Graham Stack in Moscow -

The Red October Chocolate factory is an icon of the Soviet-era. For more than 30 years Russian children have grown up craving Alyonka chocolate bars, the factory's flagship product, and the chubby face girl on the wrapper is one of the best known faces in the country. But at the end of the 2007, the owners of the factory caved into temptation: situated on one of the most desirable locations in Moscow, they decided to close its doors and redevelop it as top-end residential apartments that are sure to sell for millions of dollars a piece.

The landmark redbrick building is perched on the Bolotny Island in the middle of the river Moskva. It is a short walk from the Kremlin and overlooks the rebuilt Church of Christ the Saviour cathedral on the opposite bank. Locations in the poorly supplied heart of Russia's capital don't get better than this.

With property prices soaring to astronomical levels over the last five years, the factory owners, Russian conglomerate Guta, decided to move the chocolate operations to the city's outskirts and convert buildings and grounds into a luxury residential complex where prices are rumoured to reach $32,000 per square metre (sqm). The three main redbrick buildings and the famous chimney will remain, while 30 other buildings that have accumulated on the territory over decades will be razed to make way for new developments.

Internationally renowned architects are contributing to the factory conversion, where the most prestigious properties will be loft apartments created from the spacious top-floor production halls: boasting huge windows that afford a magnificent view across the river and of the Kremlin. "After such a long time in coming," says Ekaterina Thain, director of residential department at Knight Frank Moscow, a consultant to the Red October redevelopment project, "finally sales will be starting next year. There has been a lot development for the high end of the market, but these buildings will be a chance to buy a little bit of Soviet history too. They are unique in the city."

Bottomless pit

Property prices have soared across all of Central and Eastern Europe in the last two years and were up by just under a quarter in Russia, one of the fastest growing markets in the region. While the Red October development makes the headlines, it's the emerging middle class that's the driving force behind a booming residential property market. "Growth in 2006 was simply astonishing," says Renaissance Capital real estate analyst Alexei Yazykov. "We're talking about more than 100% over the year in Moscow.

The capital has led the market, but in the last year the regions have joined the fray and prices in all the millionki - the 11 regional cities in Russia with populations of more than a million people - are now close on the capital's heels. Prices in northwest Russia rose 76% in 2006 - St Petersburg, Russia's "other" capital, also saw prices double - and homes in the Volga Region saw their value jump 84%, according to Renaissance Capital.

The leap in prices is being driven by powerful GDP growth and rapidly rising incomes. Between 2004 and 2007, Russia's GDP growth averaged 7% per year and the growth is still accelerating: the Russian economy expanded by 7.6% in 2007, although the brouhaha on international credit markets is expected to the edge of growth in 2008, which is forecast at 6.7%. At the same time, real incomes have been increasing by an average of 12% over the same period and were up by 20% over 2007, according to official preliminary estimates. Put another way: when the late former president Boris Yeltsin stepped down in 1999, most Russians were earning $50 a month; after eight years under President Vladimir Putin they are earning $500. Since 2001, they have access to credit too, meaning whole swathes of the population have crossed the threshold where they can consider buying new apartments.

Counter-intuitively, the fact that 65-80% of the population already owned their own apartments, thanks to the free-of-charge privatization of the 1990s, simply fuelled the explosion in demand. "High level of home ownership has created seed capital allowing people to continuously trade up," explains Alpha Bank's real estate analyst Brady Martin.

The Soviet legacy of pitifully undersized apartments means that Russia's housing stock is around 21 sqm per capita - lower than CEE peers such as Poland (23 sqm) and considerably lower than Western Europe (with an average of 36 sqm in the EU capitals). "It is hard to get your head around just how short the supply of accommodation in Russia is," says Roland Nash, head of research at Renaissance Capital. "But to increase the average living space per person in Russia to just the average enjoyed in Moldova - an economic basket case - would require the construction of the equivalent of two cities the size of Moscow."

And most people don't want to buy many of the apartments that are already there. According to Jones Lang LaSalle, over two-thirds of Russia's housing stock is over 30 years old, and an astonishing 60% requires renovation - 15% is in critical condition and 12% is officially considered uninhabitable. The upshot is that although the majority of Russians own their apartments, virtually no one is happy with them, creating a powerful upward draught that is fanning the flames.

This huge pent-up demand and lack of supply has sent the real estate market spiralling upwards since about 2003, when the mortgage industry really started to take hold. Price have increased 10-fold in the last decade, but the difficulty in obtaining mortgages eventually put a ceiling on the market 2006. "Prices simply rose to a level out of reach of all but the most wealthy citizens," says Yazykov, "and so they could not go any higher."

The meltdown of the US sub-prime market has also been a drag on price growth, which slowed sharply in 2007 - especially in Moscow. Many banks have been financing their mortgage programmes with international borrowing and securitizations of mortgages were just appearing. As liquidity on the international credit markets evaporated, Russian banks have been cut off from their favourite form of refinancing loans, which has put the squeeze on property prices, which plateaued in the second half of last year.

Supply splutters

Russia's residential property market has paused for breath, but most analysts believe the stop will be temporary; continued upside in residential real estate is supported by a severely underserved market and supply side bottlenecks. "There's definitely been a construction boom here, but even with this boom supply is far short of demand. To give you an idea of the extent to which the market is under-supplied, independent bodies such as the Institute of Urban Economics and the Institute of Urban Land Development estimate the demand for residential properties at 1.2bn sqm. This is a massive amount. At present construction rates, it would take 20 years to fulfill. In terms of just residential stock, this is five cities the size of Moscow," says Yazykov of Renaissance Capital.

Paradoxically, for a country as vast as Russia, the chief bottleneck is lack of land plots, or rather of plots with sufficient infrastructure to permit development. Where there are no access roads, water or power supply, development becomes prohibitively expensive.

Supply has also been restricted by recent regulatory measures. In 2005, a new housing code came into force that toughened requirements for developers to raise funds from the population. "There's been more control of residential construction, after local investors got ripped off," explains Martin. "Previously, developments were funded by presales, even before development even started, and sometime even before obtaining planning permission. Now the new law says you have to start construction before you can start presales."

However, the tightening of regulations benefits overall transparency and public confidence in the sector. The consolidation it stimulated in the sector also benefits foreign investors looking for respectable and stable partners to develop with or to invest in.

A second regulatory issue is currently deterring foreign investors from the massive Moscow real estate market: the total absence of freehold in Moscow. The city owns the land and makes it available only on long-term lease. This gives city hall enormous bargaining power, which it uses to claim the "the city share" of any development: developers must either transfer apartments to the city for social needs, or build infrastructure for free.

While it remains difficult for international developers to make headway in Russia, Russian developers have internationalized in a big way latterly and raised capital with a slew of IPOs in 2007. "Many companies own development rights," explains Alfa's Brady, "but still have no core portfolio yielding properties, so they cannot raise debt. That's why they are so enthusiastic about equity."

Russian real estate companies raised $8bn over 2006-2007, exploding from two or three traded companies to 15, including the CIS countries. Most of these companies trade on the London Stock Exchange's Alternative Investment Market with mixed results.

Another round of real estate IPOs is on the cards for 2008, predicts Brady. Following the US' sub-prime debacle, other channels of raising finance have closed. Debt for development appeared in 2006 and financing in euros was becoming available at single-digit rates, with amortization terms for 10-20 years. Now rates are back at 14-15% and the maximum loan-to-value available has dropped to 60%.

Moscow is the new London

"Luxury doesn't care about anything. You know, they say many non-domiciles in London are currently looking for another location, because it is so expensive. The exception are the Russians, who are simply happy to live in a city less expensive than Moscow," laughs Yazykov.

While it is an exaggeration to say Moscow is more expensive than London, Knight Frank calculates the super-prime property price growth in Moscow in 2007 reached 40.9% and is set to reach London levels within 10 years. "This will continue," says Knight Frank's Thain. "The real centre is very restricted in Moscow, and construction is getting smaller and smaller from year to year. There are no more Red Octobers out there. There is no doubt top end is soon going to be close to London prices."

The recent Wealth Report published by Knight Frank and Citibank Private states baldly: "We forecast that within 10 years, Moscow will vie with London for the most expensive city in the world. While the prime area of the city will be much smaller, the prices achievable for new build prime developments will be comparable. There is huge demand for prime property in Moscow owing to little existing stock and a very small potential pipeline of additional prime property."

In fact, the London and Moscow markets are already increasingly intertwined. "We have really, really strong connections with our London office," explains Thain. "Russians are buying a lot of properties in London. In fact, we do not just sell luxury apartments and luxury housing in and around Moscow; we are famous here for also selling apartments and houses in London to Muscovites. Wealthy Russians want firstly an apartment in the centre of Moscow, where their business is; secondly a country house; and then their third location will be in London for sure. Their fourth and fifth locations are summer houses in Italy or France."

Global real estate players have come in droves to Moscow over the last few years to cater to this burgeoning business. In 2006, Morgan Stanley real estate investment fund made their first investments in Russia, snapping up a 15% stake in RGI International, a developer of elite residential in Moscow, and a 10% stake in Moscow's R.E.D, developing mostly commercial and some elite residential. In March 2007, Morgan Stanley took a 25% stake in St Petersburg-based RBI Holdings. Deutsche Bank's real state investment arm RREEF is also involved in prime residential development, and a slew of other funds are following in their wake.

Cushman and Wakefield Residential has been present in Moscow since mid-2006, and is now starting to reap the rewards of the decision. "What we do is arrange investment deals, sometimes we are representing landowners, sometimes investors who want us to find something for them. It's mostly foreign investors interested in new developments and redevelopments. Most investors we work with are international real estate funds," Christer Lystad, head of Cushman and Wakefield Residential in Moscow, explains. "Most of these are joint ventures with Russian companies doing the development and international investors contributing the finance, with plans and designs done jointly." Lystad says projects currently bring a return on investment of over 50%, and earn yields of 7-10%.

The biggest deal Lystad stitched together to date has been a luxury residential development based on the Otrada Equestrian Club in Moscow. Lystad persuaded Orco Group's Endurance Residential Subfund to invest $200m in the development. Otrada Equestrian Club is home to some of the country's pre-eminent polo events such as the Rolex Polo Cup, the Moscow Polo Cup and the Russian Polo Cup. The sporting theme is one dear to Lystad's heart - he has himself been a professional sportsman in both his native Norway and in Moscow, where he played the outdoors form of ice hockey called bandy.

Lystad says a number of similar elite residential complexes are in the pipeline for 2008 - and, not coincidentally, they mostly come equipped with top grade leisure and sports facilities such as fitness studios. Cushman and Wakefield also facilitated the development of the Mayak yacht club in its picturesque riverside surroundings on the outskirts of Moscow.

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