The banking sector will be severely affected by the deflation in prices and activity in the real estate sector, both at retail and corporate levels.
Property prices rose significantly between 2004-2008 as banks over-lent to local households, overseas investors and property developers by looking at asset/collateral values rather than the repayability potential of the loans. The combination of a decrease in overseas demand in 2008 with a significant amount of stock in the development pipeline, resulted in a decrease in property prices especially post 2009. The latter has had a negative knock-on effect on a number of construction related companies, a number of banks who financed them and the buyers of the end-product. The situation has been further complicated by delays in issuing title deeds and the use of properties that have been developed/sold by their original owners for collateral purposes, often cross-collateralisating assets across loan facilities and companies.
All of these have (and will) have a negative impact on business activity and employment. It will also affect confidence among mortgage borrowers, the ability of companies to borrow against property and use it as collateral to finance investment, and the ability of property developers to service existing loans. Thus, a large number of borrowers (developers, investors and individual buyers) are currently entering into ‘negative equity’ causing significant structural and economic implications.
Today, many borrowers are repaying mortgages that are essentially higher than their asset value. To the local banks, this means that their exposure to potential loses has increased further, especially when more and more loans become problematic and in arrears. What is worrisome is that if banks are forced, as envisaged in the memorandum of understanding (MoU) with our international lenders, to foreclose on properties, this will open Pandora’s box as procedural/legal issues will appear, losses will be crystallised, and collateral values may drop further due to the number of units coming onto the market as forced sales.
As the boom in the real estate sector was supported by strong credit expansion, this significantly increased the exposure of domestic banks to developments in the real estate sector. Loans to individuals for housing increased considerably in recent years (Cyprus has the highest household debt/GDP in the EU). Therefore, over-lending in the domestic real estate sector created several structural problems. Many property developers and investors are not in a position to repay their loan obligations as they struggle to dispose of their properties/assets, mainly due to uncertainty caused by the turmoil in the local and international markets and lack of financing from local banks to potential buyers (as banks are undercapitalised and are pursuing deleveraging strategies in tandem).
The decisions of the Eurogroup on March 25 outlined a number of prerequisites in order for Cyprus to gain assistance from the troika (ECB, EU and IMF). Through the MoU, several structural changes will positively reshape the financial and real estate sectors in the medium to longer term. Firstly, administrative hurdles and the legislative framework currently constraining the foreclosure and sale of loan collateral will be amended so that the property pledged as collateral can be foreclosed within a maximum time-span of 1.5 years from the initiation of legal proceedings. In the case of primary residences, this time-span could be extended up to 2 years.
It is stated in the MoU that the necessary legislative changes will be implemented by end of 2013, macroeconomic conditions permitting. Secondly, the government is in the process of raising the Immovable Property Tax (IPT) and it has already announced that it’s going to revise it further over the next six months. It is widely acknowledged that real estate is one of the easiest assets to tax, as there is a central registry of owners and assets (the land registry). Such taxation and the limited access to funding (as banks are unable/unwilling to lend) will push prices and demand to even lower levels. Thirdly, the central bank will implement a property price index that establishes the average property market valuation by square metre of habitable surface and land plot. This index shall be operational to provide imputed market valuations for each non-agricultural cadastral plot.
Fourthly, amendments will be made to provide for mandatory registration of sales contracts for immovable property and eliminate the backlog in issuing title deeds to less than 2,000 cases. Fifth, the authorities will also enhance cooperation with the financial sector to ensure the swift clearing of encumbrances on title deeds to be transferred to purchasers of immovable property, and implement guaranteed timeframes for issuing building certificates and title deeds. The government will also need to implement electronic access to the registries of title deeds, mortgages, sales contracts and cadastre for the financial sector and government services. Finally, the authorities shall assess the need for additional measures, including if necessary legislative reforms – to eliminate court backlogs by end of the programme.
Cyprus’ economy was in a downward spiral for two to three years, so it would be unfair to argue that the MoU is to blame for the decline in property values and demand. Before the memorandum, compared to 2007, property prices in Paphos, Famagusta and Larnaca had fallen by up to 40-50 per cent, while Limassol and Nicosia had a downward path from 2011 onwards with reductions of about 20 to 25 per cent (Leaf Research, 2013). With the signing of the MoU the market has been ‘frozen’ and it is anticipated that the prices will drop further as the affordability ratio of net income to house prices is further strained.
Nevertheless, all these MoU reforms are in the right direction towards creating a reliable and dynamic financial and real estate sector. Yes, heavy austerity and recession might be in place for the next few years and everyone agrees that after such a severe blow to Cyprus’ lucrative banking sector the country will be pushed into a deep recession. Perhaps the issue one should consider is what would have happened had all these reforms that Cyprus needed for years already been undertaken, making its financial and real estate sectors stronger and more transparent.
And yes, various investors from overseas have already started arriving on the island, looking at opportunities to invest in anything from large-scale real estate projects, operating hotels and acquiring non-performing loans, etc. They have seen this scenario play out elsewhere and they know that in two/three years the economy will start growing again, provided that the country streamlines its public sector, strengthens its supervisory bodies and restructures its banking industry. Cypriots will now be left to benefit from providing services to these new foreign end buyers, and, in time, are likely to realise that had they spent more time scrutinising their government and dealing with their problems rather than pushing them under the carpet, Cyprus would be a much better place to live.
Dr George Mountis