Is it Class A or Class B?

July 2005

The practice of downgrading office properties from class A to class B is still new to the Moscow commercial real estate market. But the situation is likely to change soon as older properties grow increasingly inferior to the more recent state-of-the-art class A business centers.
With time the older properties' failure to meet the ever increasing standards will become only more vivid. Landlords will have to choose between spending on renovation to retain their high ratings or to let things take their course — after all, these days the situation on the market is favorable to them.

Age-Related Problems

Moscow's office real estate market is expanding steadily as new buildings mushroom across the city. The new developments differ qualitatively from those erected earlier. As many as 700,000 square meters of prime office space were built in 2004, which exceeds the 2003 results by 34%, Cushman & Wakefield / Stiles & Riabokobylko reports.
“At the initial stages of the office market developers focused primarily on the speed of construction,” says Maksim Zhulikov, leading commercial realty consultant at Penny Lane Realty. “A detached business center appearing on the market was a unique offer in itself, and quite liquid, at that.”
The majority of new projects within commercial real estate in Moscow were positioned as class A, because at that time no one seemed to pay attention to any drawbacks or the lack of certain features typical of prime office properties.
The main thing was that the new buildings were initially conceived to house offices, not merely readjusted for the purpose unlike most properties available on the market at the time — i.e. rooms within Soviet-era factory management buildings and research institutes.
The arrival of foreign developers marked a new stage in the development of the office market in Moscow. Russian development companies still lacked expertise in prime commercial real estate. The first projects by Enka implemented on Kosmodamianskaya Naberezhnaya [embankment] in the early and mid-1990s were highly praised and viewed as a standard that no one would ever be able to surpass.
As the supply of office facilities grew, office space standards were nearing international levels. The luster of once prestigious office buildings waned noticeably against the backdrop of new projects. Eventually, the issue of their reclassification was raised.
As the competition between the new office projects intensifies — not only between class A properties but also between class A and B+ office buildings — landlords are forced to pay more attention to the professional positioning of their properties, says Aleksei Mogila, development director at Leeds Property Group.
When choosing an office to rent in Moscow tenants are guided by international office space standards, as well as the size of the rental rates. “That is why it is likely that new criteria for class A office properties will be set, and, consequently, the existing list of class A buildings will have to be revised,” says Regina Lochmele, office real estate analyst at Colliers International. “The development of the commercial real estate market itself calls for a reclassification of certain buildings as belonging to a different class,” adds Aleksandr Sharapov, president of Bekar Group.
“The more class A properties that enter the market the more questions arise as regards the older developments in terms of their positioning as top class properties. Sooner or later any property grows obsolete; hence, their downgrading is a natural process. With the office market growing we see new projects appearing, with better layouts, more sophisticated engineering equipment, infrastructure and additional services. That is why no matter how high their quality is today, tomorrow their value will inevitably drop.”
Elena Zanina, deputy head of commercial real estate and development at Miel-Nedvizhimost, says that properties should undergo re-evaluation every 5-6 years. Office buildings are usually downgraded by tenants themselves, as well as analysts and brokers, though “no landlord would ever publicly admit that their property has moved to a lower class,” she says.
Obsolescence is not the only reason for downgrading; another is marketing policy shortcomings. The Triangle House business center, although it is built within the boundaries of the Central Administrative Okrug [district] at 3G Krasnoselskaya Street in full compliance with class A standards, still cannot be positioned as such due to its extremely poor location, in close proximity to a rail track, warehouses and an industrial estate.
Another project — at 5 Bryanskaya Street — also has its location to blame. The business center is situated not far from the Kievsky train station. The splendid building with no less splendid engineering equipment meets all the standards but one, and market analysts have not ventured to position it as a top class property.

Non-Conformity Criteria

“To be positioned as class A or B a property must meet certain criteria. Thus, the downgrading of a property from class A to class B results from its failure to meet a sufficient number of criteria set forth in the rules of office building classification,” Regina Lochmele explains.

At the same time, experts admit that no uniform office classification criteria exist in Russia. The class of the building is usually set by landlords at their own discretion, with market requirements and principles often being ignored.
An example is the Avrora business park — the redeveloped facility of what was once a worsted textile mill — positioned as a class A property although this runs counter to international standards. “A redeveloped building cannot be classified as class A, by definition,” says Aleksandr Sharapov.
“The classification of office properties based not on strict quantitative parameters but on a variety of parameters with the principle of conformity taken into account is quite relative,” says Aleksei Mogila.
The key parameters used to establish whether a building earlier classified as a prime property fails to meet the class A criteria include the quality of construction and decorations, obsolescence of engineering equipment and ventilation systems, the quality of lifts or a shortage of them forcing crowds of employees of respectable companies to wait for a chance to get to their offices, cramped lobbies, as well as the quality of services provided by management companies or caterers.
“Moreover, a shortage of parking spaces — less than one parking space per 100 square meters of space leased — as well as insufficient amenities within and outside the property result in its downgrading,” says Elina Zanina.
“Business centers built several years ago, the then-flagships of the market, still remain competitive. Even if they do lose out to new developments, those changes proceed very slowly,” Maksim Zhulikov says.
Examples of a smooth transition from class A to class B are the first office centers built by Enka, in particular, the first buildings of the Riverside Tower compound built in the mid-1990s. These days, market experts rate them as B+ while the more recently built complex — commissioned in 1998 — still meets the class A standards.
The Putnik business center, commissioned in the early 1990s at 22/25 Bolshoi Strochenovsky Pereulok [lane], ranked as one of the most prestigious properties on the market. Foreign companies rented space there; the South African embassy occupied the entire floor. Over the course of time the facility began losing its positions. It still retains the class B+ rating — mostly due to the prime location and respectable foreign tenants. The similar fate befell the business centers at 13/2 Staropimenovsky Pereulok (built in the early 1990s) and at 75 Sadovnicheskaya Street (mid-1990s).
Another office center that has lost its high rating is the Inzhener (Engineer) business center at 23/2 Trubnaya Street.
The property initially positioned as class A office space was downgraded to a lower class as a result of incompetent management and poor maintenance. The landlords ran the building themselves, without enlisting the services of a professional management company. The Mosalarko Plaza 1 at 16 Marksistskaya built before 1998 has grown “morally obsolete” against the backdrop of many other more modern and sophisticated office properties, according to market analysts.

To Cure or Not to Cure?

Because the demand for tenancies in class A office buildings remains high landlords do not have to worry about the fate of their properties.
“Given the present-day level of technological development and moral depreciation of buildings, if the landlord fails to spend money on the building in order to maintain it in excellent condition, in some 5 or 7 years a class A building will slip into class B,” says Aleksandr Sharapov. “To maintain top class status requires constant improvement.”
Moscow has just a handful of class A business centers built over a decade ago. The number of top class offices is still low and demand is soaring. What matters today is not whether the improvements are worth being made or not but how economically expedient those improvements are, market analysts say.
Experts at the company Bekar say that in some cases it is better to agree to downgrade without having to make any significant investments because it is much wiser to spend any available funds on the construction of new facilities.
The task for the management company or the owner of the business center is to track the emergence of new market players in the same part of the market and to develop a new concept for the property, i.e. to decide if it is worth trying to keep up with the new rivals, or to accept things as they are and to continue developing one's business with class B status.
The company Bekar, for example, was faced with just such a task in St. Petersburg. Problems emerged at the Nobel business center on Pirogovskaya Naberezhnaya. The office center had entered the market as a class B+ property but risked a downgrading due to a faulty air conditioning system. The company carried out research and opted for additional spending to retain its rating.
The International Trade Center at 12 Krasnopresnenskaya Naberezhnaya, Moscow's oldest office facility, is constantly undergoing improvements with the property retaining its leading position on the real estate market.
As the issue of downgrading of office space is raised more and more often the demand for auditing of the management and maintenance of properties increases. This service is usually commissioned by landlords dissatisfied with the performance of their management companies.
The audit is aimed at detecting problem zones that result in the loss of tenants and a drop in revenues. Auditors prepare a plan of action and proposals to restructure the management company enabling the landlord either to bring order to his management company or to hire someone else.
A vivid example that shows investing in improvements does pay back is the over hundred-year-old U.S Rockefeller Center that has retained its class A status throughout all those years. Landlord's Market
Logically, the downgrading of a business center is supposed to bring down rental rates. But this is not happening. “We see no direct decrease in rentals on tenancy agreements for properties commissioned earlier in Moscow,” says Elena Zanina.
“As long as there is a demand for office space within specific properties at the rental rate set earlier, no one will make a fuss,” says Aleksei Mogila. “Especially as finding an office in the city center will always be difficult. As long as office properties meet the market expectations, the rates will be stable.”
Yulia Nikulicheva, deputy head of the strategic consulting and research department at Jones Lang LaSalle, believes that the office real estate market will remain a landlord's market, especially as regards the class A business centers because “the downgrading will have practically no impact on rentals.”
The example of the above mentioned Enka projects proves that now that the older properties have been reclassified as class B+, the average rentals there stand at $600 to $650 per square meter, VAT excl. Two years ago, when those buildings were still rated class A the rates were $500 to $550, VAT excl. The reason is the high demand for tenancies and the growing rates within that property and on the entire market.
“As long as office properties meet the market expectations the rates will be stable,” says Aleksei Mogila. “If the tenant is satisfied with the terms and conditions and rental rates, it is unlikely that he will decide to move to another office once the business center is downgraded.”