I OVERVIEW OF THE MARKET
The Russian real estate market is dominated by private companies, primarily by development and construction groups, and by financial institutions that accumulated major real estate portfolios during the period of the economic crisis as a result of defaults by their borrowers. The state and regions also remain important players, both directly and, in the case of the state, via major state-controlled banks.
Public real estate companies do not exist, and while some financial institutions – significant holders of real estate – are technically public, this does not have any considerable impact on the industry.
There is also a clear preference for certain types of real estate investments exhibited by Russian and international investors. Residential real estate is nearly exclusively the domain of domestic businesses while international players focus on specific types of commercial real estate, such as warehouses and business centres.
Investments in Russian real estate are characterised by the extremely high concentration in Moscow and its satellite towns, with Saint Petersburg a distant second. In the first half of 2016 the share of Moscow in total amount of real estate investments was approximately 82 per cent, and Saint Petersburg approximately 6 per cent.2
There is no evident trend in Russia for the real estate industry to be moving from traditional models towards stock markets, and the key players in the area remain private. At the same time, for a number of reasons, M&A and stock market tools are often used in transactions and corporate structuring exercises involving Russian real estate. Additionally, as real estate and real estate development are heavily regulated areas, these industry regulations considerably affect traditional M&A processes when real estate industry players are themselves the targets of M&A transactions.
II RECENT MARKET ACTIVITY
Practically speaking, there is little real difference between ‘public’ M&A and private equity transactions where Russian players and Russian targets are concerned, even when Russian public companies are involved. This is even more pronounced in the case of real estate industry players, which almost universally are private companies. Consequently, the reporting of the details of the transactions in the industry is generally limited and most deal data remain non-public.
Development and real estate industries were major contributors to the total value of M&A transactions in Russia in 20153 and the first quarter of 2016.4 This was in part due to the biggest Russian M&A deal of 2015, the acquisition of Stroygazconsulting Group, one of the largest construction holdings in Russia, by a consortium of Gazprombank and investment fund United Capital Partners for approximately $7 billion.
Other notable transactions include the acquisition by Yandex of the office space in the Red Rose business centre from KR Properties in the first quarter of 2016 for $680 million and the acquisition by BIN Group in the middle of 2015 of Avgur Estate and A101 Development, holding companies owning 2,400 hectares of land in the territory of New Moscow.5
Overall, the proportion of value of M&A transactions attributable to real estate and development industry has shown a threefold increase in 2015 compared with 2014 and represented approximately one-third of the total volume of the market. This trend has lasted into the first quarter of 2016 where the real estate sector continued to be a main contributor. However, this increase took place against the background of the significant drop in the total value of M&A transactions in the Russian market, and the general state of the M&A market remains weak.
III REAL ESTATE COMPANIES AND FIRMS
i Publicly traded REITs and REOCs – structure and role in the market
Russian counterparts to REITs – real estate investments funds – can be created in two forms: a joint-stock investment fund and a closed-end unit investment fund.
A joint-stock investment fund is a legal entity created in the form of joint-stock company with the sole purpose of making investments into a specific class of assets (which may include real estate).
A closed-end unit investment fund is not a separate legal entity, but rather a ring-fenced pool of assets that has to meet certain criteria placed by settlors of the trust under the management of a trustee, a management company that has a special licence to carry out such activities. The term ‘trust’ in that context refers to a special type of contract for the management of assets under Russian law, which despite certain similarities is still quite different from a common law trust.
Joint-stock investment funds essentially exist on paper and only a very limited number were ever created. Closed-end unit investment funds, especially those created for the purpose of investments in real estate, on the other hand, found a wider use in the market. Such closed-end unit investment funds of real estate for simplicity will be referred hereafter as REITs. This is the most widespread type of unit investment funds in Russia.
Shares of a joint-stock investment fund may be admitted to public trading on stock exchanges subject to the fund being incorporated as a public joint-stock company and passing the listing requirement of an exchange. Given the rarity of the form itself, presently this remains a theoretical option.
Participation units in REITs also may be admitted to public trading if the rules of trust management of a REIT allow for the possibility of exchange trading in its participation units.
While the option to list REITs is used by fund managers relatively frequently, REITs are seldom created with the purpose of public trading in mind. The main drivers for the creation of REITs are taxation benefits and the ability to ring-fence the real estate property of the founders and avoid disclosure of the owners’ identities.
Typical investments by REITs in Russia are focused on such types of properties as shopping centres, office buildings and warehouse complexes in the area of commercial real estate, and new residential complexes. REITs are often used by their founders as vehicles for separate development projects.
Joint-stock investments funds are created by the incorporation of a new joint-stock company in accordance with standard procedure for the registration of a new legal entity. However, a number of additional restrictions are imposed on such companies, for example, not being allowed to issue preferred shares and not having as shareholders the registrar of shares, or a securities depository, auditor or independent appraiser who has entered into a contract for provision of its respective services to such funds. The property of a joint-stock investment fund is split between the property necessary for the functioning of the management of the company and investment reserves that have to be put in the trust of the licensed management company. Payments related to the operations of the assets of joint-stock investments funds have to be carried out via a special separate bank account of the trustee.
REITs are created by the transfer of property into the trust of the licensed management company based on the rules of trust management for the respective REIT previously registered by the management company. The period between registration of the rules and formation of the property complex of the REIT may not exceed six months.
Composition of assets of joint-stock investments funds and REITs should comply with certain requirements. Assets of investment funds investing in real estate may include:
- a cash;
- b real estate and lease rights in relation to real estate;
- c property rights arising out of agreements on participation in shared construction funding (see Section IV.i, infra);
- d debt instruments;
- e participation units of other REITs or rental REIT funds; and
- f certain types of shares and participation units of foreign investment trusts (funds).
In addition, the assets of investment funds, shares (participation interest) that can be acquired only by qualified investors may include:
- a property rights of investors and developers related to the creation of real estate;
- b property rights arising out of construction and EPC contracts related to real estate;
- c design documentation; and
- d shares or interests in companies involved in designing, engineering and development.
Property encumbered by a pledge cannot be transferred into the assets of a REIT.
In addition, there are certain requirements applicable to the structure of assets of real estate funds, in particular:
- a the appraised value of real estate, lease rights in relation to real estate or property rights arising out of agreements on participation in shared construction funding that form the assets of the fund should comprise at least 40 per cent of value of net assets of the fund for at least two-thirds of the total number of business days within a calendar year;
- b the appraised value of participation units of other funds forming the assets of the fund should comprise no more than 20 per cent of value of its assets; and
- c cash in accounts opened in one credit institution should not exceed 25 per cent of value of the assets.
Properties owned by joint-stock investment funds and properties comprising REITs are accounted for in a specialist depositary whose consent is necessary for the disposal of such assets. Moreover, the rules of trust management of REIT may impose restrictions on the ability of a management company to dispose of real estate comprising a REIT and require that the transactions concerning the REIT property have to be approved by the REIT’s investment committee.
ii Real estate PE firms – footprint and structure
There is no significant private equity industry in Russia in the western sense of the term and key private equity investors are a number of western funds that specialise in investments into Russia, but their activities do not leave any specific footprint warranting special analysis.
i Legal frameworks and deal structures
There is a considerable body of legislation in Russia regulating deals with real estate and related rights and investment activities involving real estate. Real estate and related development activities are highly regulated areas in Russia and the transactions happening at the intersection of real estate and M&A might be affected by a wide variety of different legal requirements.
The key law regulating the investment funds is federal law of Russia No. 156-FZ dated 29 November 2001 ‘On investment funds’. It sets regulatory framework for funds’ activities and their relations with investors, and regulates general issues related to the management of the accumulated assets, control over disposal of the assets, obligations of trustees, and audit and disclosure requirements. This law is further supplemented by a significant number of lower-level acts that are mostly adopted by the government of Russia and the Central Bank of Russia.6 Inter alia, the government approves the template rules of trust management for different types of unit investment funds.
M&A transactions in general are still often subject to foreign (primarily English) law, however, there is an evident shift to the wider use of Russian law, especially at the lower end of the market and in mid-sized deals. In part, this results from the major overhaul of Russian civil law, including the law on contracts, which is currently taking place and that now provides tools similar to those envisaged in foreign legal systems. The Civil Code of the Russian Federation is a key authority on both law of contracts and a legal status of real estate. It also defines real estate and sets out necessary terms for transactions concerning real estate.
Structuring considerations for transactions involving real estate are almost always tax-driven. Russian tax law is codified in the Taxation Code of the Russian Federation. Apart from setting general rules for taxation, it specifically regulates the taxation of real estate operations, as well as taxation of the activities of investment funds, including REITs.
There are number of special laws that affect real estate transactions, the most relevant being:
- a the Land Code of the Russian Federation, which regulates the use of land, sets restrictions on the use of and transactions concerning land, and contains requirements on land protection;
- b federal law of Russia No. 122-FZ dated 21 July 1997 ‘On state registration of rights in real estate and transactions herewith’, which regulates grounds and procedure for the registration of rights, transfers and encumbrances in relation to real estate; and
- c federal law of Russia No. 102-FZ dated 16 July 1998 ‘On mortgage (pledge of real estate)’, which regulates the procedure for the conclusion and state registration of mortgage agreements, special requirements relating to foreclosure over real estate, etc.
In addition, there are separate laws dealing with investments in the development of real estate. This includes federal law of Russia No. 39-FZ dated 25 February 1999 ‘On investment activities in the Russian Federation carried out in the form of the capital expenditures’, which regulates investments in fixed capital including expenditures relating to new development, reconstruction and technical refurbishment of existing real estate, and front-end engineering design of development projects.
There is a limited number of stock market instruments in the Russian market that use real estate as a means of investment (the prevalent way to invest in real estate for most of the population is still to buy as many apartments as possible); however, there are certain tools designed to facilitate collective investments into residential real estate.
The key piece of relevant regulation is federal law of Russia No. 214-FZ dated 30 December 2004 ‘On participation in shared construction funding of apartment housing and other real estate objects’. This law was adopted in order to create a framework for the collective investment by natural persons into the development of residential real estate. Raising funds from natural persons to finance development of future real estate is a very sensitive topic, both politically and socially, because of the long history of related frauds and developers going bust. As a result, the area of such collective investments is currently heavily regulated. Law No. 214-FZ currently provides for specific types of contracts – agreements on participation in shared construction funding – as means to arrange such investments. It regulates the process of conclusion, performance and termination of relevant agreements, as well as the issues arising from the use of funds raised and required collateral obligations securing the contracts. As previously indicated, rights based on such participation contracts may be included in the assets of real estate investment funds.
Other means of raising funds permitted by Law No. 214-FZ include the issuance of a special type of bond (‘residential certificate’) by an issuer that owns or leases a land plot and has acquired a building permit for the development of residential real estate at such plot. Such bonds create a right for bond holders to demand the transfer of the residential properties from the issuer. Another permitted option is raising funds via housing saving cooperatives, which was intended for use by communities of residents, but has been adopted in practice by big developers as another way of fundraising.
In terms of M&A activity, the relevance of these regulations is mostly indirect and related to key risks associated with the underlying assets.
It is very common in Russian market to conclude deals with real estate by means of a transfer of shares (participation interests) in the holding company that owns the underlying real estate. This is done for a variety of reasons, including: tax considerations; simpler and more expedient transfer of property title in the case of the sale of equity as compared with asset deals with real estate; and the lack of the need to change existing planning and building permits.
The joint venture toolkit is also sometimes used to regulate the relationship between the owners of spaces in the same real estate property. The operational management of jointly owned properties is exercised by professional service companies, which are selected by the holders of the majority of spaces in the property. While such companies are normally affiliated with the developer of the property or the major owner, it is not unusual for some owners that together hold enough votes to appoint a service company to create the latter as a joint venture.
Transactions involving future real estate can also take other forms besides straightforward assets deals and real estate M&A transaction; for example, they may include co-investment agreements, cooperation agreements and agreements on participation in shared construction funding.
The choice of specific acquisition structure is determined by a variety of factors. These may include:
- a the stage of development of the real estate and the grounds on the basis of which the development project is being (or was) realised;
- b the nature and intended use of the target real estate;
- c the presence of co-owners of spaces in the acquired real estate;
- d the status of land rights on the plots occupied by real estate;
- e financing arrangements; and
- f the preservation of rights for VAT refunds accumulated at development stage.
ii Acquisition agreement terms
The public or private nature of transactions has basically no effect on the structuring and content of acquisition documents. The following outline would generally be applicable in both cases. Typical terms of the acquisition documents for such sort of deals would normally include:
- a a detailed description of the real estate being the subject of the transaction, allowing its precise identification by reference to state registration details contained in the Unified State Register of Immoveable Property Rights and Transactions herewith and in the public land cadastre data;
- b certain standard representation and warranties;
- c the price or procedure for its determination7 including deferred payments and price-adjustment mechanisms;
- d payment and closing arrangements;
- e procedure for the effective delivery of the underlying real estate; and
- f deal protection mechanisms, including a list of specific breaches and respective sanctions and penalties.
Standard consideration in such transaction is cash. Shares of the acquirer as a consideration would be unusual because, as mentioned earlier, there are no publicly listed industry players in Russia. As such, equity is exchanged (issued) in real estate M&A transactions mostly in joint-venture situations, where liquidity concerns have lower priority.
Typical representations and warranties in an M&A deal at a minimum would cover:
- a the legal capacity of the parties and obtaining of the necessary authorisations and corporate approvals;
- b title warranties both in relation to the equity being sold and the underlying real estate; and
- c the absence of encumbrances and third-party rights, and claims affecting equity and real estate.
Specifically in real estate M&A deals, it is normal for an acquirer to request warranties regarding:
- a conformity of the real estate with the declared operational and technical characteristics;
- b compliance of the real estate with technical regulations and building rules; and
- c compliance with legal and contractual requirements during the development stage of the real estate.
The list is far from exhaustive and additional representation and warranties might be given depending on the specifics of the deal and bargaining power of the parties; for example, warranties related to occupancy rates and the validity and duration of leases with tenants are often encountered in transactions in relation to shopping centres and office buildings.
Typical conditions to closing are similar to any other M&A deal and include:
- a all necessary corporate authorisations and approvals being received;
- b all regulatory consents (usually related to merger control) being obtained;
- c securing financing when debt financing is envisaged by the terms of the transaction;
- d preparation and delivery of standard documentation package in relation to real estate being transferred; and
- e for ongoing development projects:
• completion of certain development stages;
• obtaining specific building permits or securing specific land leases with the state; or
• registration of the property title for newly built real property.
Closings are usually carried out on a delivery-versus-payment basis and assume same-day payments and transfer of title to shares.
In terms of deal protections that might be embedded in the contracts as a matter of Russian law, it is usual to have penalty clauses. Penalty clauses are recognised and enforced in Russia and do not have to necessarily correlate with losses incurred by the parties; however, the courts have the authority to lower the amount of penalties at their discretion if they believe them unfair. In the case of high penalty amounts, case law almost universally demonstrates the courts reducing the respective penalties.
In addition, after changes in 2015 to Russian civil law it became possible to agree break-up fees in contracts allowing one party to unilaterally terminate a contract subject to paying the other party a certain pre-agreed amount. As this is a new provision, no case law has yet been formed around it.
Executive compensation matters rarely come into play as there are normally no option programmes, virtual stock options, ‘golden parachutes’ or other forms of incentive and compensation for the management in situations where an M&A deal is a tool for the transfer of specific real estate. Such matters might become relevant in those M&A transactions that do not serve exclusively as means of real estate transfer, especially involving large and mid-sized industry players.
iii Hostile transactions
There is no practice of US-style hostile takeovers in Russian in general, and while hostile corporate situations in the real estate industry are not uncommon, they happen in private companies and each such situation is usually highly specific.
iv Financing considerations
The key sources of financing in real estate M&A transactions and development projects are the own funds of the industry players and, more significantly, loan financing extended by financial institutions. Development projects are also often partially financed using such collective investment structures as agreements on participation in shared construction funding, co-investment agreements or mechanisms based on REITs. Certain cash flows related to the financing of development projects may be further securitised by financial institutions. Stock markets are almost never used as a source of capital for the industry.
v Tax considerations
As previously mentioned, deals involving real estate are to a considerable extent tax driven. Specifically, there are a number of considerations related to the payment of corporate and personal income taxes.
Transactions involving properties constituting REITs are exempt from income tax. The holder of a participation unit will only pay income tax at the time of repayment or sale of such unit, as well as at the moment of receipt of interim income on the unit. Such deferral of income tax payments allows for full reinvestment of income obtained from transactions involving REIT properties up until the moment the unit holder has actually received the income (the units have been repaid and the interim income has been paid).
At the repayment of participation units, the managing company acting as a tax agent will withhold the amount of tax from the individual shareholder. Corporate entities will pay taxes as per the effective tax rates. Resident shareholders’ income will bear personal income tax (at a rate of 13 per cent) and that of legal entities will bear corporate income tax (at a rate of 20 per cent).
Non-resident unit holders’ income in the Russian Federation will be taxed at source and will be withheld at the source of income payment (30 per cent for individuals and 20 per cent for corporate entities). Where a foreign company (or individual) is a tax resident of a country party to a double taxation treaty with the Russian Federation, such non-resident shareholders’ income will be taxed in the Russian Federation as per the provisions of such treaty.
Transactions involving shares (participation interests) in Russian companies are subject to personal or corporate income tax, where appropriate, at the rates indicated above. Transactions with shares (participation interests) of companies that have been continuously held by the taxpayer for more than five years since the transaction date are exempt from taxation, except for situations where more than 50 per cent of such companies’ assets directly or indirectly comprise real properties located within the Russian Federation.
Asset deals with real estate are also taxed at the aforementioned rates. However, Russian individual non-residents’ transactions involving real properties are exempt from taxation where the properties have been owned for at least five years (where properties have been obtained in certain ways, for example, as part of a will, this period is reduced to three years).
vi Cross-border complications and solutions
When structuring transactions involving Russian real estate, it is necessary to keep in mind that Russian law prohibits the private ownership of certain type of lands in principle (for example, forests, land reserved for the placement of federal railway infrastructure and natural reserves).
Some of these restrictions are applicable only to foreign persons. For instance, foreign persons are prohibited from owning land plots situated in the territories adjacent to the state borders, included in the list approved by the President of the Russian Federation, land plots within the borders of seaport zones and plots located in agricultural land. Moreover, the restrictions on the foreign ownership of the agricultural lands also apply to Russian companies in which the share of foreign participation exceeds 50 per cent.
Another structuring point to keep in mind is that M&A transactions involving Russian (and in some circumstances offshore) holding companies for real estate might be subject to merger control in Russia and require the consent of federal antitrust service if the assets (or revenue) of the parties to the concentration exceed certain materiality thresholds. Merger control requirements also might be applicable in the case of asset deals if the subject of the transaction is real estate used for industrial purposes.
V CORPORATE REAL ESTATE
Most often, within corporate groups real estate is owned by the entities directly operating such properties (this pattern is most often seen where a group includes several manufacturers carrying out operations and domiciled in various Russian regions). Sometimes, the ownership of real properties used by the companies within a group is concentrated within a single company acting as a holding company for all (or significant part) of the group’s real properties, although this is less common. The latter practice might be seen in infrastructure companies and financial lenders optimising the portfolios of their non-core real estate assets.
Russia is still undergoing a large-scale reform of the civil law, within the framework of which the legal regulation of quite a number of issues relevant to M&A transaction structuring have been amended and revised. Statutory regulation of a large number of important aspects has been brought more closely in line with the needs of businesses, which had previously mostly chosen foreign jurisdictions for M&A deals. Specifically, a number of institutions have been introduced corresponding to popular English law instruments (for example, specific regulation of warranties and representations, indemnity-type arrangements, option clauses in contracts and the right to withdraw from an agreement subject to a payment to the counterparty).
Further amendments to the Civil Code of the Russian Federation dealing with rights in rem and certain transaction types, including financial transactions, are expected in the near future. These developments, together with the initial body of case law around previous legal changes are likely to result in a further shift toward the wider use of Russian law in M&A transactions.
In addition, a number of legislative amendments dealing with more specific matters related to investments on the real estate market is being prepared. These include regulations on agency activities on the real estate markets, new rules for advertising related to attracting funds for shared construction funding, and clarification of the rules of technical record-keeping and cadastral valuation of real properties.
In terms of expected economic developments, the situation remains unstable and while the M&A market in general, and the real estate segment in particular, shows certain signs of recovery, it is necessary to keep in mind that some of this growth can be attributed to distressed sales of assets and therefore this trend might be impossible to sustain. Still, there may be some additional localised drivers of growth in the near future, particularly:
- a financial institutions being under a certain amount of pressure to dispose of accumulated non-core real estate assets, as holding them for a long time may adversely affect the reservation requirement for banks;
- b the upward local driver for the Moscow market may come from the expected approval of the general development plan for New Moscow, which is currently expected to happen at the beginning of 2017; and
- c the declared intentions of the Russian government to confiscate unused agricultural land (the amount of which is vast) and auction them at market.
1 Andrey Mashkovtsev is a counsel at Egorov Puginsky Afanasiev & Partners.
5 New Moscow is an administrative project extending the Moscow territory at the expense of the area of the Moscow region (Moscow and the Moscow region are different constituent entities of the Russian Federation).
6 The latter has exercised regulatory oversight over Russian financial markets since 1 September 2013, when previously independent agency, Federal Financial Markets Service of Russia, became a department of the Central Bank.
7 In the case of asset deals with real estate under Russian law it is a mandatory legal requirement to fix the price or a clear process for its determination in the agreement.