Given the success of Ukraine’s Orange Revolution and the current government’s emphasis on rule of law and sound economic decision making, it stands to reason that investing in the country’s real estate market would be a wise move. However, despite the kleptocracy’s fall there remains an ill-conceived bureaucracy with sets of occasionally bizarre legislation that must be rationalised.

The government of Victor Yushchenko is quite aware of the situation. In a February meeting with Michael Deppler, director of the European Department of the IMF, President Yushchenko admitted that the old administration left a series of problems “which cannot be changed in one day”. An investor who is aware of these issues will have a much greater chance of seeing FDI bear fruit, and a look at Ukraine’s real estate market illustrates both its potential and its pitfalls.

In January, Ukraine’s sales in the residential real estate market temporarily collapsed by 75%. The sole source of the downturn was the enactment of a residential real estate capital gains tax that came into force on January 5. The law was designed to curb grey-market sales that often under-report the official sale amount by as much as 90%. Officials, who were ordered to determine the tax payment and were legally responsible for the accuracy of the tax calculation, quickly noticed that there was no clear way to assess original property values, because many of them had been privatised but never been sold before, much less assessed.

Nick Cotton, regional director in Kiev for property adviser DTZ, says that the law is typical of the legislative issues facing Ukraine: “Commercial real estate is unaffected by the law, as corporate tax has been in effect for some time already. The law was passed with the intention to flush out the retail market, and it will eventually work in general.”

Breaking with the past

Overcoming poor conception in legislation was a common occurrence under the old administration. Andrew Mac, partner at one of Kiev’s largest commercial law firms, Magister & Partners, mentions that a 2003 tax regulation – indirectly concerning the process by which company charters were amended – took months to properly enact and put large-scale investments on hold for almost half a year.

“The major issue lies in the fact that Ukraine inherited a strict form-over-substance legal system and an inefficient and non-transparent bureaucracy. This combination has proven quite frustrating for investors and has turned many away,” he says. “The old government, although it initiated and passed significant legislative reforms, did not begin to address the massive administrative reforms that were necessary for the new law to work. The new government needs to act very quickly and begin these administrative reforms, including a complete overhaul of the civil service system”

However, Mr Mac is encouraged by what he has seen so far from the new administration. “The new government, based on its initial words and actions, understands the problem and appears to be resolute to begin with a long and arduous reform process that will ultimately change how business is done here,” he says.

DTZ’s Mr Cotton agrees that the situation must change. The Ukrainian economy had been “held to ransom by its own bureaucracy, but this really does have to change now”. That said, he believes that, if the new administration fosters an effective reform policy over the long term, the real estate market will see a boom equivalent to that in central Europe in the 1990s. “With a vibrant delivery market, we still wouldn’t see structural maturity until 2010-2011,” he predicts. “Kiev has double or triple the population of most central European capitals and an undeveloped market.”

Untapped demand

Both the commercial and residential real estate markets have also fallen victim to their own lack of planning. There’s “too much ill-conceived construction” in the country, says Mr Cotton. Residential construction has focused on luxury apartments or rather poorly constructed, low-profit mass construction. Indeed, many of the apartment blocks built since independence are wearing poorly already. The demand for mid-level, mass-market flats is largely considered untapped.

Both Mr Cotton and Mr Mac agree that the commercial market is poised for a major boom. “Private equity funds are starting to show their interest in Ukraine now,” says Mr Mac. He adds that there’s a three to four-year window for those who are willing to put up with the legacy of the authoritarian aftermath of the Soviet Union to establish and solidify a presence on the market.

Positive indicators

While a boom can be expected in other large cities, such as Kharkiv and Dnipropetrovsk, and in creating the tourist infrastructure required to turn the Crimean coast and Carpathian Mountains into resort destinations, the forecasted demand for well-planned commercial projects in Kiev bodes well for investors. However, they must be prepared to work in a market still in its infancy. At 365,000m2, the entire Kiev market volume amounts to just over double of new deliveries in Budapest or Warsaw alone. Most office and retail space is derived from rehashed public buildings and almost all is considered Class B or C. Ukraine did not even use a recognisable classification code until 2003.

Real estate market volatility will be an issue until the market starts to mature. At this time, a major delivery can swamp the market for six months and, because delivery schedules are guesses, it is difficult to see what is being delivered until it happens.

Fortunately for those who plan well, their efforts will be rewarded as the long-term demand for office space with flexible floor-plates and good parking should remain high in this congested city centre. As automobile ownership increases and more people begin to feel the need for convenience, suburban retail demand should bring a steady income, though with lower rents than on Kiev’s high street, Khreshchatyk.

Long-term plans

Ukraine also suffers from a crippling lack of well-appointed logistics centres, which leads to rentals at double Warsaw’s or Budapest’s rates. There again, the government will have to change to foster a dramatic improvement. Current legislation forbids the sale of agricultural land until 2007, which includes the land most suitable for development in logistics. “I have half a dozen investors willing to start on logistics parks as soon as the land becomes available,” Mr Cotton notes.

Both Mr Cotton and Mr Mac advise prospective investors to approach the Ukrainian market with their eyes open. “The number one mistake people make is applying Western patterns to things like drawing up leases or getting impatient too quickly,” Mr Cotton warns.

Mr Mac agrees and warns against taking shortcuts. “Investors meet lots of people who claim to be well connected and offer to speed things up. The bottom line is that the Ukrainian real estate market, as well as the investment climate in general, requires a long-term commitment from an investor,” he says.

“A prudent investor should not rely on middlemen or fixers, but should focus on finding knowledgeable and committed Ukrainian partners and complement such a partnership with independent and reputable local counsel.”

Local knowledge

Most of all, both men suggest a need for understanding Ukraine on its own terms. “You have to remember, this isn’t Poland and it is not exactly Russia either. Don’t impose your understanding of how things work here, no matter where you have done business,” Mr Mac cautions. “Ukraine is a diverse country with a gigantic land mass and a population of over 48 million people. Although there are some correlations with Moscow and some with Warsaw a decade ago, the Kiev and Ukrainian real estate sector is a unique market with its own regulatory and legislative framework.”

Mr Cotton puts the situation into perspective by adding that Kiev’s current real estate market most closely fits Budapest or Warsaw in the early 1990s. “Moscow has its own dynamic, and if you really must compare it to a Russian city, Petersburg would be closest.”

For those who come to Ukraine now, plan properly and have enough patience to endure while the business and legislative climates change, Ukraine holds out the promise of a fast-growing and dynamic economy which sees it itself in the EU.