Las Vegas has nothing on Moscow. The City of Sin is America’s hottest urban real-estate market. But prices there pale compared with those in Moscow.

According to Mercer Human Resource Consulting, this Russian city is the most expensive in the world for expatriates, and soaring real estate prices have largely propelled its rise to the top of the list. “If you go back 10 years ago, to find a decent apartment in Moscow you paid $5,000 to $7,000,” says Carlos Mestre, head of the global mobility unit at Mercer. “Since then, prices have nearly doubled.”

The reason is the sort of economic fundamental that was willfully ignored during the Soviet era: Demand is outstripping supply. Moscow simply doesn’t have enough safe, modern and spacious apartments that foreigners and rich Russians want. “You can find deals, but people might be sleeping in the hallways because the front door’s not secure,” Mestre notes.

The shortage may begin to ease in the next year or two because high prices and a robust economy are driving a building boom in Moscow and St. Petersburg, which also has a dearth of top-quality residential and commercial buildings. “St. Petersburg now is almost like Moscow,” says Valery Yakubovich, a Wharton management professor and Russian native. “Price levels there are almost Western European.” Even secondary cities like Samara, an industrial center on the Volga River, are seeing rising prices. “In all the major industrial centers, you see the same pattern,” he adds. 

So much money, both domestic and foreign, is flowing into Moscow real estate, in particular, that Yakubovich and other Russia watchers have begun to worry about the possibility of a bubble. “It’s crazy,” he says. “Apartment prices [are close to] world levels, like London or Tokyo, but the average income of Russians isn’t that great. This is what makes the boom really puzzling.”

Not all the money pouring into the sizzling sector is local. A division of Germany’s Deutsche Bank has earmarked $500 million for Russian real-estate investments. A Swedish outfit called the Russian Real Estate Investment Co., or Ruric, is aiming to invest $100 million, mainly in St. Petersburg. Also in St. Petersburg, a group of state-owned Chinese companies has committed more than $1 billion to a 500-acre development.

But perhaps the biggest foreign-funded real estate venture is Great Domodedovo, near Moscow. The plan calls for a new 44,000-acre city with homes, commercial buildings, schools and recreation facilities. The developer of the $11 billion project is Limitless, the real-estate division of Dubai World, a conglomerate owned by the ruling family of the emirate of Dubai. 

Alongside the gush of foreign cash, Russian firms, too, have been able to raise hefty sums for investment in their home market. Consider RGI International, a Moscow developer. It grossed more than $200 million via a stock offering on the London Stock Exchange in March. Even before that, Morgan Stanley, the New York investment bank, was one of its larger shareholders. The International Herald Tribune has estimated that Russian development firms raised $2.75 billion via stock offerings in 2006 and will raise at least that much this year.

Russian real estate is so hot that star western architects like England’s Sir Norman Foster are trying to put their imprints on the fast-changing cityscapes. Foster, a winner of the Pritzker Prize, which is the Nobel of architecture, has designed Moscow City Towers, slated to be the tallest building in Europe, and is putting an enormous retail and hotel complex on a site overlooking the Kremlin.

A Boom with Legs

At least one leading Moscow investment bank, Renaissance Capital, has predicted that the good times will likely endure for several years.

Over the last 12 months, “we have seen an unprecedented boom in Russian real estate: Prime office prices went up by 38%, selling values for warehouses jumped by 33% while retail premises climbed by a hefty 56%… ” according to a recent Renaissance report. “Residential properties have beaten even the most aggressive forecasts with a 90% average price increase.”

Russia’s economy has soared in this decade thanks to rising prices for oil, natural gas and other commodities, of which the country has huge supplies. Commodity prices have stayed high for long enough that money is coursing through the Russian economy, spurring the growth of the middle class and the banking sector. Those developments, in turn, have contributed to the surge of real estate development.

“Macroeconomic growth has led to falling unemployment, rising disposable incomes and consumption, wide availability of cash, increased mortgage lending and greater capital investments, all of which have combined with insufficient supply of high quality office, retail, warehouse and residential properties to lift the fledgling market,” Renaissance explained in its report. “Although property values in most segments are currently at an all-time high, most leading indicators point to further strength in the market.” 

In the United States and Western Europe, real estate purchases depend on mortgages. Until recently, mortgages weren’t widely available in Russia. But the growing banking sector is introducing all sorts of new loans, putting home buying within reach for more and more Russians. At the same time, legal reforms have cleared away restrictions that prevented some consumers from obtaining loans and have given greater default protection to banks. As a result, the volume of mortgages in Russia more than quadrupled from 2003 through 2006, rising to more than $5.5 billion. “A new generation of Russians may not be living with their in-laws much longer,” the International Herald Tribune observed last year.

Granted, talk of ultra-expensive real estate in Moscow has been dismissed by a few commentators as misleading. Like many internationally prominent cities, Moscow exists on two levels — a costly, glitzy one that caters to expatriates and the rich, especially the country’s much-gossiped-about “oligarchs,” and a more modest, workaday one that serves the middle- and working-classes. “Moscow is slowly being segregated, as in the West, with upscale neighborhoods and separate middle-class and poor ones,” says Wharton’s Yakubovich. 

Many Russians, for example, still live in their shabby Soviet-era apartments and crowd three generations of a family into a small suite of rooms. Some have to share kitchens and bathrooms with neighbors. And plenty of bathrooms still have only cold water. But thanks to privatization during Boris Yeltsin’s presidency, many Russians own their homes. That ownership is giving them at least a currency that they can use to take advantage of the real-estate boom.

“For people in Moscow, their apartments are turning out to be a huge asset,” Yakubovich says. “I know one family that has an apartment in a building that’s old and very spacious but with few amenities. If they renovate, it’s worth hundreds of thousands of dollars. They are thinking of selling and moving to the outskirts of Moscow into someplace that’s more modern.” In contrast, people who want to stay in the city often find themselves stuck with their old apartments. “They can’t move because they won’t find anything cheaper,” Yakubovich adds.

Buyers Beware

Land in downtown Moscow has become so valuable that real-estate developers have begun to pay people bonuses to leave their apartments, rather than wait for properties to go on sale.

Over the last few years, some downtown apartment owners have become targets of unscrupulous developers. These developers persuade some Muscovites to relinquish ownership of their homes with promises of new apartments on the outskirts of the city. The developers then fail to deliver the promised new homes.

“Development companies would go bankrupt and then claim they didn’t have the money to pay people back,” Yakubovich explains. “That’s a huge problem right now. People are really upset. [First Deputy Prime Minister] Dmitri Medvedev had an online press conference, and people were pounding him with questions about this. They are demonstrating in the streets over it. Russians have been portrayed as apathetic about politics. But when it’s an economic issue, people are mobilized very easily.” 

The government will “have to address these issues of buyers who got cheated,” he adds. “They have to do something or this will backfire during next year’s election.”

President Vladimir Putin has made housing one of his four national projects and has earmarked government revenues for affordable housing construction and mortgage assistance.

After talking with a friend who is a homebuilder, Yakubovich has doubts about whether government-aided construction will work. “You can push down prices if you set up large-scale production of assembled homes, and they are attempting to get into that,” he points out. “But as soon as a developer is offered any kind of funding from the government, he’s concerned that he may have to give the bureaucrats a share. One way or another you’ll have to motivate them to let you in; you’re at their mercy. That’s why the person I talked to decided to stay away from it.”

Even in Moscow, where private development is surging, the local government — and people with ties to it — has a lot of influence over who gets building permits. “People believe that the mayor’s wife indirectly controls the permits,” Yakubovich says. “She owns a construction-materials company. The thinking is that, if you don’t buy construction materials from her, you might have trouble getting a permit.”