Real estate market overheating: myth or unavoidable reality

1
Real estate market overheating myth or
unavoidable reality

• Georgs Lansmanis
• Ravenshill Consulting
• Chairmen of the board

2

• The market may longer behave irrational, than
  you can pay for it
• James Meinard Cains
• British economist
• Government solutions for economical problems are
  as bad as problems themselves
• Milton Freedman
• Nobel prize winner

3
Beginning

• 1. Abstract
• Economy is cyclical and its breakdowns are as
  inescapable as bankruptcy of ventures. The
  questions is not when the RE market will burst,
  but
• At which circumstances will it happen
• How long will the downfall continue
• What effect will it have on the economic
  development of the country
• 2. In Latvia
• most rapid house price increase in the world
• most favourable investment place in Europe
• one of the most favourable mortgage conditions

4
3. RE market types, differences and price
dynamics fundamentals

• RE market base types
• residential and commercial RE markets
• owner and tenant occupied RE markets
• RE price fluctuation fundamentals
• building price increase in the long term should
  approximately equal price increase of land in
  absolute terms
• demographical development of the country affects
  the RE market prices

5
3. RE market types, differences and price
dynamics fundamentals

• mortgage credit rate, as RE market development
  factor
• changes in vacancy rate is a good supply
  indicator
• new residential and office building construction
  takes time, creating relatively inelastic supply
• RE price cycle length and price fluctuation
  volume depends of housing and mortgage market
  structure in the country, in correspondence with
  supply responsiveness
• bubbles most often develop in commercial RE prices

6
3. RE market types, differences and price
dynamics fundamentals

• RE cycles in different countries may be seen as
  unrelated, but market globalisation may create
  correlations
• rent price levels clearly affect profit bearing
  object price
• the more unexpected is the economical development
  and the more optimistic are household about their
  future income, the greater will be the prices
• it is untypical for a bubble chain to develop in
  owner occupied segments

7
4. RE market overheating history and examples

• Common RE market cycles
• Sweden's and Finlands example
• Japans disaster (1990-2000)
• Irrational expectations in Paris
• Small and middle bank crisis in Great Britain
  (1991-1992)
• Switzerlands case

8
5. RE market overheating may directly cause
financial crisis and breakdown

• expert opinions of, which was the primary guilty
  one of the RE bubble burst- the worsening of
  economical situation or the RE market itself,
  substantially differ
• bubble in Asia RE market exploded before the rest
  of the domino pieces fell, incl. Currency crisis
  development

9
6. Macro economical preconditions of market
overheating

• Common worsening of economical situation
• balance of payment current account deficit
  indicator is very alarming, besides the worsening
  of 2006 deficit was encouraged by week export
  data
• the rapid outflow of citizens from Baltic states
  to work abroad, from RE overheating view my be
  looked upon from two aspects
• base inflation proportion in total inflation
  indicates RE and construction effect on the high
  inflation of the country

10
6. Macro economical preconditions of market
overheating

• Resident solvency falls behind price increase
• current crediting pace in Latvia maintains
  prices, which make credit takers for one sqm pay
  four to five month average income, while in other
  parts of the world it compiles one to one and a
  half month income
• only 9.5 residents average official month income
  allow to take on mortgages

11
6. Macro economical preconditions of market
overheating

• External economical conditions as crisis
  initiators
• Closed market as overheating precondition
• Decreasing competition tendency
• Sometimes banks, real estate agents and
  assessors cooperation is one of factor, which
  makes RE market explosive due to risky credits

12
7. Banks Policy

• Non-discriminating loans- loan amount is not
  connected to the income potential
• in most economic developed countries exactly
  commercial banks were the greatest sufferers
  after the RE market breakdowns
• real bankruptcy situation development is slowed
  down by the rapid land price increase
• crediting is dangerous, if banks start to give
  out credits for amounts, which are close to RE
  market prices

13
7. Banks Policy

• RE loans from total issued loans
• in most SEA (South East Asia) countries before
  crisis mortgage credits made up 30-55 from total
  bank issued credits
• mortgage credit proportion in Latvian banks of
  total credit portfolio compile 47

14
7. Banks Policy

• Banks issued credits exceed GDP growth pace
• SEA banks credit amount growth to GDP growth
  1990.-1996.y. Indonesia 62, Thailand 70,
  Philippines 115
• with the current crediting pace Latvia may reach
  EU average indicators for credit amount from 2-3
  years from 15 2005.y. to 50 2008.y.- growth
  to GDP 80

15
7. Banks Policy

• Lost mortgage credit proportion (nonperforming
  loans)
• most SEA countries banks lost (nonperforming)
  mortgage credit proportion was high (Korea 34,
  Thailand 50)
• in Latvia the low non performing loan amount
  (0.3) indicates not the credit taker
  responsibility, but the rapid RE price increase

16
8. European Central bank policy

• Credit rate base changes
• 2006.y. 4. august European Central bank (ECB)
  decided to increase euro base percent rate from
  2.75 to 3, which for Latvian credit takers
  increases interest payments by more than six
  million euro (4..2 million LVL) in a year
• experts in the end of 2005 did not project such
  credit rate increase

17
8. Latvian Banks (LB) and Latvian commercial
banks policy

• Latvian Bank Policy
• as a result of LB decision, to increase
  obligatory reserve norms for banks from 6-8,
  approximately 145 million lats were taken out of
  free circulation
• LB policy did not affect commercial banks
  actions
• Added credit rates
• Credit margins or added rates to mortgages in
  result of competition significantly decreases, if
  non performing loans increase the credit margins
  may increase as well

18
9. Other overheating preconditions

• Globally to characterize RE market a specific
  index- housing price relative to rent price per
  month is used
• In England, USA and Australia after the breakdown
  of stock exchanges in the end of 90ties index
  rapidly increased to 130 ,155, 170, afterwards
  heavily falling down
• In Latvia at the moment index is over 200 and it
  keeps rising
• In the old town of Riga at the price 4500
  euro/sqm and rent price 10 euro/sqm- 40 years are
  necessarily to pay for the flat

19
9. Other overheating preconditions

• States and municipalities participation in
  markets overheating
• National scale project construction may
  contribute not only to construction sector, but
  to all economy's overheating
• Broad national housing program realisation with
  following flat distribution will cause immediate
  NI burst

20
10. Residential and office market development
tendencies

• RE development in residential area market
• RE burst in residential market is less likely
  than office market, because significant risk
  diversification happens
• market conditions at the moment are thankful for
  construction of residential houses
• in reality delivered apartment count does not
  match to the planed amounts- due to inelastic
  supply and speculation with projects
• new projects account for 15-25 of total housing
  supply, which further on accounts for price
  increases in secondary market
• intension in Rigas RE removes growing supply
  in outer Riga for acceptable prices
• market overheating depends more upon macro
  economical conditions and resident purchasing
  power, than market participant behaviour

21
10. Residential and office market development
tendencies

• RE development in residential area market
• stable growth in credit rates will cool down the
  market, instead of causing its burst
• significant problem residents don't look upon
  flats as income generating objects, but as a
  purchase for personal welfare improvement
• speculator behaviour, creating finance
  pyramids, may create RE burst
• subject to the highest risk are carrot villages
  around Riga
• in case of RE burst the most will suffer mass
  segments, those developers and clients, who
  realize or buy small middle quality class houses
• residential RE bubble burst most likely will
  follow office RE burst instead otherwise

22
10. Residential and office market development
tendencies

• Office area rapid increase one of RE market
  overheating significant pre determinants
• Office RE overheating possibility is greater
  comparable to residential area, due to smaller
  risk diversification possibilities
• Office RE are more cyclical and volatile as
  retail and industrial RE
• Return on RE own capital is mainly from income
  return rather than capital gain, because income
  is significantly dependant from rent prices which
  are stable comparably to RE prices
• Unmotivated optimistic expectations as
  speculative bubble initiator
• In most SEA countries a significant office supply
  increase was observed comparing to historical
  values, in result huge empty office proportion
  was created and rapidly worsened developer
  solvency
• SEA office RE market oversupply, main RE and
  finance market breakdown pre determinant

23
10. Residential and office market development
tendencies (Latvia)

• 2005/06.y. significant investment diversion from
  residential segment to office segment was
  observed
• office premise segment 2005.y. was highest in
  commercial property market and build 70 of all
  transaction total
• A and B1 class office rent price is higher in
  Riga than in Bucharest, Oslo, Prague, Budapest
• project developers are basing their opinions on
  the assumption that Riga will become Northern
  Europe finance and transaction centre

24
New Office Centres
25
10. Residential and office market development
tendencies
26
10. Residential and office market development
tendencies
Source Colliers Int., Jones Long Wosson, Kon
Research
27
10. Residential and office market development
tendencies
Source Ravenshill Consulting
28
11. RE stress scenario

• Rapid offices construction boom creates a large
  vacancy rate in the office space
• The expectations of the offices project
  developers about foreign tenant arrival in the
  market stay unfulfilled
• The office developers can not cover anymore the
  bank payments rapidly increases the lost loan
  proportion
• The banks transfer the losses to the residential
  mortgage loan segment decreasing the loan
  maturities and increasing the margins

29
11. RE stress scenario

• Residential pyramid speculators begin selling
  apartments in large quantities, thereby starting
  the rapid RE prices decline in this segment
• For the remaining mortgage loan possessors,
  sharply declines mortgage values, and it starts
  fast prices decline in the residential segment
• The liquidity of the banks is substantially
  diminished
• The government has to save the banks by
  overtaking their assets
• The macroeconomic figures rapidly worsen, thereby
  creating a crisis in other economy fields
  firstly connected to consumption

30
12. Recommended government policy to prevent
overheating

• Government intervention in free market economy
  can only be allowed for ensuring the economic
  stability and long-term development
• RE market optimal price increase is 5-7 more
  than inflation in the country
• Only fiscal policy can be effective in the
  macroeconomic level

31
12. Recommended government policy to prevent
overheating

• Administrative constraints
• government control over direct foreign
  investments
• diminishing the amount of mortgage loans, by
  introducing loan tax
• introducing fee for the RE registration,
  including company share deals
• increasing VAT base rate and increasing the
  excise duty for gasoline

32
12. Recommended government policy to prevent
overheating

• Soft policy
• stimulate residents to place their free money
  resources in commercial banks deposits
• government requirement to increase risk weighting
  for mortgage loans
• introducing a RE tax also to the buildings and
  uniting it with the land tax
• RE cadastral value levelling out with the market
  value
• stimulating alternative investment opportunities,
  such as stock exchange, public stock, PPP

33
12. Recommended government policy to prevent
overheating

• Government action in the RE overheating peak
• The possible government intervention in the
  residential and offices RE market, by acquiring
  the gone in bankruptcy, unfinished projects

34
13. Conclusion

• Already now the time has come, when all the RE
  market participants including the developers,
  commercial banks, government, and speculators
  have to carefully fallow the market development
  tendencies, in order not to arrive to the
  situation when in the place of cashing in huge
  profits, they would have to think how not to go
  bankrupt.

35

• In the beginning of September Ravenshill
  Consulting will publish a research Latvian RE
  market overheating feasibility analysis