On one hand, the large credit expansion of the years 2006-2008, especially in the real estate sector, was instrumental in fuelling the overheating of the property market during that period. On the other hand, when demand from domestic and foreign investors collapsed post 2008 and prices took a significant hit, the banking sector was faced with an unprecedented situation due to the skyrocketing of non-performing loans (NPLs) that were collateralised by real estate, resulting in extreme lack of credit, which in turn amplified the fall in demand for real estate.
To date, loan origination remains at extremely low levels and consequently the ability of buyers to buy property is limited and property prices remain depressed. This is what is often described as the “cyclical” effect of the lending criteria and policies employed by the Cypriot banks. It is obvious now that during the inexorable rise in property prices in the period 2004-2008, the banks in Cyprus “underestimated” the credit risks implicit in mortgage loans. This could be attributed to various reasons, including the lack of sophisticated systems of risk assessment and the lack of reliable data and information. But the main reason is that the continuous increase in property prices created a false sense of security in Cypriot banks, which in turn led to the rapid credit expansion in the island’s housing market. This is the classical myopic expectations view, which is one of the main factors driving cyclical movements in real estate markets.
These myopic expectations were among the main reasons that kept property prices increasing rapidly up to the Q3 2008, but also kept prices falling after the beginning of the global financial crisis as international investors stepped back in the side-lines expecting further deterioration of demand and prices.
The sharp decline in property prices and the depreciation of mortgaged properties has led to the significant deterioration of the loan portfolios of domestic banks and increased the credit risk and bank capital requirements. The shortage in the supply of credit by the banks has reduced the demand for properties by home buyers and investors alike, further reinforcing the downward trend in property prices.
The Central Bank of Cyprus (CBC) and the local banks have to consider the consequences of the property price declines and the re-pricing of their portfolios and adapt their policies accordingly. In order to do this in the most effective way, data for all mortgaged properties need to be collected and appropriately analysed. For example, using such tools, the geographical concentration and other characteristics of problematic properties/mortgages can be identified, allowing the risk assessment to the sale/ divestment of specific types of properties and specific areas.
The demand for properties has become more vulnerable to the fluctuations of prices because of the banking system influence. Theoretically, the decision of granting a loan must be based on long-term projections regarding the future value of the financed property until the repayment of the loan. Also, the repayment ability of the borrower has to be assessed and seriously considered. The lack of adequate information for assessing and evaluating prevailing market trends and possible future prices, however, prevents a correct evaluation of requests for mortgage loans. The funding decisions as a result, are primarily based on the prices of similar properties at the time of the loan request.
The experience from international markets indicates that property prices are subject to considerable fluctuations, which may or may not coincide with the “economic cycles”. Due to the strong link between credit availability and effective real estate demand, these fluctuations are amplified and become much more intense due to policies applied by credit institutions, when these are of cyclical nature. For this reason, monitoring recent trends and assessing most likely medium term movements in property prices should be of direct interest to the monetary and supervisory authorities. As the recent experience from the domestic financial crisis has shown, the sharp decline of property prices can have a severe impact on the banking sector and the real economy of the country. It is no surprise that under these circumstances both the authorities and the banks are reviewing their credit rating systems and their methods of monitoring mortgages/properties so as to better manage their portfolios.
Overall, the experience of the past seven years has shown that the banking and the real estate sectors in Cyprus are strongly interlinked and that the restoration of the health of the banking system is vital and necessary for the sustainable recovery of the real estate market. We expect that the passing of the foreclosure law will pave the way for the gradual recovery of the banking sector but also mark the beginning of the bottoming-out process in the Cyprus property market within the next 24 months.
Dr George Mountis is the Managing Partner of Delfi Partners & Company
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