Between 2005 and 2008, Ukraine became one of the most attractive markets for investing in real estate. In part, this was due to the high returns investors received that were sometimes 30 percent annually or more. Such big returns led many investors to ignore many real estate investment issues ranging from corrupt authorities to heavy tax burdens and a murky and burdensome regulatory system.
However, the global financial crisis caused weak demand in the real estate market and forced investors to reassess their attitude about such risky economies as Ukraine and become more cautious about investing in Ukraine’s real estate market.
The Lack of Regulatory Framework in the Sale of Land Plots Through Auctions
Ukraine obtained its independence in 1991. It began transferring land from state to private ownership in earnest after the 2004 Land Code. State or municipal land, as well as the ownership and use rights to such land (lease, superficies or emphyteusis) including municipal or stateowned buildings and other structures, is subject to sale as separate lots on a competitive basis using land auctions. Land sales are to be conducted exclusively through auctions. Such land sale procedures are required by the 2004 Land Code and are to be further stipulated by a separate law. However, the required separate laws regulating the procedure of land auctions have not been adopted by the Parliament of Ukraine.
A license is required to conduct land auctions, but there are no legally approved licensing terms and conditions for carrying out land auctions (as provided by Article 8 of the Law of Ukraine on Licensing of Certain Types of Business Activity). Under such circumstances, properly organizing and conducting land auctions is impossible.
The lack of laws approving the procedure for selling land plots and providing the licensing terms and conditions for carrying out land auctions makes most land auctions illegal. However, such auctions are held in many regions in Ukraine on the basis of legally questionable land auction procedures developed and approved by local public authorities. Such unapproved practices may raise questions about the validity of such land transfers as evidenced by relevant decisions and warrants made by the State Land Department and General Prosecutor’s Office.
While the law permits Ukraine-based subsidiaries to purchase land plots directly from private owners, there may be underlying defects in the chain of title to certain land sold under such transfers.
Restrictions on the Foreign Ownership of Agricultural Land in Ukraine
Non-agricultural land may be purchased by non-residents of Ukraine only if the land is located within the formal boundaries of a settlement or if the land lies under an existing construction that is acquired by such non-resident. The acquisition of agricultural land by non-citizens is strictly prohibited by the 2004 Land Code. In addition, an official moratorium (imposed by parliament) exists on the sale and purchase of certain agricultural land by anyone.
Notwithstanding the current prohibition on the acquisition of land under Ukraine’s law, some non-residents acquire land by creating corporate structures that may allow them to conduct a lawful land transfer. Such practice includes the use of a questionable two-tier corporate structure; it is not clear that such a practice is failsafe. Theoretically, Ukraine’s authorities may challenge the use of such twotier structures. Such an imperfect and ambiguous practice may be viewed as quite risky and raise questions about whether a project structured in such a manner is “bankable.”
Complicated Regulatory System for Construction Projects
Although state authorities have attempted to simplify the procedure for receiving construction permits, it is still a very complicated process for real estate developers. The procedure for project documentation involves obtaining many approvals including town-planning documentation, official project requirements, the construction project itself, receipt of construction work permits and the beginning of building.
According to the Doing Business project (www.doingbusiness.org) of The World Bank Group, Ukraine is rated 181 out of 183 economies for the ease of obtaining construction permits. For example, to construct a warehouse, a developer must seek 30 different approvals. In Ukraine, under normal circumstances, it takes about 476 days to build a warehouse. This is almost twice as long as the average construction period for Eastern Europe and Central Asia, which takes only 264.2 days.
Contributions to the Social and Transportation Infrastructure and Investments in the Construction of Utility Systems
Before investing in real estate development projects in Ukraine, investors must carefully calculate the total costs of such projects. For example, in addition to obtaining the permits and approvals, investors are obliged to make contributions to the development of social and transportation infrastructure of settlements. Such contributions are regulated by law and may not exceed: (i) for non-residential structures 10 percent of the contract price of construction of a structure and (ii) for residential structures 4 percent of the contract price. Investors must enter into respective agreements with the local authorities before they may obtain a construction work permit. Investors must pay contributions in one installment or in several parts not later than one month after the project has been approved.
Further, a developer must obtain approval from different organizations to connect to electricity, gas, water supply and sewage utility systems. In many cases, the utility systems in Ukraine are very old or do not have enough capacity to meet modern demands. Thus, owners of the utility systems may require developers to build new utility systems, considerably increasing the costs of a project. Fortunately, a recently amended law allows developers to decrease the sum of contributions by the cost of construction of the utility systems outside of the developer’s land plot.
Questions remain: Must a developer transfer the newly constructed utility systems or structures to the utility system’s owners? The law does not provide a clear procedure for such transfer or address its tax consequences for the developer and the utility system’s owner. Moreover, the law does not provide for a mechanism to decrease contributions that must be paid to the local government. Such ambiguity creates a potential risk that a developer will be unable to transfer the constructed utility systems or objects to the owners of such systems or that the local authority will not agree to decrease contributions.
Inconsistent Ukrainian Legislation
Inconsistencies and ambiguities in Ukraine’s legislation raise many issues for even the most straightforward investment activity. Ukraine’s legislative system consists of acts at different levels and authority, such as regulations and subordinated acts of the Cabinet of Ministers, the Ministry of Regional Development and Construction, the State Tax Administration and others. It is not rare for different standards to contradict each other. Sometimes special written clarifications from the state are required to begin working on a project. The inconsistencies and ambiguities and a slow court system may prevent investors from seeking assistance from the courts. Making one’s way through the appeal process may bring some relief, but that process may take years.
Taxation Issues – Using Special Purpose Vehicles
The inconsistencies in Ukraine’s law and taxation system including enforcement by tax authorities force investors to seek ways to optimize their tax liabilities, as well as to better protect their investments through special purpose vehicles (SPVs) created in offshore jurisdictions where laws are more consistent and corporate rights are better protected. Offshore SPVs are used to:
- Protect investors’ corporate rights associated with assets located in Ukraine;
- Obtain more flexibility in making investment decisions and redistribution of financial returns; and
- Provide access to use legal remedies established in more mature commercial jurisdictions than Ukraine.
The use of offshore SPVs in the holding company structure allows investors:
- To hold assets in Ukraine indirectly through offshore SPVs, reducing the risk of hostile takeovers;
- To more easily transfer real property or land in Ukraine by selling the SPV that owns it rather than the real property or land itself; and
- To better attract funding from investors interested in investing in the Ukraine-based company indirectly, in an offshore jurisdiction, which provides them a much higher level of investment protection than in Ukraine.
Problems in Residential Construction
The financial crisis has exposed many problems in housing construction which were in place before. Some developers build their business relying on administrative access to land plots and fund their projects mainly at the expense of small investors seeking to own housing in the proposed development. Given Ukraine’s population’s drop in income, the lack of bank financing for housing purchases, the lack of confidence in developers and the resulting suspended market requirements, it is necessary to introduce new mechanisms for financing housing construction that will allow investors to build, using their own or secured funding, and sell new houses. Ukraine’s law allows a developer to secure sales of housing premises and reduce the amount of its own capital by attracting investment, such as 10 percent of the construction costs, at the early stages of construction. However, this presents a great risk to the small investor who is not protected by the law.
The other problem for developers in Ukraine is the quality of construction projects. In recent years, most projects in Ukraine were built without proper construction standards for housing, courtyards and infrastructure – often with obsolete construction technologies. Developers must now significantly improve the quality of projects, reduce the price by reducing the cost of construction and bring modern technology to the construction. Those who are able to meet such requirements will have a good chance to participate in the development of residential projects.
Financing Real Estate Projects
One of the biggest problems in the construction industry in Ukraine is the lack of confidence of foreign investors in Ukraine and the lack of private capital for financing real estate construction projects.
To attract foreign investors, Ukraine must reform the regulatory framework for investing in land and real estate projects and tackle the corruption at the state and local levels to simplify the procedures for obtaining various permits and approvals and bringing the construction rules and regulations within Europe’s standards.
Further, to obtain the significant funds needed to finance real estate construction projects, there is a need to clarify all laws and regulations so that ownership of land and real property is unambiguous and clear.
Due to the vast amounts of undeveloped land in Ukraine, the country is ripe for real estate investment. There have been some recent improvements such as a new simplified system of acceptance of the constructed structures being introduced in 2009. A new construction code is being developed. It attempts to combine many construction normative acts into one document making the design, development and construction process much more clear and less time consuming. However, much more must be done to bring in the investment and financing necessary to support real estate development. Ukraine must complete its land reforms and create a land cadastre and a land market. It must adopt new laws to create a more investorfriendly environment, considerably reduce the number of different permits and procedures in the construction sphere, unify the system of real property rights registration including unfinished structures and effectively fight corruption.
To work effectively in Ukraine, like in any other country, investors should not only understand the real estate construction business but understand potential problems to mitigate the risk factors and protect their investment.