Marc Bartholomy and Anna Krutik of Clifford Chance take an in-depth look at the Russian real estate market.
"The Russian real estate market continues to be of great interest to domestic and foreign investors, and, as such, the sector is expected to continue to be busy, but there will likely be more medium-sized deals in commercial real estate than extraordinary headline transactions."
State of the market
In the last 12-18 months, the Russian real estate market has seen some of the biggest transactions in the history of Russian real estate: the Metropolis shopping centre (the largest single commercial property transaction undertaken in Russian corporate history), the Ducat office centre, the White Square Office Centre and the Silver City business centre, to name but few, were all sold. More recently, the Aura shopping centre in Novosibirsk was also sold, making it the largest retail real estate transaction in Russia outside of Moscow and St Petersburg. The Russian real estate market continues to be of great interest to domestic and foreign investors, and, as such, the sector is expected to continue to be busy, but there will likely be more medium-sized deals in commercial real estate than extraordinary headline transactions.
Another Russian real estate sector high on the agenda of many market players is PPP and similar infrastructure projects. With the World Cup taking place in 2018, everyone expects major road, railway and bridge projects to take up speed shortly. This should also provide many opportunities for foreign sponsors. That said, it still remains to be seen to what extent foreign players will be able to engage in such opportunities. The preparation of the Sochi Winter Olympics in 2014 has shown that the vast majority of real estate projects are handled by Russian players, with few involving international groups. Also, the successful Russian PPP projects have largely centred around St Petersburg and Moscow thus far, and it will take some more projects across Russia to create a reliable level playing field. Moreover, legal certainty and predictability will be key for Russia.
What is real estate? A dummy’s guide
Irrespective of the selected transaction structure, the key asset in any property transaction is real estate (whether acquired directly or indirectly), therefore general property issues are always relevant during the due diligence stage and negotiations of the contractual arrangements.
Russian law defines real estate as: land plots, buildings and structures, unfinished construction and everything that is closely connected with land (ie, objects that cannot be removed without impairing their utility); and objects qualified real estate by virtue of law (such as registrable aircraft, seacraft and spacecraft).
Unlike other jurisdictions, Russian law still makes a legal distinction between land and the structures located on it, treating them as separate legal interests. In practice, this means that the building and the underlying land plot exist as separate real estate objects and may be held on different titles and by different parties (eg, ownership title to the building and lease rights to the underlying land plot which is in public ownership). At the same time, there is a principle of tight and nonseparable correlation between the land plots and the building which is expected to be further developed as a part of a large-scale Russian Civil Code reform and may result in full extinguishment of separate registration of buildings and underlying land.
Share deal v asset deal
There are two main transaction structures available for the acquisition or disposal of commercial real estate in Russia: a share sale (ie, the sale of shares in a property company holding real estate or development rights or its parent holding (typically offshore) company); and an asset sale (ie, the direct sale of a real estate asset).
Each has advantages and disadvantages in terms of tax, legal and commercial efficiency that are briefly summarised below. However, in practice, real estate acquisitions have been typically structured as a share sale, which proved to be more tax and commercially efficient than a direct sale of a real estate asset.
The reason for a share sale rather than an asset sale is generally one of tax-efficiency. A direct sale of real estate would result in both a significant taxable capital gain for the sellers as well as much higher property tax payments for the investor going forward. Further, the purchaser would have to pay Russian VAT on the value of the buildings.
In addition to the above, parties often opt for a share deal structure for a number of other legal and commercial reasons, including: the possibility to choose more flexible and predictable English or other foreign law to govern the sale of shares instead of mandatory Russian law governing real estate transfers; and where you have a development project at an early stage (ie, no physical assets can be acquired) and thus a suite of contractual arrangements or permits are being acquired.
Formalities to remember
Before any real estate transaction is implemented, such real estate and rights thereto shall be registered with the Unified Register of Rights to and Transactions with Real Property (Register of Rights). Prior to such registration, any real estate object must undergo cadastral registration in the State Real Estate Cadastre (Real Estate Cadastre), during which all key technical parameters are established and a unique state cadastre number is assigned. The regulatory reform currently in progress envisages a phased merger of these two databases into one unified state real estate register.
The transfer of ownership rights to, and certain transactions with, real estate (such as mortgage, land leases and occupational leases for terms of one year or more) requires state registration in the Register of Rights and become effective as of the moment this record is made. As a general rule, notarisation of real estate transactions by the notary public is not required.
Information from both the Register of Rights and the Real Estate Cadastre on a particular property is publicly available upon written or online application to the registration authority, and can be utilised to confirm registered property rights and technical details of the property. Thus, the usual practice in real estate transactions involves obtaining the most up to date extracts from these databases in order to have conclusive evidence of the existing property rights, encumbrances and property details.
It should be noted that entries in the Register of Rights are deemed the only evidence of the existence of the relevant right or transaction, and are generally treated as conclusive unless the registered rights are challenged by an interested party in court. Consequently, unlike other jurisdictions, there is no full “public faith” concept with respect to the validity of a title to real estate registered in the Register of Rights. Therefore, in addition to public searches in the Register of Rights each real estate transaction involves quite a substantial review of the historical documents on the basis of which the current title to real estate was acquired.
Merger control – is clearance required?
As a general rule, acquisitions of land plots, buildings, unfinished structures and other facilities, premises and parts thereof, except where such assets are used for industrial purposes (eg, production and storage facilities and gas stations), do not require merger control clearance. As a consequence, most Russian real estate transactions that are implemented by way of an asset deal are exempt from any merger control requirements.
Share deals are often subject to Russia’s merger control regime and may only be implemented upon clearance by the Russian antimonopoly authority (which may have a timing impact on the transaction). Its structure and procedure is, generally, comparable to the merger control regimes in Western Europe and North America.
Given that the statutory notification thresholds are low, Russia’s merger control regime extends to a large number of transactions that do not raise competition concerns, which, in particular, holds true for real estate transactions. Consequently, merger clearance of real estate transactions has become more of an administrative and technical procedure, rather than a substantive review.
Roubles, dollars, euro...
Although the majority of currency control restrictions have been lifted, there are still certain limitations on currency payments in Russia. These practicalities are sometimes overlooked in the heat of the transaction and, as a result, can hold up completion.
In particular, Russian law requires that payments between Russian entities (unless one of the entities has a banking licence) be made in Russian roubles. Payments between Russian entities and non-residents are generally allowed in any currency, however certain administrative procedures must be complied with by a Russian entity in order to make payments to and receive payments from a non-resident under a contract. In particular, Russian entities are obliged to submit certain documents and information, and open a deal passport (pasport sdelki) with an authorised licensed Russian bank no later than on the date of the first currency operation or other payment under such transactions.
Law and disputes
Russian law requires that transactions with real estate located in Russia shall be governed by Russian law. After a landmark decree of the Russian Constitutional Court in May 2011, it was recognised that the dispute resolution mechanism in real estate transactions shall not necessarily be limited to the Russian system of state courts, and may be referred by the parties to local and international arbitration.
It should be noted, however, that the applicable dispute resolution mechanism needs to be assessed on a case-by-case basis, taking into account transaction and dispute resolution timing, types of disputes and registration formalities that are likely to arise in the course of or as a result of such dispute.
Rights to real estate
Typically, there are two main types of rights on the basis of which real estate is held: an ownership right (the right to possess, use and dispose of real estate) and a lease right (the right to possess and use the real estate in accordance with the terms agreed with the owner).
Further, Russian law envisages a number of real estate encumbrances granting their beneficiary a limited right to use real estate which include, in particular: long-term leases; easements or servitudes; mortgages; trust management; concession agreements; and attachment or seizure of property.
As a part of the Civil Code reform, there has been a legislative initiative to refine and widen the list of the rights in rem, including by introducing a number of new types of rights, such as development right (pravo zastroiki) to land; and encumbrances, such as usufruct, option to purchase real estate (pravo priobretenia chuzhoi nedvizhimoi veshi) and the right of benefit from property (pravo veshnoi vydachi). This draft bill is still to be considered by the Russian parliament, and it is currently unclear what changes will be incorporated in the Civil Code and when.
Private and public ownership
Although private ownership of buildings is common, private ownership of land is still rare and leasehold title continues to be the main form under which land is “held”. Publicly owned land held either by state (federal or regional) or municipal authorities still comprises more than 92 per cent of all land in Russia while legal entities own only 0.6 per cent of the land and the rest is held by individuals.
According to the Land Code, owners of buildings enjoy an exclusive right to purchase the underlying publicly owned land. Until recently, this right was not widely used in Moscow and St Petersburg, largely due to the reluctance of public authorities to grant ownership rights to land. However, the approach is now changing, and we hope to see more and more examples of ownership title to land being granted to private investors.
Restrictions on private ownership
Generally, Russian law grants all individuals and legal entities an unlimited right to acquire real estate. However, there are certain legislative restrictions which apply to ownership and turnover of specific types of property.
In particular, under no circumstances may an individual or a legal entity acquire ownership or lease rights to certain facilities and underlying land such as nuclear energy facilities, state penitentiary facilities, burial places, national parks, facilities of the Russian defence forces, the Federal Security Service, communication lines and other facilities constructed for the purposes of defence of the boundaries of the Russian Federation.
Furthermore, certain land plots may be held on lease only while state or municipal authorities retain ownership to them. This applies, for example, to land under airports, sea and river ports, as well as to land plots belonging to the categories of “forest lands” or “specially protected areas” (other than national parks).
Also, certain restrictions on foreign ownership of land apply. In particular: foreign individuals and legal entities may not own land near Russia’s borders, in sea ports and in certain other territories specified by federal law; and foreign individuals, foreign legal entities and Russian legal entities that are majority owned by foreigners may not own agricultural land but are authorised to hold such land only by way of lease.