Maurice Pedergnana: We’ve discussed this at length with those real estate experts who were main contributors to the KPMG study. Stefan Fahrländer and Stephan Kloess helped us consistently take the key perspectives on the various markets into consideration. You have to look beyond owner-occupied residential properties. If you take multi-family homes in German-speaking Switzerland, for instance, you’ll see considerable differences in transaction returns depending on whether they are in central or peripheral locations. One main trend is that returns for both are declining at the same rate. Multi-family homes in central locations are rarely purchased with initial returns of around 3 to 4%. At these prices, they offer very limited opportunities for returns to develop over time, particularly since rental income generally does not hold any potential for growth. Demand-driven price increases in income-generating property with rental income that does not hold any upside potential are a sign of overheating. In metropolitan areas, overheating in city centers also leads to lower initial returns and a purchase price that isn’t commensurate with the risk involved.
Maurice Pedergnana: The margins in high-volume business are adequate. From a historical perspective, risk premiums of more than 10 basis points or 0.1% aren’t justifiable in the area of owner-occupied residential properties, for instance. Everything else covers refinancing and operating costs and generates profits. Throughout the entire banking system over the past 20 years, no more than 10 to 20% of the risk premiums currently imposed on properties and borrowers have actually been used. That means that if a bank’s equity situation is healthy, there is enough capital nowadays to cushion fluctuations in the quality of the loan portfolio. Most retail banks are fit as a fiddle and generate a profit of around 40 to 50 cents from every CHF 1.00 in net interest income. I don’t see any consolidation pressure as a result of competition in this segment of the mortgage lending market. Not even in those areas where banks provide financing for numerous real estate promoters, major construction projects and managed real estate on a large scale. There the cycles aren’t necessarily larger if geographic diversification is taken into consideration.
Maurice Pedergnana: The SNB and FINMA are working on putting a stop to that kind of enticement as well as anybody engaging in it, an effort clearly documented by warnings, on-site visits and additional reports. But there’s also one thing we have to understand: The current level was generated by micro- and macro-prudential regulators themselves. Oliver Wyman just recently wrote an excellent report on the topic. Even the illustration on the cover of “The Financial Crisis of 2015 – An Avoidable History” says a lot.
The interest environment is still quite tempting. Financing conditions will remain attractive for a while and in a slightly inflationary environment, this could make real mortgage debts even more attractive. What’s interesting, however, are the macro- and micro-economic relationships between cause and effect. And that’s precisely why the KPMG study was performed. It contains all the essential information: whether there is potential for corrections on the real estate market, where it comes from and how banks can avoid the impact of these corrections in their balance sheets.
Maurice Pedergnana: That’s not quite clear. Some people seem to tell themselves: “My job is safe and money won’t get any cheaper. It’s now or never.” In fact low, long-term fixed rates can well mean that it’s cheaper to buy at a higher price today than to buy something at a slightly lower price later but at higher rates. Strangely enough, regulators have never commented on this. For most banks, granting mortgage loans is of central importance. Around three quarters of a typical bank’s total income comes from this branch of business. That’s reason enough to structure this business in line with its financial means. It is undisputed that the mortgage business carries risks. These need to be minimized through moderate policies and appropriate organizational measures, particularly in the context of a low interest environment which could be tempting for borrowers.
Maurice Pedergnana: In our study there are four central aspects involved in this issue. First, the bank must determine the “right” collateral value and only issue a mortgage for no more than 80-85% of that amount. One increasingly frequent occurrence is that the appraised value is considerably lower than the purchase price paid. Second, and this holds particularly true in a low interest environment, a long-term, economical loan with a relatively high amortization rate needs to be enforced to prevent the increasingly large number of new homeowners from swiftly reaching the limits of their financial resources – to the benefit of both clients and the bank. Since legislators have expressly permitted Pillar 2 advances, this means of obtaining equity has become widespread and is frequently brought in to make up for missing funds. That’s deceptive; if a large portion of future retirement benefits have already been used in advance, they might be missing once the buyers have reached retirement age. Third it must be said that ETP transactions involve higher risks than transactions concluded in compliance with the regulations. Yet distinctions must be made when looking at these risks. It’s important that ETP transactions be conducted with a volume limited to a level that is in line with the bank’s risk appetite and risk capacity. And the last point I’d like to mention, one still in need of improvement in many places, is ETP reporting to the board of directors.
Maurice Pedergnana: We really don’t see any downward trend. Thinking prospectively means taking cyclical risks and potential chain reactions into consideration. The study therefore recommends that banks participate in a workshop with experienced real estate specialists. Cyclical aspects are pivotal both on the supply and the demand side. On the supply side, extensive project development work is begun during good phases of the economy which could potentially lead to a surplus following an economic turning point.
The general conditions of the economy, international and national migration as well as the general sentiment are central elements of the demand side. Particularly in regions of high demand, this results in great volatility in rent and prices. How should a regionally active bank handle that? In order to understand cyclical risks related to location and usage, banks themselves should prepare extremely precise assessments and forecasts regarding the supply and demand developments on the real estate markets of their regions. Here we still see room for improvement.
Maurice Pedergnana: We have to keep the real estate market’s long-term drivers in mind (migration, macro-economic development, employment, real interest rates). Many indicators are on green and that means growth. Yet we are shifting more and more toward being a service and knowledge society. This structural change also means that greater emphasis will be placed on atmospheric working and living environments and that people will have higher expectations of facilities and their environment. At the same time, however, mobility demands are likely to rise. From a political perspective it doesn’t make much sense to use tax-privileged home loan savings to intensify the promotion of residential property ownership even further. Countries with low home ownership rates have proven to be more flexible during periods of change and crisis. At the individual bank level this also means that we want to emphasize the quality of opportunities on the real estate market and the related loan market. Undoubtedly there are challenges that some will overcome better than others. This will also determine how banks will handle the findings and self assessments contained in the KPMG study.
Interview: Andreas Hammer, Marketing & Communications