FX.co ★ Central banks around the world are seriously concerned about overvalued real estate

The higher the inflation, the more anxious the central banks are about bubbles in the local real estate markets. The central banks of Ireland and Germany are planning stricter regulation of commercial real estate funds.

Central banks around the world are seriously concerned about overvalued real estate

The reason for the decision of the Central Bank of Ireland is the fear that the shift in prices in the real estate market may intensify in the economy during the recession. In turn, this may lead to a repeat of the scenario of 2008, when the bankruptcy of the mortgage bank Lehman led to a global crisis.

The bank's management is alarmed by the extremely unfavorable situation with Evergrande, a Chinese mortgage bank that has been teetering on the verge of bankruptcy for several months.

As a result, the Irish central bank is currently "advising on a set of measures to limit leverage and liquidity mismatch" for property funds, "which in recent years have become increasingly linked to the domestic economy," central bank governor Gabriel Makhlouf told reporters on Thursday.

"The leverage of Irish real estate funds is higher than that of European comparable funds, which creates additional vulnerability to falling prices, which can lead to selling pressure in the market," he said.

The set of recommendations will include proposals for the introduction of leverage limits and instructions on notification periods for real estate funds "investing more than 50% directly or indirectly in Irish real estate," the central bank said in a report published on Thursday.

According to the proposal, the central bank can temporarily lift the limit in case of a downturn in the market and tighten it in case of a "growing recovery" in the sector.

The central bank has made it clear since at least February that it is concerned about the level of leverage of some real estate funds and has since repeated these concerns repeatedly. It will accept applications according to the planned rules until February 2022.

But even in the eurozone, not everything is going well with real estate loans.

Echoing the Central Bank of Ireland, the Bundesbank is preparing for "rainy days".

"German banks are becoming increasingly vulnerable to a real estate market revaluation, and financial authorities should force lenders to increase capital reserves," Germany's main financial regulator said in a report on Thursday.

Germany reduced the so-called countercyclical buffer for banks to zero at the beginning of the pandemic, but currently economic growth is steady and bank lending has gained momentum, so they should be forced to hold more capital.

The Bundesbank added that the buffer, now 0, was set at 0.25% of banks' total exposure to risk before the pandemic, but current lending levels suggest an even higher level may be needed.

To date, this buffer clearly does not take into account the rapidly developing residential real estate market, which requires careful monitoring and possible actions by regulatory authorities, said Claudia Buch, Vice President of the Bundesbank.

Real estate prices around the world continue to rise. The growth rates make experts think that, perhaps, investors are now considering real estate not only as a profitable investment due to low interest rates of lending, but also as a fairly safe haven for the period of rising inflation.

Indeed, as we have already said, interest rates will not always be low, and the potential benefits of buying real estate at an inflated price are questionable. However, the need to invest makes real estate attractive.

Therefore, sector indicators indicate that further growth is expected ahead of housing prices, as a result of which real estate will be overvalued, since the growth of prices and rents outstrips income growth.

"The price peaks in the residential real estate market tend to grow further," the Buch said. "According to the Bundesbank estimates, in 2022 in Germany they will be from 10% to 30%."

This means that banks may overestimate the cost of securing a loan, exposing them to large losses in the event of a price adjustment.

Banks are also vulnerable to rising interest rates because most of their long-term lending is provided at fixed rates, especially in the case of mortgages, the Bundesbank added.

This really creates the prerequisites for a repeat of the 2008 scenario, since a drop in the value of mortgaged housing by only 1-2% can bring down the economy. Given the bubble in the real estate market, this is not such an incredible scenario. Although with the normalization of inflation to 2-3%, prices, indeed, will only grow over time. And again they will sink only with virtually zero increase in producers' incomes, which will mean a decrease in purchasing power in all markets.