their value by paying out dividends amongst other things: Russian companies now pay the highest dividends in the emerging markets universe, about 5% of net profits, or double the MSCI EM average.

“Russian shares are cheap thanks to sanctions. So companies want to increase the value of their shares and hence they have a generous dividend policy. Good corporate governance policy is part of the same thing,” says Gordeev.