Streetwise Professor

December 10, 2008

I Knew There Was Leverage in There Somewhere

Filed under: Economics,Russia — The Professor @ 11:47 pm

Business Week has a very interesting article regarding a topic that generated a good deal of debate back in October–the Russian real estate market.   There are a variety of interesting contentions in the article.   One is that it is widely expected in Russia that big city real estate prices, especially in Moscow, will crash.   And I mean crash, big time:

It couldn’t last, and it hasn’t. Now that the global economic crisis has hit Russia with full force, real estate prices are finally tumbling. And if recent trends are any guide, the mother of all crashes may be in the offing. “The property market in Russia is on the brink of collapse,” says Vasily Koltashov, head of economic research at the Institute for Globalization & Social Movements, a Moscow think tank. “Property prices are very severely inflated, and demand is obviously slumping.”

Down 10% in Two Months

According to the widely cited IRN Index, the value of residential property in Moscow fell by 2% in the first week of December alone. That compares with a decline of 2.3% for the whole of November, and just 0.9% in October. Oleg Repchenko, IRN’s head of research, says that real estate prices in Russia have fallen on average by around 10% in the last two months. He estimates they’ll fall by a further 30% before next summer.

Others go further. Peter Aven, president of Alfa Bank, one of Russia’s leading commercial banks, has predicted that Moscow property values will fall “several times over.” In an October conference presentation, Aven pointed out that the value of Moscow property prices is some five times the European average. When it comes to choice property in the center of Moscow, the cost for a 100 square meter apartment is 155 times the income of the typical Russian. That compares with a multiple of just 5.9 in Germany.

Little wonder that Moscow property prices are now sinking rapidly. Indeed, some analysts say that the real market situation is way worse than the headline figures suggest. According to Inkom-Nedvizhimost, a Moscow real estate consultancy, the city’s major development companies sold an average of five new apartments in the city in November. That compares with around 40 to 50 apartments per month in the summer, and 90 to 100 in the first half of the year. The collapse in demand means that many developers are already offering deep discounts on new apartments, typically ranging between 25% and 40%. <

Nor is it just residential property, the most overheated segment of the Russian market, that is now crashing. Commercial property also has taken a dramatic hit. Irina Florova, an analyst at real estate consultancy CB Richard Ellis (CBG) in Moscow, says that average office rents have fallen by 20% since October and are expected to decline by 25% more by early next year. The take-up of new office space has fallen by 50% since a year ago, while the volume of vacant office space has doubled. “Now it’s a tenant’s market,” says Florova. “Landlords were used to increasing prices, and now they are faced with a completely different situation. For them it was a bad surprise, which happened in the space of two or three weeks.”

An issue that I discussed in some detail related to the leverage in the Russian real estate market. In response to the original posts, some commentors noted that mortgage finance was unimportant in Russia. I concurred with that assessment, but expressed doubt that such pricey properties could be purchased without leverage. Moreover, given that wealthy Russians apparently found it quite advantageous to lever up their other investments, it strains credulity that they wouldn’t lever their housing assets.

The BW article repeats the point about the infancy of the Russian mortgage market, and is silent about the leverage in the residential real estate market. It does state, however, that banks have a major, major exposure to commercial real estate:

Spare a thought, too, for Russia’s construction and development companies, many of which now face ruin. Over recent years they have collectively plowed tens of billions of dollars into new construction projects, typically financed with the help of short-term loans. But even before property prices began tumbling, the sector was in a crisis brought on by a complete halt in financing. In comments to the RIA-Novosti news agency in November, Vladimir Ponomarev, vice-president of the Association of Russian Builders, described the situation facing the industry as “practically a catastrophe.”

As a result of the financial crunch, investment in the construction sector has already ground to a virtual standstill, with knock-on effects for other sectors of the Russian economy. “Of course, changes on the real estate market can significantly affect the rate of investment in the economy,” says Evgeny Nadorshin, chief economist at Trust Bank in Moscow.

The real estate crunch also will affect the wider economy through its impact on the banking sector. When it comes to the banks’ balance sheets, the fledgling mortgage market represents just the tip of iceberg. Alfa Bank’s Orlova estimates that around 14% of corporate loans are to construction companies, while an additional 30% of loans use some form of real estate as collateral. That means that the volume of bad loans—already estimated at around 10% of banks’ portfolios—is now set to rise sharply.

The article is somewhat ambiguous when it says “an additonal 30% of loans use some form of real estate as collateral.”   Does this refer only to corporate loans (as the first clause in the sentence suggests), or to all loans?   Either way, it suggests that the real estate exposure of banks is far higher than the mortgage lending numbers would suggest.

My interpretation is that the mortgage contract is relatively new and novel in Russia, so instead lenders primarily use recourse loans collateralized in part by real estate.   Mortgages are non-recourse loans, meaning that all the lender can do is seize the mortgaged property.   If you default on a recourse loan, the lender can seize the collateral and go after the rest of your assets.   If I am correct in this, if real estate indeed continues to collapse, the collateral will fall below loan value, banks will seize the collateral and start going after the borrowers’ other assets.   That could get ugly.   And the same kind of dynamic currently operating in the US would kick in in Russia–banks seize real estate collateral, dump it on the market, reducing housing values, leading to more defaults, etc.

Even for those who own property unencumbered by debt, the decline in property values will lead to a wealth effect that will depress consumption and economic activity–again, something that is happening in the US.     This is also bearish for the Russian economy.

There is little room for solace if the price bubble was concentrated in Moscow, St. Petersburg, and perhaps some other cities; the housing price bubble was highly concentrated in the US too, and mortgage defaults are highly concentrated, with most occurring in three relatively small areas (in CA, NV, and FL).   A concentrated collapse can have systemic consequences in a connected system.

(I also wonder how much of this debt is dollar or Euro denominated.   I know that a lot of Eastern Europeans borrowed in foreign currency.   I also know that Russian corporates also borrowed a lot in FX.   Given the rosy expectations about the ruble appreciating on the back of a spiraling oil price, I would not be surprised if a lot of the debt collateralized by real estate is also in dollars or euros.   If so, everything I said before goes double.   Or triple.   Or whatever.)

The BW article is not definitive (I’d like to see more data, less journalism) but it is suggestive, and does support my suspicion that there is a lot of debt tied directly or indirectly to real estate sitting on Russian bank balance sheets.   Since real estate prices have just begun their descent, and given the level that they had reached likely have a very long way to go down, the financial strains in Russia will only intensify in the coming months.   The effect on banks plus the wealth effect will test mightily the Russian economy, and make growth very hard to achieve.   To put it mildly.

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1 Comment »

  1. Land prices are falling in Moscow:

    Panorama Estate acquired a chunk of land along Novorizhskoye Shosse in Moscow’s western outskirts for $33,000 per 100 square meters a few months before the crisis.

    Now, the Moscow-based real estate company is pushing hard to sell the plots for $5,000 apiece.

    “We would be glad to sell it at a 70 percent discount,” said Omar Gazheyev, managing partner at Panorama Estate.

    “We are being forced to sell at huge discounts because undeveloped land is a burden for landowners in times of crisis,” he said…….

    Comment by penny — December 11, 2008 @ 11:38 am

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