Russia became an instant global pariah when it invaded Ukraine on February 24th. As more bloodshed and war crimes have come to light, the country has become further isolated from the international community. Western companies have hurried to divest in Russia, facing pressure to stand against the war. Foreign firms with multi-billion Russian investments like BP, Shell, and ExxonMobil have pulled out, and many others like Apple, Starbucks, and McDonald’s have suspended Russian operations. It has been easier for some brands to do this than others, but the picture for some real estate firms has been a little more complicated. International real estate companies with Russian assets have publicly condemned the war, but some questions about what they can do with their investments remain.
Even before this recent invasion of Ukraine, many Western real estate companies were pulling out of Russia. When Russia annexed the Crimean Peninsula from Ukraine in 2014, international sanctions were levied, and foreign investment slowed considerably, according to Denis Sokolov, former Head of Research CEE at Cushman & Wakefield in Russia. “Even five years ago, real estate firms were considering exit strategies. So, there haven’t been many significant transactions in the last several years,” Sokolov said. “The impact of those sanctions wiped out most Western real estate activity in Russia.”
Many Western tenants insisted on exit clauses on the leasing side and were hesitant to sign long-term leases. “Most international companies didn’t have strong confidence in Russian politics, they were cautious,” Sokolov said. In reality, foreign investment in Russian real estate has been minimal in the past several years. Inbound capital flows averaged just $960 million in the last 5 years, according to Real Capital Analytics. Inbound capital accounted for only 2.2 percent of Russian real estate investment in the first three quarters of 2021, according to Knight Frank’s research. It was the lowest level of foreign real estate activity in Russia since 2009.
Most international companies didn’t have strong confidence in Russian politics, they were cautious.
Denis Sokolov, former Head of Research CEE at Cushman & Wakefield in Russia
A deep freeze
Russia has never been an easy place for foreign investors, and the market there is now riskier than ever. No matter how many Dostoevsky or Tolstoy novels you read, the country is tough for foreigners to understand. Winston Churchill once described Russia as a “riddle, wrapped in a mystery, inside an enigma.” Political corruption significantly impedes most businesses there, especially foreign ones. “High-level and petty corruption is common, especially in the judicial system and public procurement,” said a 2020 profile of Russian business by the Risk and Compliance Portal, a resource maintained by GAN Integrity.
Yukos, one of Russia’s biggest oil companies, is a recent and notable example of this. The company’s CEO, Mikhail Khodorkovsky, angered President Vladimir Putin with comments about political corruption in 2003. Shortly after that, Khodorkovsky was arrested on fraud and tax evasion charges and sentenced to 14 years in prison. The company, Yukos, was forced into bankruptcy, and pieces of the firm were sold off for fractions of its actual market value.
Real estate firms that managed to exit Russia in the years following the Crimea annexation appear to have made a wise move. The ones that remain are caught in a messy situation. More than 300 foreign companies have suspended or withdrawn from the Russian market in response to the war in Ukraine. The Russian government has responded with countermeasures to restrict the exits of foreign companies, including the trade and sale of real estate assets. Authorities approved legislation to nationalize foreign investors’ holdings from so-called “unfriendly states” that have imposed sanctions against Russia, such as the U.S., the European Union, and Canada.
Nationalization will lead to the forced replacement of company management by ‘special external management’ and the sale of assets. Even if foreign real estate firms can avoid this and sell assets, they likely can’t take their money out of the country. This has essentially led to foreign companies freezing their real estate investments and operations.
Caught in the crossfire
The pressure from the Russian government has made decisions exponentially more complex, as Western firms are squeezed between facing reputational damage and severe threats from the authorities. “These Russian government measures, like nationalization, are to prevent the selling of foreign assets,” Sokolov said. “They want to calm down the fire.” Sokolov said government cronies would likely scoop them up later at a dirt-cheap price if Western firms abandon assets.
Perhaps the most high-profile example of a Western real estate firm walking this tight rope is Houston-based Hines, which has made multi-billion-dollar bets in Russia over the past decade. Hines is half owner of the Metropolis Shopping and Entertainment Mall in Moscow and another 11 office and retail assets in Russia. Hines’ Russian portfolio was valued at about $2.9 billion before the invasion of Ukraine, which only comprises about 1.8 percent of its total $160 billion assets under management. The real estate firm purchased Russian assets as recently as 2018, and now they seem to have few options on what to do with them. Sources say the keys for the Metropolis mall, at least, will probably be handed back to the Russian lender, and Hines won’t be able to withdraw the sales proceeds from the country.
Hines has operated in Russia since the fall of the Soviet Union in 1991 and has a significant headcount of employees to consider there, too. The firm has 250 staff managing assets in Russia. It has publicly condemned the invasion of Ukraine and said it would cease any new investments there, but questions remain about how it will wind down operations. “We do have commitments made to our investors, partners, tenants, and lenders, and we are in discussions with them to determine the best path forward,” Hines told the Wall Street Journal.
Hines believed Russia’s rich energy resources, educated labor force, and growing middle class compensated for any political risks. Hines has a history of investing in emerging markets that could be considered risky, such as Iran, Egypt, China, and Brazil. The company began expanding overseas in the early 1990s during a lousy downturn in the U.S. commercial real estate industry. Hines now exists in 27 countries, but its presence in Russia seems to have backfired.
Other foreign firms have Russian real estate investments, but their situation isn’t as messy as Hines’. Morgan Stanley Real Estate Investing (MSREI) had a stake in two large Russian malls in St. Petersburg and Moscow. The firm sold off half-stakes in the St. Petersburg mall in 2019 and its stakes in the Moscow mall in 2013 to a joint venture between Hines and the California Public Employees’ Retirement System. “MRSEI, therefore, significantly de-risked before Russia attacked Ukraine,” according to a report by PERE News. Morgan Stanley will likely emerge from Russia relatively unscathed.
Effects of the exodus
Sokolov told me the effect on Russia’s economy from foreign divestment, including real estate, has been brutal. Putin reportedly made pre-war preparations to sanction-proof the economy, such as reserving more than $600 billion in foreign currency. Still, analysts say he wasn’t ready for the mass exodus of foreign companies. International sanctions have also hit Russia’s economy hard. Its currency (the ruble) lost 40 percent of its value. Inflation is expected to climb up to 20 percent. The Russian Central Bank raised its interest rate to 20 percent, making it harder for citizens and businesses to take out loans.
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According to some estimates, real economic activity in Russia is expected to decline by 25 to 30 percent this year. The country is also on the verge of defaulting on its foreign debt for the first time since the Bolshevik Revolution more than 100 years ago. “Russia is facing a deep and prolonged economic depression that is only going to get worse the longer they remain isolated from the rest of the global economy,” said Christopher M. Herrington, Associate Professor Of Economics at Virginia Commonwealth University.
Whether sanctions work politically remains to be seen, though it’s putting pressure on the Russian government. Sokolov said the government believes the country can be self-sufficient, but they’re paying a hefty price. Sokolov plans to move out of Russia, and he’s certainly not the only one. One Russian economist estimates as many as 200,000 Russians have left the country since the start of the war. Sokolov is heading elsewhere in Europe to set up shop as a real estate consultant now that his former employer, Cushman & Wakefield, has closed its Russian operations.
An ESG eye-opener
The invasion of Ukraine may also make international companies and real estate firms more aware of values like political freedom and human rights in ESG investing. Evidence of that happening is already emerging. Before the war, global ESG funds had at least $8.3 billion in Russian assets, according to a Bloomberg analysis of roughly 4,800 ESG funds representing more than $2.3 trillion in total assets. The funds owned shares in Russian state-backed companies like Rosneft and Gazprom and Russian government bonds. “We need to do some kind of rethinking here,” Erik Thedeen, Chairman of the Sustainable Finance Task Force at the International Organization of Securities Commissions, told Bloomberg. “This disastrous war is an eye-opener. The whole ESG community needs to think through how to handle state-owned companies” in countries that violate human rights.
This disastrous war is an eye-opener. The whole ESG community needs to think through how to handle state-owned companies.
Erik Thedeen,Chairman of the Sustainable Finance Task Force at the International Organization of Securities Commissions
Most ESG rating agencies have given Russia poor marks for suppressing domestic dissent and aggressive military actions, but that hadn’t necessarily stopped funds from including the country. MSCI, an ESG rating agency, had rated Russia BBB until the Ukraine invasion. It has since cut the grade to B and then CCC. Sustainalytics, another rating firm, actually gives Russia a higher rating than Ukraine; it did so before the invasion and continues to. There will likely be more pressure on rating firms to take human rights into account, but the recent war also raises deeper questions about ESG in the first place. Often touted as a tool to improve the world, ESG could really just be a measure for firms to avoid financial risk.
Russia’s invasion of Ukraine has shocked many of us who may have thought such a wide-scale conflict in Europe was impossible in the 21st century. The war has had major repercussions on the global economy, not to mention the bloodshed, tragedy, and brutality of the fighting itself. More than 1,800 civilians have been killed in Ukraine since the invasion began on February 24th, according to the Office of the U.N. High Commissioner for Human Rights. The U.N. also reports that more than 10 million Ukrainians have fled their homes, with 4.3 million leaving for neighboring countries and another 6.5 million displaced inside the war-torn country.
Western companies are suspending Russian operations and leaving in droves. The same goes for foreign real estate firms there. The war has provided a stark lesson in geopolitical risk management and lessons for investment in markets that have always been more perilous. Like Hines, some real estate firms may have rolled the dice in Russia for too long, and exiting the country now is proving trickier. Others have slowly been de-risking since the Crimean annexation of 2014, and they appear much better for it. Russia is a “riddle, wrapped in a mystery,” as Churchill once said, and the real estate firms that tried too hard to solve that mystery may be regretting it.