The “Real” Real Estate Market
By Uldis Cerps
A couple of observations merit attention in the Latvian real estate market. The first discussion is about the price structural aspects of market price level, supply and demand factors, the quality of intermediation, land value assessment, and the approach to taxation. The other issue is the extent to which fluctuations in the real estate market can affect households who have taken credit to buy real estate. And finally, the third issue is about the measures which could be contemplated to address some of the structural problems associated with real estate market.
First, one may argue that there is no universally applicable rule how to calculate ‘objective’ price for a real estate. In other words, to know when the real estate is undervalued or overvalued. One may treat residential real estate purely as a financial asset, and establish its market price based on net present values of future cash flows from rental income.
One may also attempt to get a picture of the value of real estate relative to other countries, but this may lack conceptual rigorousness. Alternatively, one could look at a ‘replacement’ value of a real estate, that is, what are the construction costs and the land costs. The tricky cost component in this estimate is the value of land. To summarize, it is very difficult to know or predict when the housing prices are becoming unsustainable, when there is a bubble, or how big it is. What we can, however know, is whether the price level is comparative to other countries with similar economic development and economic cycles, whether it looks expensive if rental incomes are compared to prices, and how do prices compare to construction cost.
However, for public personalities whose survival crucially depends on whether the general public considers them credible (public officials, members of academia and journalists), it always pays off to be cautious and send signals that markets may be overvalued. Such statements must normally be skilfully crafted so that they could not be tested for accuracy ex-post. In some cases, the quality of rhetoric in Latvia has reached levels when newspapers take for an argument a statement that the extent of speculation in the real estate market can be assessed by “walking through Riga and seeing how many windows were dark in the evening” (the article was published in summer when many people resided outside the city or had vacations in the countryside). This climate is also conductive to all kinds of ‘ spin doctors’ , or even special interests (public notaries, for instance, have come with a proposal that in order to avoid fraud, all real estate contracts would have be validated by a notary public, at present only the validation of the signature is mandatory. The cost implications, of course, would have to be born by the customers).
If one looks at statistics on the real estate market, sources of price increase become apparent. First, Latvia has inherited from the 50 years of Soviet occupation a sensationally low stock of household living space – less than 25 square meters per member of household. Notably, during the past few years, this indicator has increased only marginally. Second, the quality of inherited living space is still for the most part rather unsatisfactory: this can be best seen when examining suburbs of Riga, or indeed suburbs of any city or town in Latvia. If one wants to get a flavour of the situation from official statistics, one may find, for instance, than in 2004 less than 50% (!) of households had access to hot running water. Third, property rights have been returned to the pre-World War II owners and their heirs, but the pressure has been building on those many thousands inhabitants having the right of lease of those apartments, as the lease market will be fully liberalized in less than 6 months time. All these factors have been building pressure on the demand side. The supply side has, so far, been considerably less elastic.
Demand for new housing, or improved existing housing, has been greatly facilitated by better access to financing. Indeed, the mortgage loan industry, starting from almost non-existent base in the year 2000, has reached a solid size: by the end of 2005, the outstanding value of mortgage loans to households was 1.7 billion lats, about a quarter of banks’ credit portfolio or about 16% of banks’ assets. However, the number of households who can afford a mortgage loan is still low, as evidenced by the number of mortgage loans issued by local banks so far – slightly more than 100- thousand. If one looks at official statistics, out of about 1 million economically active households, just 20 percent earn more that 500 euros per month after taxes. Given present price level, for a family with two kids wanting to work in Riga, the option to rent, as opposed to buying their own apartment, is getting increasingly more realistic.
It must be also underlined that despite the intensive competition among banks, many consumers were not so far been able to creep full benefits from better availability of finance, although relatively high rates may be also interpreted as a higher risk premium for more risk. Margins on lending have stayed comparatively high: the net interest margin, although lower for mortgage loans, has been 2.6 for the credit portfolio as whole. Credit conditions often are severe, with high penalties for non-payments, and simplified foreclosure and collateral sale provisions. In short, banks have protected themselves adequately. This can further be seen from the average loan to collateral value ration for outstanding loans. By the end of the year 2004 when detailed statistics on every single mortgage loan were colleted, the ration stood at 51% although in reality it may have been even lower due to the fact that collateral values was recoded at the time of the issuance of the loan. This shows that financial institutions have put in place appropriate safeguards, but the question remains about the extent the borrowers are aware of the risks facing them in under a negative scenario.
Much has been said in a public debate about the nature of this possible negative scenario, and indeed real estate price fall was often quoted as one such cause. However, the only real shock, in our view, could come from the contraction of the real economy. Mortgage loans are issued to persons who have to meet the monthly payment from their income. Even if real estate prices fall, this shall by no means affect the income of people, except for the ones working in, or exposed to, the real estate industry. That is why borrowers have to be mainly concerned about their capacity to meet their monthly payments under such scenarios as the loss of employment, or sharp increases in interest rates. As most loans are in euros, additional channel hitting borrowers under a sharp negative development in the economy is a possible adverse change in exchange rate for lats. In addition to this, few people have actually calculated and a few people know the extent to which the interest rates for euro and its predecessor currencies have changed over the past 20 years, which is a reasonable time horizon for a mortgage loan.
A hot topic in the debate on real estate is about the extent of speculative buying. First, some clarity of the concept may be needed. Speculative buying using bank credit shall merit a particular attention, therefore we propose to focus on just this aspect, while discussing other forms of speculative buying, although being exciting or possibly dramatic, only marginally. Speculation can be operationalized in several ways. We propose two definitions, both of which can produce measurable outcomes, so that the discussion is better informed. One way to define investment in real estate as speculative, is to classify as speculative all loans where the payment of principal has to be made only at the end of the maturity of the loan. Statistics shows, that a 18 months ago, out of all outstanding loans to households, 15% of the value of loans could be attributable to this category. Another way to define speculation is to assume that all persons who have more than one mortgage loan are speculating, even this may or may not be the case. With this definition, 5.1% of the number of loans and 6.3% of the value of loans matched this criteria. This means that, whatever the definition of speculation used, the outcomes indicate that about 10% of real estate purchases financed by credit are possibly speculative. This means that the value of speculative buying is far from being “dramatic”, although at present demand and supply conditions the only effect of such buying is chasing the limited supply. However, at a certain price level, possibly very close to the present one, such arbitrage opportunities may disappear. If, however, speculative patterns only increase, this will push prices higher than their true market value, and will result in a more abrupt fall as otherwise warranted, which could make a hard landing for those 5 thousand (or so) speculative actors, and an increase in the bad loan book for financial institutions financing these ventures.
A good question to ask would be how many of the real estate transactions NOT financed by credit are speculative? This is what we do not know-, although there is anecdotal evidence of “Russian money” going into Riga and Jurmala real estate market, “Scandinavian money” buying up land, agricultural land and forests, and a class of local (and possibly international) speculators purchasing options to apartments in new construction projects by making a small down payment, and then selling the option to the end-investor. Whatever the anecdotal evidence, hard facts suggest that ONLY about a half of all real estate purchases are financed by a loan. Take, for instance, Riga City. In 2004, there were 42 thousand transactions in real estate affected, while only 17 thousand new mortgages were recorded (net difference between end-2004 and end-2003). Who are those investors who can afford to buy real estate in Riga without credit? A part may be attributable to people who move in a smaller apartment and finance the purchase from sales proceeds from their former house or apartment. However, we believe that a significant demand is coming from two distinct sources: the first being foreign investors and local high net worth individuals, and the other being investors possessing proceeds generated in the grey economy. The inflow of foreign investment is something that comes naturally with the membership in the EU and, if any measures are designed to prevent certain parts of real estate market from inflating, these measures shall have an equal effect to both domestic and foreign buyers.As to the amount of presence of proceeds generated in the grey economy, the exact figures are hard to come by. Another analytical difficulty is to distinguish those transactions where the formal sales price is artificially lowered in order to mask transfer of illegal cash from those transactions were the money paid is legal, but both sides agree, again illegally, to reduce the formal sales price in order to minimize the tax burden. Certain speculations about the size of under-pricing could be made. According to the official statistics, the median sales value of one square meter in Riga in 2004 was 169 lats, which, according to a very prudent estimate, represents an under-prising of at least 50% and an aggregated underreported value of over 400 million lats, thus significantly reducing state revenues from registration and levies (2.1% at present), and also raising questions about the true size of the grey economy. At the end of the day, 400 million lats is a lot of money for a country whose GDP is just over 9 billion lats.