Ben Aris in Berlin -

Russia's real estate sector is soaring after prices put in their fifth straight year of strong growth, up 70% last year. But with the cost of a three-room apartment in central Moscow passing the million-dollar mark in a country where the average income is still only $390 a month, some are asking if this boom is actually a bubble.

In all, real estate prices have grown 253% in the primary market and risen 288% in the secondary market between 2000 and 2005, while inflation was only 189% over the same period.

It's these stratospheric rises that have tempted more and more Russian companies and banks to invest in real estate; no one doubts that Russia in general, and Moscow in particular, is in desperate need of more housing, office and commercial space.

Tens of billions of dollars are being poured into real estate by banks and oligarchs, funded out of their own resources. At the end of last year, construction was contributing 15% to GDP growth, according to Trust Bank in Moscow, or $113bn in 2005, the latest figures available. Real estate is one of the three biggest contributors to Russia's economic growth, which ended last year up 7% year-on-year and is expected to accelerate further this year to 7.5%.

In an effort to keep up with demand, companies are leveraging up to finance the construction frenzy. Last year, four credit-linked notes worth a total of $450m and 18 ruble bonds worth a total of $850m were issued by investors to finance construction.

Residential real estate

Creating affordable and comfortable housing for the citizens of Russia, has been designated one of the Kremlin's "national projects" – an effort headed by the deputy head of the presidential administration, Dmitri Medvedev, who also happens to be the frontrunner to replace President Vladimir Putin in presidential elections next year.

Owning a comfortable apartment is close to most Russians' hearts after the nightmare of finding accommodation in Soviet Russia and most Russians are still living in their Soviet-allocated apartments that were gifted to the population in the 1990s as part of the first round of privatisation. IMS, a leading Russian market research company, estimates that over two-thirds of Russians are unhappy with their current housing and want to move.

The Kremlin is perhaps pouring oil on the fire by specifically targeting reforms to the financial sector to make it easier for regular Russians to borrow money to buy a new apartment. Last year saw the introduction of laws to underpin mortgage-backed securities that allow banks to refinance housing loans for the first time, and mortgages have become the hot financial product for this year for banks with retail aspirations.

The volume of mortgage loans last year topped the $5.5bn mark, up from about $1bn in 2003 when mortgage lending first became a widespread product. And the mortgage portfolios of banks that have specifically targeted mortgage lending as a core competence are growing even faster: Russia's state-owned bank VTB, the second-largest bank in the country, is leading the growth after its mortgage portfolio increased by 270% in 2006 to reach $875m by the end of 2006.

Experts say that 30% of credits last year were used to buy newly built housing, while 50-55% of mortgages paid for items on the secondary housing market in 2006. Mortgage lending is expected to reach $8.3bn by the end of this year, with more money being spent on new housing than on the secondary market.

Residential real estate is the main source of growth and is expected to drive the sector for at least the next decade. The volume of residential construction grew by 44% between 2000 and 2005, or 7.5% a year, which is on a par with GDP growth over the same period. However, in 2006 residential growth rates accelerated to 12% as 48m square metres were added with a market value of $60bn, according to Trust Bank. That is about an extra square metre for every adult in the country against the average of 20.8 square metres they currently inhabit - less than half the European average.

"Taking into account that just over a third of this space is rundown and needs extensive repairs, this actual space the average Russian has for accommodation is really about 13.5 square metres. Even with construction growth rates of 10% a year, it will take Russia a decade to catch up with Western Europe," says Alexei Dyomkin, a real estate analyst with Trust Bank.

The government estimates that there is a deficit of 1.7bn square meters that will take 16 years to build at current rates of construction.

Moscow remains the biggest and most attractive real estate market in Russia, accounting for a fifth of the total space, although the growth rates of new construction in the regions is already higher. However, the prices of real estate in Moscow are more than three times higher than those in the regions, and the total market is worth $24bn, or 40% of the Russian total. And according to the Moscow City government, construction firms will add another $85bn worth of real estate to the capital's market between 2006 and 2010 with the main players - SU-155, Don-Stroy, Glavmosstroy, PIK, Mirax Group - accounting for half this.

Running in second place in importance is St Petersburg, where volumes of construction are six-times lower and average prices are half those in the capital.

Commercial real estate

Russia's commercial real estate sector is currently the fastest growing in the world and an estimated $3bn-$3.5bn was invested into commercial real estate in 2006 - several times more than the previous year. And the money is still coming: this year total investment in to commercial real estate is expected to top $5bn, with half of this coming from foreign investors.

As with residential, the Moscow commercial real estate market is by far the biggest and also one of the most vibrant in Europe, second only to Paris with its annual growth rate of 1.0-1.2m square metres a year.

The total commercial floor space in Moscow is 8.5m square metres, including 5m square metres of A- and B-class office space. Vacancy is very low, less than 3%, while rents are high, says Trust Bank. Likewise, in other forms of commercial space, such as warehouse and retail, there is also a shortage of space.

The bubble bursts?

However, experts say prices have run ahead of themselves and they are expecting a correction, possibly as early as this year. Although prices grew strongly last year, in the last quarter price growth came to a halt and there is some anecdotal evidence that potential sellers were forced to drop their prices slightly to close deals, according to Greg Thain, a director of Knight Frank, a leading real estate broker.

"In the future, the residential real estate price dynamics in Moscow will be erratic, and will depend on the housing quality. Due to the limited purchasing power of the population (even including mortgages), prices of economy class housing have reached the ceiling. In the business class and premium real estate segments there is potential for further price increases - the shortage of supply and excessive demand from the higher income bracket still exist in the market - but do not rule out 10-15% downward price correction soon, " says Dyomkin.

The big unknown is the number of speculators in the market. Estimates vary wildly, but analysts believe that individuals and companies are buying 4-6% of apartment sales on the expectation of rising prices. If these speculators loose their nerve and put these apartments up for sale the bottom could drop out of the market overnight, says Trust Bank.

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