Success of Product Repositioning Strategy - Essay Example

 Success of Product Repositioning Strategy for Class B Office Development in Moscow The idea of selling offices in the big office centers like private residential apartments is a perfect example of creating market space while looking across substitute industries in line with Blue Ocean Strategy described by W. Chan Kim and Renee Mauborgne. In 2010, the group of private developers under umbrella of Absolute Group (one of biggest property developers in Moscow and Moscow region) introduced to the property market specially designed office buildings tailored to the retail sales. My company hired by a real estate investments fund, an owner of this property, received commercial contract to arrange marketing campaign and to sell these buildings as residential property. The reasoning behind this strategy is quite simple. On one hand, relatively small investors receive opportunity to invest into lucrative office property market in Moscow, which has 10-12% rate of return on investment compared to 5-6% that of residential property market. On the other hand, property developers receive so much desired cash significantly decreasing the whole property development cycle and improve their own rate of return on investment. The classical scheme (when office buildings are kept by developers to receive lease income or sold to strategic investors interested in regular income stream provided by lease payments) is modified with a new buy option for typical clients (lease holders) and completely a new option for residential property investors. Despite recent severe turbulence on the equity markets and overall pessimistic attitude towards any long term investments our group managed to achieve remarkable results. The success of the strategy is proven by retail sale of a number of office buildings in Moscow. The purpose of this essay is to illustrate how theoretical strategic tools can be used in a real business situation to identify new business innovations and to assess how close the theory is to reality. The strategy theory undoubtedly provides useful tools for assessing current situation and identifying new opportunities. Elements of Five forces, basic supply – demand analyses, Value creation model, ERRC (Eliminate, Raise, Reduce, and Create) grid, reluctant customers and non-customers issues are theory tools used in the analysis. The analysis consists of macro and micro examination of the current commercial property industry situation in Moscow, and formulation of new opportunities in the office property sector of the industry based on the above analysis. The description of the real estate investment market in Russia In the situation of global market economic crisis, investors are becoming more risk averse and switching investment portfolios in favor of core assets like gold and real estate. Investments in property market in Russia in 2011 demonstrated 46% year on year growth with the highest volumes of 7 bn USD (See Exhibit 1 Investment volume dynamics), of which the commercial real estate sector accounts for about 95% (See Exhibit 1 Investment by sector). 2011 in Russia was remarkable by the rising number of foreign capital investments, which comprise around 45% of the total investment volume (See Exhibit Investment by investor origin). The reason for this is potentially high demand almost on all sorts of commercial property. Retail and office segments usually dominate the sector investments having 40% of total investment volume each (See Exhibit 1 Investment by sector). Moreover, the deal size increased in 2011: the number of deals exceeding 100 mn USD increased to 33% of total number of deals compared to 23% 2010. The market sector prime yields in Moscow stabilized at 9% in office and 11% in warehouse sectors in 2011 from the recent highs of 11.5% and 14.5% in 2009 (See 1 Exhibit Prime yield dynamics in Moscow) reaching pre crisis levels achieved by the market in 2007-2008. Historically, the office sector in Moscow has been the most attractive for investors, as it was the most familiar and transparent. Officially, Moscow inhabitants account for around 11.5 ml of registered residents and, unofficially, 15 ml based on the cellular phone sim cards that are used in Moscow. The Moscow population makes around 8%-10.5% of total Russian Federation population. Russia is the largest country in the world in terms of many vital mineral and energy resources, the number one natural gas and oil producer. All Russian big companies without exceptions have headquarters in Moscow. As a result, almost all political and financial powers of the country are concentrated in Moscow. Furthermore, Moscow is the scientific and educational center of Russian Federation. Such concentration of human, financial, scientific, and educational recourses make Moscow (in terms of infrastructure and quality of life) closer to Western Europe than to the rest of Russia. Traditionally, investments into residential real estate in Moscow are considered as the most secure and reliable in terms of capital protection and investment income. The current yield of investment in the residential property is around 5%, which is remarkably lower compared to commercial property yields. The key issue that arises from analysis of residential and small business investor’s purchasing power and high yield supply of commercial property is how to provide these classes of buyers with ability to invest into the high yield commercial property. Due to lower maturity of real estate investment market in Russia and several financial scandals with real estate publicly traded funds, the latter publicly traded equities are not considered as reliable investment instrument. Despite significant potential, most of real estate public companies demonstrated terrible performance and actually destroyed shareholders value (See 2 Exhibit Russian Real Estate Play the Cycle). Supply and Demand analysis of office real estate in Moscow Product Supply High yields and relatively lower level of office space per inhabitant in Moscow secure high annual supply of new office space, which reached around 14 mn sq m in 2012 (See Exhibit 3 Modern office stock dynamics) starting from around 2 mn sq m in 2000. Level of office space per inhabitant in Moscow is still one of the lowest in Europe with 1 sq m per capita (See Exhibit 3 Office space per capita), especially compared with that of 3 sq m per capita in New York and London and 5 sq m per capita in Paris. Currently, almost 2.5 ml sq m is under construction and scheduled to enter the market in the next three years. Across all zones in Moscow, supply of Class B office space is 4 times more than that of Class A. The lowest availability is recorded in West and North West zone despite the fact that these areas are most prestigious because of environmental issues, historical location of industrial facilities in South and South East, and less severe traffic situation in the area. Product demand The take-up in 2011 amounts to 1.6 ml sq. In 2009, the office property market experienced radical shift from the “sellers” market to the “buyers” market with vacancy rates suddenly dropping to 20% (See Exhibit 1 Vacancy rate dynamics). Now the market is in the recovery mood. Vacancy rates for Class B decreased to 14% but still are well above 4-5% in period before the recent crisis. In the future, vacancy rates are likely to be around 5-10% in line with that of Western Europe. Market balance Supply-demand balance is in favor of the lessee with some exceptions with regard to high quality office space in central locations. Class B rent rates are in the range of 400-600 USD per sq m. The less competitive buildings now attract lessees with the additional incentives: lower rates for the first year based on a rent free period (4-6 months), partial fit-out compensation, relocation of some parts of lease payments to the future, and flexible payment scheme depending on market rates. My company pioneered some of these incentives techniques in 2009-2010 in 150 sq m Class B office center, which was fully leased in this period. Prime yields for commercial property in Moscow now are around 9-11% (See Exhibit 1 Prime yield dynamics in Moscow). The theory indicates Class B building in the West part of Moscow as the most attractive projects. Should such buildings provide 12-15% (4-6% above current levels) yield in investment including some incentives schemes, they would likely meet market demand and have commercial success. But still the theory at this stage of analysis does not tell who the potential clients are and what kind of values they are looking for. Are there any other opportunities that can boost market success for this class of property? Value creation model 420 USD /15%= 2800 USD/per sq meter * 15% rate of return before taxes required by real estate investors Source: Globus Estate Lease cash flow from real estate property discounted by the required rate of return (Base Lease Model) is a good indicator of property fair market valuation. In the above case 420 USD net cash flow from operating expenses and 15% discounting rate gives 2800 USD valuation per sq m. On the other hand, 1500 USD average cost of construction per sq m plus 90% margin also gives the similar price. Taking 2-3 years construction cycle, this project brings for developers 18-25% returns on investment; which is an acceptable level by industry standards. Value creation approach to the Base Lease Model and the Retail Sale Model gives the same price per square meter, which is not a surprising result. For the sake of simplicity, all taxes and timing issues are ignored. In reality, the market price for this type of property is just starting from 2800 USD per sq m for Class B (See Exhibit 3 Asking rental rates and sales prices). This approach (though intentionally simplified) gives very useful insight for viable economically justified price levels. In reality, it perfectly works because in my practice any attempts to charge price significantly above this level almost immediately stopped any sales. In this stage, it is worth to mention that the value creation theory assumes perfect market conditions and homogeneous clientele (it does not differentiate between different types of customers, their abilities, and preferences). More detailed analysis of current and potential clients is required to find out about new opportunities. Existing customers and non-customers analysis There are two types of investors in real estate industry: institutional investors (real estate investment funds, corporations) and private investors (wealthy individuals). The first category represents very sophisticated class of investors armed by lawyers, financial professionals usually looking for purchasing the premier properties in the best locations. The property investment funds typically charge around 2% of total average annual asset value and, in some cases, 15-20% of success fee. In recent years, the most of real estate publicly traded developing and investment companies demonstrated far worse performance than the aggregate market index (See Exhibit 2 Russian Real Estate Play the Cycle). “In spite of its enormous potential, the sector destroyed value over the last cycle, four companies flirted with bankruptcy, and real estate IPO’s are down 67% on average against the RTS Index”. Private investors willing to make investments into the real estate sector are left with not too many choices: either to buy residential property or to invest in the publicly traded equities discussed above. These investment options are questionable for non professional investors and relevant for professional investors who can make sophisticated analysis of market timing, industry and individual companies’ fundamentals. The average price per square meter of residential property in Moscow is 5991 USD (See Exhibit 3 Average price levels). The investments into residential property typically give 3-5% rate of return on initial investment and are still considered as the most reliable and desirable option. Despite recent financial crisis, the real estate prices have not shown any significant weaknesses and were relatively stable during the last years (see Exhibit 3 Average Price Growth in Moscow). Thus, there are potential customers who never thought of investing into the commercial real estate properties as the industry had never offered them a product. Furthermore, there is a psychological factor in the property investing. It is a tangible viable asset. In the world of high stock market turbulence and inflation, property and gold are still considered as reliable investment instruments whose values are not easily replicated and destroyed. If there is a product that can offer an attractive yield (based on the cash flow) and be easily understood by a non professional investor, such product might have market success. Value curve analysis gives deeper insight on a product analysis. Direct investments into office property can be an attractive product for many risk averse investors willing to accept some inconveniences of direct ownership in favor of full control over investment. Creating a New Value curve The value curve theory is perfectly suited for illustration of investments in the property market. The task is to design a new office building consisting of 50-200 sq m blocks in the relatively low cost location to secure 1500 USD per sq m development and construction costs. As result, at basic price of 2800 USD per sq m the typical sale deal would be around 140-500, 000 USD, which is comparable to that of a residential property deal. The value curve demonstrates that in addition to many similarities between direct investments into residential and commercial properties, commercial property has a distinctive advantage in terms of yield on investments. As a result, the new product created for existing customers and none customers have advantages for both a developing company and property buyers. A developing company gets quicker exit from the investment into cash, mitigates solvency risks, gets relative high 20%-25% rate of return on investment, receives stable cash flow from property exploitation fees and reinforces its ability to finance new projects. Private investors make controllable investments into commercial property, diversify existing portfolios (usually consisting of cash equivalent investments, equities, bonds, precious metals), secure relatively high 12-15% rate of return from lease payments cash flow stream, have opportunity to refinance property at 12% rate (if required) and gain some capital protection. Canteen, 24 hours security and exploitation service, reception, pleasant interior and exterior design parking are provided to raise industry standards up to the best class A office buildings. Any legal costs are reduced to minimum required levels. Standard set of legal documents is provided for every property block (See Exhibit 4 Floor Plan). Application and Analysis How close is theory to reality? Theory gives the powerful tools to assess an industry and find new opportunities by attracting new types of clients and providing existing clients with new options. Having performed top down approach for real estate industry analysis in Moscow (supply-demand analysis) to micro level study of basic value model, it is possible to identify the whole class of investors previously locked from investing into this sector. In the current case, the product repositioning allows to bring new clients/buyers (private investors) who were not even considering buying commercial real estate because of entry barriers (deal size, product complications) and none availability of such products on the market before. Though it was always possible to buy some commercial property for investment like a small shop on the ground floor in the residential building, the standardized office blocks in the big business centers were not available for sale in Moscow until recently. The theory does not take into account many demand factors such as consumer tastes and income. Second, it focuses on the whole industry rather than on individual firm. In the real estate business, it is a very important issue as every project is unique in terms of geographical position, architecture, and design. Third, on execution level factors affecting demand like advertising, promotional and sales techniques are not usually taken into account. Fourth, detailed economical models are ignored but in every case such calculations are very complicated and include high number of inputs including taxes, time value of money issue, cost of capital, financial targets of business owners, and other combinations of unique circumstances. The theory of competing on resources brings an issue of sustainability of this model. Though long term replication of this business model leaves no doubts, in reality the property development and construction cycle takes around 3-5 years and can not be easily followed by other companies. What can we learn from this gap? The theory gives the general framework and instruments to utilize the technical approach for assessing the new opportunities. In the real life it is always a matter of art and good combination of theoretical studies and execution. In my particular case, the current developers have highly diversified portfolio of land and old production/manufacturing properties (not even in the prime locations). The strategy to build business parks in these locations was not obvious at all. There exist a number of examples of such projects in Moscow that were built and abandoned as owners were not able to lease or to sell these property into pieces as buildings were initially designed for big clients and not suitable for the needs of small tenants. Execution is also crucially important as it allows for not only achieving high level of operational efficiency but also to address unexpectedly raising issues. As an example, a client- an IT company- required an additional secured power source from diesel generator to make a deal. The diesel generator was provided and the deal was signed. Execution of a new strategy as a rule requires some modifications of current value creation activities. Traditionally, business centers are advised through real estate agents. In my case other advertising channels were used including outdoor advertising in the areas close to the building, Internet contextual advertising, and residential property periodicals. As a result approximately one third of sales are generated by agents, one third – on line and off line advertising and the rest – recommendations of existing clients and building itself. Legal preparation consisted of making standard set of legal document for standard blocks of 100 to 200 sq m. New lines of services for office owners were introduced: tenants search, deal negotiation and contract preparation, interior construction and maintenance service. The “devil in details concept” is also important for success or failure of a real estate project. The strategy to exceed clients expectations on the whole chain of client service cycle gives positive feedback without significant additional costs. My clients were the first on the market to bring class A building features to class B buildings. This approach, together with some economy of scale features, delivers amazing results. Open recreational space inside the building, flowers, fireplace in the reception area, small shops, good quality affordable canteen, sport club, charter busses, 24 hours service are just a few things to name. Ability to retain “new” clients and to exceed their expectations is also important issue usually left below scope of theoretical investigation. In my case, the clients who bought office property were connected with potential tenants who assisted in negotiations and in signing of a lease agreement. High number of such clients come back to make second and third property purchases. Their recommendations are also important sales channel. For me, it is the best indicator that the strategy is correct. In this an opportunity to change our reality or an opportunity to modify our theories? Or both? Different angles and combination of theories help to clarify business opportunities. Value creation model described above gives the same financial results for both class of investors: institutional and private. But if someone considers specific details of commercial property investments while utilizing other theoretical tools, it would be clear that traditional property products lock value for certain classes of investors. From this prospective, theory and/or combination of theories open new business opportunities. Strategy theory gives tools to understand and describe successful and unsuccessful business models. It is very unlikely that any of the successful entrepreneurs has used only strategy theory for business development. From my experience, common sense, natural curiosity, emotional passion, and business stamina are far more important properties than theoretical knowledge. I can hardly name any of successful start up projects or revolutionary business models designed by cold minded consults or business advisors. In the matured business environment, theoretical tools are extremely important as they allow assessing overall situation relatively quickly, achieving completeness, and accuracy of research. Nevertheless, theoretical implementation analysis gives amazing practical implications. Despite the fact that the described approach and the model work perfectly fine in sense that my company actively participated in development and implementation of the above strategy, currently I have began working on structuring of our abilities of redeveloping old industrial buildings into the modern business parks and public equity market product. Read More