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Office Real Estate of Ukraine: Change of Trends and Prospects

The beginning of 2008 foreboded no troubles for the most of office property developers and owners. Growth of rates, excess of demand over supply, lessees’ plans to expand office areas – everything spoke in favour of high profits for developers and owners of the property that was in operation at the time. However, accumulated disparities in the real estate market development as well the serious economic crisis that overcame Ukraine changed dramatically the situation on the office property market.

Most of 2008 the office real estate market kept developing in favourable environment. According to Colliers International, the new supply to the capital city office property market reached 200,000 m2 in 2008 bringing therefore the total supply volume of professional office real estate in Kiev to about 1 million m2 by the end of the year. Rental rates kept growing step by step increasing therefore profitability of the existing objects and those under construction. Since the beginning of 2009 explainable slowdown of office area enlargement has been observed. Thus, in the first quarter of 2009 only one office facility - BC Capital Hall (total area 12,000 m2) was set in operation.

The dramatic trend change of the market development was mainly caused by a serious decrease of business activities, by most companies’ freezing of their development plans including those related to renting new office areas, by cutting down activities and/or closing down many economic agents that used to build up the demand for office facilities. If at the end of the 3rd Quarter – beginning of the 4th Quarter of 2008 the UAH devaluation made it impossible for the lessees to pay according to old ‘dollar’ rates, further exacerbation of the crisis made some companies completely unable to pay their office rents and even forced them to vacate the premises. Others had to move to cheaper offices and/or to reduce seriously the rented space trying in such a way to cut their expenses in conditions of the crisis. Accordingly, the dramatic fall of the demand for office space within a relatively short period of time became the main reason of changing market trends.

Consequently, within a short period of time the office real estate market dominated by the lessor who used to be ‘the market king' for several years, turned into a lessee dominated market where a financially reliable lessee can dictate his/her terms to the lessor. In conditions when the demand seriously decreases and more premises are vacated the supply of office space at quite attractive prices has considerably increased compared to the pre-crisis period. Furthermore, the market has received a big supply of non-professional office property which previously used to be purchased for speculative purposes. Besides price reduction, serious moderation of lessors’ line can be also seen from modification of rent terms: now many owners of office premises are ready not only to lease out bare rooms to be decorated (shell&core in the market glossary) but also to decorate the buildings at their own expense and then lease out ready-to-use rooms. Taking into account price uncertainty, market players prefer to conclude shorter new contracts (previously long-term agreements used to prevail).

Market changes made lessors to change their policies. After all, additionally to price reduction, the issue of vacancy rate of office premises is critically important. The economic recession has raised the vacancy rate of the existing office property facilities and seriously reduced the occupancy rate of newly built office premises. By the end of spring 2009, the vacancy rate of professional premises reached 15% on the capital city market (compared to 1-3% of vacant space during the pre-crisis period). The lessors who didn’t want to adapt to the market crisis started losing lessees and finally losing the competition with those who appeared to be more flexible in the current conditions. The owners of the premises who accepted the adequate rent rate reduction have managed to stabilize and even to improve their office property vacancy rates. The highest index of quitting offices by lessees was registered at the end of 2008-beginning of 2009. By the end of spring 2009 the situation stabilized to some extend due to the fact that many companies had by that time adapted to working in crisis conditions and reduced both their personnel and their rented office areas. Another wave of the financial and economic recession can cause a new step in reducing rented premises.

The supply of office areas for secondary leasing has seriously grown up in the crisis conditions which previously happened very seldom. In such a way the lessees try to recover at least a part of rent expenses. The average size of requested office premises is also reducing. Most of the companies tend to rent smaller offices.

Situation on regional markets is worth mentioning separately. As in case with retail property segment, the regional office property markets have suffered more than the capital city market. Even before the crisis major investors paid less attention to the regional markets than to Kyiv’s one. Now, when most of the companies that build up a reliable demand for office premises focus their efforts basically on the capital city and some million-population cities, the problem of preserving lessees has become very critical for regional office centres. Many office premises possessed by uncompromising owners are getting empty.

As mentioned above, the crisis on the market has considerably reduced the office property sale prices and rent rates. For example, in some high level capital city centres the rent rates in US dollars reduced 2-2.5 times which considerably exceeds UAH devaluation rate. This proves again that pre-crisis prices of the office property were overheated. In average, by the middle of spring 2009, the rent rates of the A class offices were between 480—600 US dollars per square meter per year, those of the B+ class – between 360—480 US dollars per square meter per year and those of the B- class – between 180—360 US dollars per square meter per year. The price difference between A class and B class office premises has also reduced. Similar trends of serious rent rate reductions are also observed on the regional markets. To prevent dramatic vacation of office centres some owners are even ready to offer rent payment holidays to their lessees.

Even deeper recession is observed on the office property sale market. According to market players, the average office property price on the capital city market has reduced to 1.9 thousand US dollars for a square meter which is 2.5 times lower than the pre-crisis prices. Moreover, many owners are ready to make discounts, mainly those who need money urgently and those whose office property was purchased on credit and remains pledged in a bank.

The crisis on the real estate market and exaggeration of credit terms resulted in reduction of the investment value of office property objects almost two times. The capitalization rates for the office property segment reached almost 20% which is two times higher than the pre-crisis indices. Moreover, now most of investors who still display interest in Ukrainian market prefer to buy operational office premises capable to generate profits and located in the central part of the city. No wonder, that they would prefer Kiev first of all.

In the field of office property development the crisis revealed itself through ceasing implementation of many projects as well as slowing down implementation of the others. This was mainly caused by serious problems of attracting funds for construction. As mentioned above, the regional markets have suffered most because of switching investors and developers’ interests over to the capital city market. Furthermore, major projects that have not been brought to the closing stage find themselves under a particular threat as they need bigger investments to be finalised which appears to be quite a challenge in the environment where most investors are short of liquidity and the future of key market indices, rent rate in particular, is so uncertain. It is difficult to forecast and calculate legitimately the economic component of a project in such conditions of uncertainty. The crisis in the field of development has explainably resulted in deferring of object introduction-into-service terms to later dates.

In the crisis circumstances the professional level of office property development is getting more and more important. In conditions of an advancing market the lessees had to turn a blind eye to some drawbacks of office premises, but now they can afford a much more discerning approach. Offices with disadvantages in engineering, design, with less parking space will have to compete basically by reducing their rent rates.

Future development of the office property market will strongly depend on the general economic situation in the country. Really, business activity and consequently the demand for office premises, companies’ development plans, availability of resources for financing, etc. will depend on how the Ukrainian economy in general emerges from the crisis.

In mid-term perspective there will be no office areas supply shortage on the market, and the supply will exceed the solvent demand. The office area vacancy rate value will remain high. The vacancy rate might spring up again in case of a new wave of the economic recession as well as in office premises possessed by uncompromising owners.

In the short-term perspective one can forecast a step-by-step reduction of the rent rates; this indicator will be particularly sensitive to national currency fluctuations. In the mid-time perspective much will depend on the situation in the Ukrainian economy. Oversupply of office real estate especially in the segment of non-professional objects will shape further reductions of sale prices for such objects.

Development of new office premises will suffer from financial difficulties and unwillingness of many players to invest in conditions of uncertainty. Thus, forecasts of new supplies on the capital city market for 2009-2010 are fairly factitious as it is quite difficult to judge if one or another object will be finished in proper time. According to Colliers International, about 300,000 m2 of office real estate could be added to the Kiev office property market in 2009-2010. Forecasts concerning supplies of new professional objects on regional markets are even more factitious.

As can be seen from the above, the financial and economic crisis in Ukraine has delivered a serious blow to the office property market including the new object development segment. On another hand the crisis has removed a number of market disparities and made the owners more compromising in their deals with the lessees. The market further development indicators will depend on the status of the Ukrainian economy as the most important generator of the demand for professional office property.