Investment in unfinished construction
Investment in unfinished construction
Тhe skyrocketing price of real estate Kiev makes it an interesting and vibrant, yet incredibly challenging, market.
Other major Ukrainian cities will undergo the same fantastic change in the near future. The question is, how do foreign investors get access to land and buildings in Ukraine?
The good news is that there are no impediments to purchasing property on the secondary market from a private party. Just review the background title documents and sign a sale-purchase agreement before a notary public. Dealing with the government, however, is an entirely different matter. And yet, the government owns the best (and most) land that could be used for construction.
Below we review the legal and practical issues involved in obtaining access to land for construction of residential and commercial property.
I. Access to Unfinished Construction
International hotels would make millions in Kiev, but they are justifiably apprehensive of investing in existing unfinished construction projects. Instead, they prefer either to obtain a parcel of land and build to their own specifications, or wait until the risks inherent in the construction process have passed and the building has been put into commission.
However, buying land from the government via competitive means such as an auction or tender is often an unrealistic expectation, especially in Kiev under the firm rule of former Mayor Omelchenko and the Kiev City Council. In many cases, therefore, in order to enter the market an investor is forced to join forces with a local partner who has future property rights and is better able to navigate the murky local waters.
From a legal viewpoint, two methods exist to obtain access to land for construction purposes: (a) entering into a lease agreement (for up to 49 years) with or without a right of buy-out; and (b) acquiring shares of a Ukrainian company that owns or leases land. Entering into agreements with future obligations is not advisable for reasons described below.
A. Lease Agreements
The practice of government officials entering into land lease agreements with foreign companies varies throughout Ukraine, depending on the location (i.e., Kiev vs. Ivano-Frankivsk). In Kiev, for instance, only a select few "insiders" with close connections to the City authorities are allocated land rights for construction purposes. This, not surprisingly, expressly excludes foreign companies.
Incidentally, the reason the "insiders" prefer to enter into lease agreements to obtain land is because lease arrangements are signed without any auctions, and land transfer takes place after the construction is finished on a non- competitive basis. In contrast, buying state land takes place only via auctions, and it is more expensive than leasing.
In other Ukrainian cities and regions, where government officials are more even-handed than in Kiev, anyone interested in obtaining land for construction purposes should insist on a buy-out clause in their lease agreements to prevent any future ambiguities.
B. Acquiring a Ukrainian Company with Property Rights
From a strictly legal perspective, the acquisition of a Ukrainian company (or a share therein) that possesses land rights is not the same as a land sale-purchase agreement. Yet, the company's new shareholder exercises the same rights over the land (and other company assets, if any) as any rightful Ukrainian land-owner. This investment avenue is widely used by foreign companies seeking to bypass the notorious Kiev City administration (see section II, below).
Before acquiring any Ukrainian company with land rights, we highly recommend that any investor conduct full legal and financial due diligence, focusing on the target company's property rights, existing debts and other obligations/liabilities.
C. Preliminary Agreements
As a rule, a foreign company cannot sign a sale- purchase agreement or a lease agreement for a building undergoing construction because such properties do not yet have an owner. These agreements can be signed only after such properties are duly commissioned and their ownership is recorded with the Bureau of Technical Inventory.
Some investors rely on the Ukrainian Civil Code (Article 635) and Commercial Code (Article 182) in an effort to circumvent the above lapse in legislation by entering into a so-called "preliminary agreement" with developers or construction companies.
These types of agreements usually obligate the parties to enter into a sale-purchase or lease agreement in the future.
Unfortunately, due to the Bureau of Technical Inventory's refusal to recognize any property ownership rights before the building is commissioned, the notary public will not affix its seal to such an agreement. As a result, we cannot advise the use of preliminary agreements in cases of unfinished construction.
II. Barriers to Entry
The single biggest impediment to entering the construction arena in Kiev to date has been the
city government. Specifically, former Mayor Omelchenko's office and the Council of People's Deputies, which allocate land for construction. In the past, they have handed out plots of land only to an inner circle of people, presumably in exchange for something of value.
For example, a company called "Mars-1" (with two founders and no employees or track record) mysteriously obtained two prime land plots in a sole-source deal; another well- connected company, "KievVisotBud," obtained prime Dniepr River frontage on Obolon without any auctions or tenders. Many of the "insider" companies had no intentions to actually build houses, but simply tried to sell their projects off to third-party investors.
The corruption surrounding the construction industry is a widely acknowledged reality. In fact, one Kiev developer estimates that a build- ing in the center costs around USD 700 per square meter in production costs. Of this, about USD 200 per square meter goes to bribes. The land allocation process has become so thorough- ly riddled with inside deals, that in December of 2005 the Antimonopoly Committee threatened to file a law suit against the Kiev City Council, claiming that its Resolution of July 5, 2005, #810/3385 "On the Temporary Procedure for Acquiring Land Rights on a Competitive Basis" allowed the City Council to circumvent the competitive procedure and allocate land without holding auctions or competitions.
The Antimonopoly Committee recommended to the City Council not to sell land plots without auctions to single purchasers. It also said that including such conditions as "additional investment into engineering and transportation infrustructure" have a negative impact on competition and are not required by Ukrainian legislation. Then came the March 2006 elections, kicking out the Omelchenko administration and welcoming the new Mayor Leonid Chernovitsky, President of Pravex Bank and Parliament member.
Due to the above political situation, we will dispense with the largely theoretical discussion concerning the legal difficulties connected with land allocation process.
III. Risks upon Entry
Entering into a lease agreement can be a long process (up to 3 years in Kiev). It is an extraordinarily expensive and emotionally draining experience that consists of obtaining numerous permissions and signatures of countless city bureaucrats. After the lease agreement is signed, however, significant risks continue to exist, ranging from a unilateral increase in rent by the city to termination of the lease agreement itself.
With reference to an increase in rent, for instance, in December of 2005, the Kiev City Council resolved to unilaterally revise lease payment rates at its own discretion, which means applying much higher tariffs to interested foreign companies (if any).
Termination of a lease agreement is perhaps the most serious risk. For instance, a stock company "Alex Bud" (the "Company") had a long-term, ten-year land lease for construction of a residential building, signed off by the Kiev City Council in 2003. The company began construction in 2004, but residents of neighboring buildings began protesting, so in the end of 2004, the Kiev City Council promptly reversed its prior decision to enter into a lease agreement. By that time, however, the Company pre-sold more than half of the apartments in their building. Fortunately, Ukrainian courts (including the Appellate Court) ruled in favor of the Company, but the City appealed to the Supreme Court. Meanwhile, the investors were justifiably concerned.
In November of 2006, the Kiev City Council cancelled land lease agreements for about 200 more construction projects, many in the process of laying the foundation. In all, about 83% of the scheduled construction was "frozen," according to Milan Paevich, director of company "Slav- Invest." Most of these sites are still "frozen sites" despite the construction companies' ability and desire to finish their projects, and the investors' dreams of moving into their long-awaited apartments. One notable exception is ongoing construction across from the Republican stadium, which was "unfrozen" on March 15, 2006, by the Cabinet of Ministers, headed by the Minister of Construction, Yuri Kazmiruk.
IV. Property Taxes
On January 1, 2005, the Parliament passed a property tax law that was promptly cancelled by the moratorium on property taxes on March 30, 2005. Another futile attempt to tax property owners came on January 1, 2006, imposing a profit tax of 1% to 13% on the sale of real property. This time, the Parliament cancelled profit tax on the sale of property under 100 square meters, provided that such property is not re-sold within the same tax year. Profits derived from the sale of any property above 100 meters will be taxed at 1% (instead of a scale ranging from 1% to 13%, as was originally intended).
Conclusion
Foreign investors are at a distinct disadvantage when dealing with the mighty Ukrainian bureaucracy responsible for land allocation and construction permits. The intentionally complex system of procuring land and construction permits is only one of the reasons for the existence of just two high-end hotels in the nation's capital. City hall corruption is another.
And yet, somehow Radisson SAS opened its four-star hotel (reportedly worth USD 57.3 million) in 2005, while Hyatt is reportedly working away on a centrally located glass hotel monstrosity, near the graceful St. Sophia's Church. If there is a will, there is a way.
Sourse:Frishberg&Partners
