Welcome to the Suicide Club. Notes on the Moscow property market

 Background

Legend has it that one day the famous American businessmen Joseph Kennedy decided to have his shoes cleaned.  When the man shining his shoes asked him about future prospects for some shares he had bought, the banker thought "If shoe-shiners appear in the market, it's time for the professionals to get out" and promptly sold all his shares.  This happened just two days before the stock market crashed.  From that time there has been a law in the market:  cobblers, housewives, Belgian dentists and other uninformed people signal an imminent fall.  To get rid of anything, one needs to find someone to offload it on to and Belgian dentists are ideal for this purpose.  They're not very up in financial matters and super trusting of the media.  To judge by the present state of the Russian property market, we can expect crowds of Belgian dentists. It's the last wave that sweeps up what no one else wants, as the saying goes, and it is these people who will pick up the ticket for profits made by others.

I must say immediately that I am talking about the Moscow property market: this is where the real pyramid is.  Any comparison of bank balances will show that all flows of funds in Russia accumulate in the capital.  Moscow is the vector determining movement in the regions:  everything happening now and in the future on the Moscow market will to a greater or lesser extent affect the provinces.  This extent will depend finally on how greedy the local administration is and what the real possibilities for the general public are.

The essence of any financial pyramid is that initially a small group of people make super profits.  Subsequently, more and more ‘bricks' are needed to keep up the profit level and a huge publicity campaign is set up to advertise the pyramid.  Remember MMM?  Lenya Golubkov only wanted to buy his wife some boots. For those who do not remember or are too young to know,  Lenya Golubkov was the hero of an advertising campaign launched in the nineties by the Russian financial pyramid MMM.   Lenya was a simple, funny, folksy character of the TV commercials, who successfully invested in MMM bonds.   For the citizens of impoverished post-Soviet Russia he was the best example of how easy it is to become rich. When MMM fell, thousands lost their life savings. Now try and remember when it was that the stability of the Moscow market was first promoted.  Not so long ago - about 3 years and particularly during the last 2.  At that time the price per square metre was increasing by 100-200% per annum and the idea of investing in a flat was less widespread.  No one reveals what he earns or marks up a map showing his gold mine, then calls in the neighbours.    That only happens when the source has dried up.  Take a good look - the last 2 years have not seen any increase in prices.  Belgian dentists are being hoodwinked:  prices are indexed in dollars, but rouble values are unchanged.  It is even more revealing to compare the price per square metre and the gold price.  Gold is a real indicator of changes in asset prices - it's the instrument which indexes inflation and protects against currency fluctuations.  2 years ago the price of a square metre in Moscow was equivalent to 250 grams of gold.  That was the peak.  In 2007 prices fell (!) almost 25%.  Today the market has recouped and come to a standstill in a state of indecision.  There are particular reasons for the turnaround: rumours of a possible redenomination, a change of president, the military action in Ossetia, a change in the exchange rate dynamics and a sagging stock market, but these are certainly not pre-requisites for continuing price increases.    Over the last 2 years investments in the Moscow property market have not produced an effective yield, but you wouldn't think so to listen to the TV. Belgian dentists - don't give too much credence to advertising campaigns.  And bear in mind that all indexes of market value are calculated on the asking price:  actual transaction values are, for various reasons, not made public.

Apologists for price increases most commonly use the argument that in Russia there is enormous unsatisfied demand for housing, which will not allow the market to slide.  I'm sorry, but that is disingenuous.  What sort of an income does a man have to have if he decides to buy a flat, even with a mortgage?    A minimum of $6 - 7,000 (if  he is buying a small one-roomed flat far away from the centre with a 30 year payback period). In Moscow an income of $4-5,000 is considered pretty good; the average per capita income is just over 30,000 roubles (approx $1145) per month.  There are practically no real buyers in the market, and never were.  It's true there is an enormous demand, but it is for social housing, not for property costing 500,000 provisional currency units (equivalent to dollar or euro) and more.  According to RF Audit Chamber data only 10-15% of Russians are in a position to buy a flat with a mortgage.  Interestingly, mortgage level calculations are done very differently in Russia and America.  There the total mortgage must be no more than 18 months' earnings irrespective of the length of the payback period.  If this method of calculation were applied in Russia, the only people able to take out a mortgage to buy a medium-sized flat would be the President and Mr Deripaska.

The present - new build?

Prices in Moscow were moved up and down by investors and large-scale speculators, not consumers.   It was civil servants-developers-bankers acting almost as a monopoly that established values.  Large-scale speculators close to this trinity bought new-build flats with almost no risk attached and on credit, so everyone had a real interest in price increases.  Now investor demand is different:  there are no more large-scale investors and anyone left is waiting for the right moment to offload their assets.  Property is no longer a financial instrument: liquidity and profitability are reduced and production costs are growing.  It has become quite difficult to get hold of finance against such assets, or to use the increase in prices to cover one's costs and remain in the black.

Construction costs are now lagging behind price increases for the finished product. Costs have risen since the beginning of 2008 by 21.2% (in dollars), whereas prices have only risen by 15.7% for new-build and 13.6% in the secondary market.  As a result, banks are scaling back financing and developers en masse are winding up operations at an early stage, then trying to sell unfinished projects.  Transactions which are clearly investment driven have decreased in the housing market:  in 2005 they were 20-25% of the total, in 2006 15-20% and in 2008 - less than 10% (IRN data).  Professionals may be leaving the marketplace, but the cobblers and housewives are arriving.  They don't buy whole floors of new-build apartment blocks or land in hectares.  They try to take out a mortgage or to pawn what they have to buy anything they can get, but they can't get much - the market for apartments in Moscow is clearly skewed, sometimes to an absurd extent.  Flats with a floor area of 15 (!) sq metres are being sold at top prices and even communal flats can command a fairly high price. There are queues for dangerous structures - the cheaper the apartment, the greater the demand for it.

To rent?

What is our naïve would-be investor, Lenya Golubkov, hoping for?  His strategy is very simple: I'll let the flat and my wife can have a fur coat.  6 years ago that's how it was - letting an apartment was a very profitable business.  But now it's the other way round.  Rental income doesn't cover one third (!) of official inflation.  A special point for Belgian dentists: throughout the world the safest option is considered keeping one's money on deposit in a bank, which is why the return is very low.  Any business has a greater element of risk, so it has to bring in a good return.  Letting apartments is real business: you have to find a tenant, ensure he pays on time, keep an eye on the apartment and do a minimum of running repairs.  These days annual interest rates on deposits are more than 10%, whereas the return on a rental is on average not more than 5%.  And that's without taxes, utility payments, repairs, down time between lets and other upkeep costs.  In this way net profit from renting out an apartment is 1.5% to 3%.  4 times less!  But new flats keep appearing on the market and it's much harder to find a desirable flat than a very basic one, but at the right price.  One can understand the Belgian dentists and the grannies -the flats were not bought by them and have never been considered in value terms.  They're an asset that has been privatised or inherited, which is why the market is so inert.  If it were any other way the supply of rental accommodation would shrink rapidly.  With an official inflation rate of 12%, who needs a return of 3%?

However, it's still worth the Belgian dentists pricking up their ears and weighing up the risks.  The turnover of the Moscow rental market is valued at 4 billion dollars.  Almost no one pays any taxes.  In the worsening economic climate the government might just remember those funds not paid into the state budget and ask for it all back, everything for the last few years, with fines and penalties added on.  And at the same time they might raise the level of property tax and it would be calculated on market value, not official prices, with rates for owners of two or three flats two or three times higher.  Work it out - you would pay taxes of 1 to 1.5% taxes a year on a flat with an effective yield of 3%.   Payback period for an investment should on average be 8 to 10 years, but we would be looking at almost 100 years (yet one more proof of the fact that the marketplace is full of cobblers).  Is the game worth the candle?  You will hardly be able to recoup your losses by putting up the rent.  Prices are already hiked to the limit and people's incomes are being eaten up by inflation, so the potential for salary increases has been exhausted.   There's another risk.  The situation in the Russian housing market is catastrophic: more than half the stock should be pulled down and new buildings put up.  Data from the Ministry of Industry and Power show there is a need for 1.6 billion sq m of housing.  The state must continue to build social housing, but how and using what criteria is this housing to be allocated to those in need: by means of a mortgage with the state paying the deposit, on a long-term loan or simply rented?  This is not important:  the flats will be built, supply will increase and the tenant will have a choice.  The banks hold an enormous amount of properties as collateral.    The government will, of course, help state banks (it was they who were mainly involved in giving mortgages and financing the developers), but the banks' efforts will all be directed towards state corporations, so they will not be able to hold on to real estate assets.   The government will be able to kill two birds with one stone by letting social housing - this helps the people and supports the banks.  So, dear Belgian Dentists, you must now be prepared to pay for the right to let your flats.  Incidentally, in most countries the guarantee of property market stability is the correlation between the mortgage rate and rental rates.  Total payments over the credit period, including interest and commission, should not exceed the cost of renting a similar flat over the same period.

A mortgage?

Lenya Golubkov has another investment strategy:  I'll get a mortgage on the flat and let it.  That way I'll get it for nothing.  Too late, Lenya!  Firstly, there's no avoiding the deposit and this is a minimum of 30%.   Secondly, rental rates for apartments are now lagging considerably behind selling prices.  In the first half of 2008 the price of a one-room flat increased by 31% (in dollars, naturally), whereas the rental increase was only 6.5%.  So the rent is clearly not sufficient to cover debt payments to the bank.  Alas - there's no such thing as a free lunch!  Here is some information about mortgage risk Russian style.  Realistically the minimum rate for a bank loan is 20%.  This may not put off the Belgian dentist confident in the continued growth of the market, but I should like to point out that if you take 100,000 for 15 years, you'll end up paying the bank 215,000.  Seems rather a lot!  And that's only if housing prices don't fall.  If they do, then you will have more problems.  The small print of any standard contract will tell you that if prices fall, then the bank is entitled to revalue the mortgaged property and to demand additional collateral.  In other words, the bank always ensures that the value of the mortgaged property corresponds to the amount loaned.   It must be worth more.  If not, then the bank's risk increases significantly.  As soon as that ratio is disturbed, the bank requires the borrower to make available the essential sum for the restoration of the status quo.  For example, you have taken out a loan of 300,000 to buy a flat costing 500,000 and property prices have fallen by 20%.  The bank will require you to adjust the situation, to make up the difference.  This will be slightly less (by the amount of payments they have already received) than 100,000.  If you can't, then you have the option of early repayment of the whole sum borrowed.  What if prices fall by 30%?  Remember you have unlimited liability.  The greatest risk is incurred by the person who has managed to take out a mortgage for the full price of the property or with a minimal (5-10%) deposit.  In England in the ‘90s, when property prices fell, the banks increased monthly payments for their borrowers.  So the favourite argument of the apologists for the property market  - in any event nothing can happen to the flat, defaults are no worry, you can't lose it -  is far from axiomatic.   Defaults are very likely, and you could easily lose the flat, along with all your other goods and chattels.

A crisis?

Naïve Belgian cobblers believe that we are not going to have a mortgage crisis like the one in America - our borrowers are reliable and anyway not many loans have been issued for the purchase of property.  I agree, but only with the last part of this statement.  It is true that in Russia as a whole there have not been many mortgage transactions.  But there have been enough in Moscow to change the layout of the market and affect the price dynamic.  It is mortgages that have inflated the market over the last year.  The main problem is that it is the same Moscow banks financing the construction and giving loans to the purchasers.  The apartments that come on to the market first are not the mortgaged ones, but those that have had developer loans.  As for a crisis LIKE THE ONE IN AMERICA, that crisis has long since gone beyond the bounds of either mortgages or the USA.  It is truly global and was caused by the imbalance between production and consumption in various parts of the world.  The crisis of confidence in the world financial system is only the beginning.  It will be followed by increased liquidity squeeze (not yet in Russia, where there is only a squeeze on borrowings), then changes in the exchange rates and the subsequent revaluation of assets.  The crisis will last longer than many think.  True, it won't be exactly the same for us as in America.  Over the last decade American banks have increased their capitalisation by a factor of ten, earned excess profits and offloaded "MMM tickets" on the whole world.  Russian banks haven't managed to do either of these things, but they have managed to construct a shaky tower which is higher than the American pyramid.  If American banks had raised prices for fixed assets i.e. property to Moscow levels, then even the Federal Reserve would not have managed to avoid a default.  Derivatives increased in price in America (which did not happen in Russia), so the banks wrote off those excess profits.  But what could our banks write off? Incidentally, our well-remembered default only cost the Russian economy 30 billion, whereas the property pyramid (which in one way or another is part of the flow of funds and was, indeed still is, being used as guarantee for credit) is valued at more than 1 trillion!

As for our reliable borrowers....how can one be sure of anything over a long period in Russia?  The wage increase potential is exhausted, inflation is growing with the strengthening rouble, the economy is slowing down, oil prices are considerably lower than at their peak and foreign investment is being cut back.  The future even for Gazprom managers does not look radiant.  In bull market conditions buyers were interested in the size of the loan and the term - they shut their eyes to the interest rates and other parts of the contract.  However, when any hope of increased revenue disappears, people are not pleased.  Remember the Russian Standard bank consumer loans?  Suddenly it turned out that the real interest rate was more than 40%!  There are bad debts now too, but the banks don't publicise them.  The Russian mortgage is too young for us to draw any conclusions:  there isn't one borrower in Russia who has completely paid off even a 15-year mortgage.

Cutbacks

Naïve people like Lenya Golubkov are being told about the downturn in building and warned of imminent shortages.  True, Moscow Deputy Mayor Yuri Roslyak has said that in the first 9 months of 2008 only 2 million sq, m. of housing was built, as compared to 3.5 million for the same period in 2007.  If we look at the flats that come on the market, then the downturn in construction looks even more alarming.  Developers used to be able to put pressure on the market: as soon as prices stopped growing they, like OPEC, announced the end of sales.  Now what developers do has no effect whatever.  With such a massive downturn in construction there's no question of price increases.  Why is this?  Professional businessmen are cutting back, new-build flats are bought as one-offs, rather than whole floors at a time.  Margins are reduced and profitability has fallen.  Social housing, however, is still being built and allocated.  It was 50% of all new housing, now it's 65%!  And they're going to have to keep building.

Belgian Dentists should remember that the elasticity of demand has its limits.  Sooner or later the time will come when prices reach their ceiling, even if supply is reduced to zero,  and this seems to have happened already in Moscow.

On the one hand there is an army of needy people whose purchasing power does not allow them to even dream of a flat.  On the other a regiment of speculators and the fortunate owners of privatised flats.  "Moszhilservis" is the organisation that registers the right to let flats that are the property of Moscow city.  Their figures indicate that approximately 120,000 Muscovites currently own 2 or more flats.  You could try one evening driving past new apartment blocks and counting the dark windows.  There are varying calculations of how many ‘investment' flats there are in these districts, but it's between 50% and 75%.  Look at the paper and see how many flats in one of the new buildings are already for sale.  Or try and calculate how many flats in Moscow are to let - an unconscionable number, one in ten, according to the Moscow city Housing Department.  These are official statistics - by no means every landlord declares his business.  Such significant market demand cannot act as guarantee for the stability of the market.  Speculative capital is like liquid in connecting vessels:  it very quickly moves where there is promise of greater profit.  Real demand is directly dependent on people's income increasing.  Over the last 3 years available housing has decreased by over 50%!  Prices are growing 3 times faster than salaries and inflation twice as fast - and that's now, when the economy is still benefiting from the petrodollars.  Interestingly,  this subject is discussed in the press much less often than the interrelationship between price per square metre and the cost of oil or the size of the monetary base.

The Future

In the estate agency "Agent 002" I was told that since early August for every 7 available flats there is only 1 purchaser, and that's top end of the market.  The number of owners wishing to sell, often more than one flat, has increased by 36%.: the discount rate for quick sale of several flats at a time has reached as much as 20-30%!  Among the elite and business people offers for sale increase by 2.5% a week.  This is only the beginning.  The Moscow property market capacity has been assessed at more than a trillion dollars.  If there's no change in the situation over the next 3 months, 20-30% of the flats (according to Agent 002) will flood on to a market where there are no purchasers.

Yes, the market is bound to cool down.  The higher you stand, the further you fall.  But is there a limit? Yes, there is - the nationwide programme "Affordable Housing".  After all, the name of the programme doesn't indicate whether the affordable housing will be owned or on a long lease.  In the West market stability is supported by a well-developed system of social letting, which balances the rental market overall:  a civilised rental system offers a person the choice of living in rented accommodation on a long-term fixed price agreement or buying his own apartment.  Until the government addresses this problem by abandoning the practice of transfer  (which leaves loopholes for those making the transfer to someone with a steady income, rather than to the needy), there will be no market stabilisation.  It wouldn't take much:  the law should be developed to protect consumers, borrowers and tenants, rather than producers, creditors or landlords; there should be registration in law of sales by instalment and social tenancy and the law covering construction of blocks of flats pre-financed by the future owners should be reformed.   That will produce genuine investors, rather than speculators.  The best investor at this stage is the general public.  There you have your national mortgage, market stabilisation and GDP growth.  But for this the market has to shrink by about 50%, which is unlikely to happen tomorrow:  we hope that the fall will be smooth and happen over several years.  We should, however, not forget that delayed action contains one more buried mine.  The imminent withdrawal of the state from housing and utilities sector will be fatal:  most people will not be able to afford to maintain their flats and will be obliged to sell them.  If the flood of social housing should coincide with the end of the reform of the public housing sector, there will be another tumble downwards.

As for our Belgian dentists...if the energy market can find substitutes for oil, the Moscow property market too can find more than one alternative.  We could start looking at securities:  the stock market has already collapsed by more than 50%.  One might invest in other property, abroad, for example.  Prices are lower, lending rates more affordable and life there is, sad to say, calmer and easier.  Or one could simply put one's money on deposit in a state bank or abroad in a reliable currency, like, for instance, Swiss francs.