A BUBBLE IN RESIDENTIAL REAL ESTATE

In recent months, many opinion articles have been published about the possible formation of a real estate bubble in Portugal, about to burst.

The theme is not new, and has been recurring since 2015, when housing prices started to skyrocket in Lisbon, Porto and the Algarve, later progressively infecting, and in a more or less evident way, the rest of the country.

However, it has been evident to everyone that the income of the Portuguese has not grown at the same rate, thus making housing increasingly inaccessible to the general population, especially in the central areas of the country's large cities.

But then, is there, or isn't there, a bubble in the residential market about to burst?

The origins

Following the subprime crisis in 2008 in the USA and the debt crisis in 2011 in Europe, central banks bet on an injection of liquidity and a reduction in interest rates, in order to get out of a global financial crisis, boost the economy and the job.

From the point of view of financial assets and real estate, it was the fuse for an appreciation trajectory, which continues to this day.

These financial conditions, extremely favorable to contracting debt and penalizing traditional savings, meant that many (individuals and professional investors) did not find better risk-benefit alternatives than real estate investment.

Simultaneously, with the advent of low-cost airlines and the phenomenon of local accommodation, Portugal, a peripheral country, benefited from strong tourist demand, in addition to the usual boom during the Algarve summer.

This tourist mass, reoriented towards the city centers and with a much more favorable seasonality, created an obvious business opportunity for catering, accommodation and entertainment services. Real estate is a key point in these services.

Simultaneously, investors' desperate search for yield, in a world of zero or negative interest rates (in the euro zone) and abundant liquidity, with a supply lower than demand, led to too many competing for the same assets. Making them more expensive.

As a matter of risk management and profit margins, given that there are few barriers to the movement of capital between geographies in the modern world, a new subspecies was born: “the international real estate investor”.

The Real Estate Investor

An international phenomenon, organized individually or collectively, based, or not, on local partnerships (law firms, real estate agents, construction companies...), greed for income from properties intended for residential use.

This financial purpose of real estate is not new, but in our country, already little given to long-term leasing, it has stirred up even more competition for available assets, in a format we were no longer used to, since in 1974 the Portuguese government implemented a new wave of legislation aimed at controlling rents (which practically ended investment in the rental market and accelerated the degradation of the national housing stock).

This trend of owning your own home underwent a new and decisive boost in 1995, with the entry into the common market and the process of joining the euro, where a significant decrease in reference interest rates began (in 1993…. 17%, in 2003.... 3%!!!) and a new home loan regime and easy access to bank credit.

But this wave of financial investment further exacerbates the imbalance between demand (originated in national households) and supply (centered on the high end and on investors).

The point is that with the current market dynamics, investors dominate. Will it be much longer?

The Offer side

Our country is known for having one of the highest housing/tax aggregate ratios in the EU.

In fact, this ratio can be a bit misleading. And it has a possible explanation in the way the number of existing fires is accounted for in statistics. It is not weighted by factors such as “living conditions” and/or “actual availability”.

According to CENSOS 2021, only 20% of buildings in Portugal are less than 20 years old. And knowing the low national appetite for the maintenance and modernization of housing, despite the great commitment to renovating the housing stock in the center of large cities in recent years, there is a lot to do to improve living conditions.

As a result of decades-long immigration to the coast, a large portion of residential real estate in the interior of the country has been abandoned for decades.

If we add to this the fact that we have an aging population, living in dilapidated buildings (in the Lisbon metropolitan area alone, an estimated 50,000 are vacant and 27,000 are unhealthy and/or unsafe), with old rents, without the possibility of a real update, and even when, due to the death of the tenant, they are vacant, it is usually difficult to place them on the market (for reasons of family sharing and others), we realize that if in “gross terms” we have a number of dwellings far superior to the needs of families, in “ net terms” is no longer quite the case. Especially in big cities.

If it is not easy to access vacant land and/or buildings in areas where the needs of the population are met (affordable price, close to work, services, etc.), the major development typically comes from neighboring areas and “small islands” where there is still free space to build tall at reasonable costs.

But with the cost of development skyrocketing (prices of materials, labor and financing), even there it is becoming extremely difficult for the majority of the population…

The INE's statistical reading, however, indicates that after a peak in building permits in 2007 (monthly average of 5500 permits) this past year of 2022 - in line with the previous 4 (2100 permits/month) - does not, therefore, reach half of what was once done around here. And if we look at the number of energy certificates awarded in January for building projects - 3100 new buildings, 614 renovated buildings - nothing indicates, for now, a reversal in the will of property developers, since this number is in line with recent years. On this side of the building, therefore, there is no indication of an increase in volume that could reverse the sale prices.

On the supply side of houses for sale in Portugal (new and used). According to the IC they will have decreased to 47.

300 homes in the 4th quarter of 2022. A minimum of 15 years, which can either mean a “wait and see” or the beginning of a market stoppage.

At this moment, what surely results is an increasing difficulty of access to housing by Portuguese families - the traditional housing market.

And if the mountain does not go to Mohammed… Mohammed goes to the mountain… or in another way: if the market does not solve the needs of the population, politicians exploit the opportunity to do so…as they have done so many times in the past in Portugal.

The political options for market regulation that are coming

In the EU there are several examples (specifically 16, according to the news of 01/17/23 in the DN) of countries that have legislation in force to control rents in general, and/or restrictions on the sale of residential real estate to foreigners in particular. Therefore, this option of politically controlling the market is neither original nor recent. It simply “renews”.

What is already known about the OE 2023:

1. Limitation of IMT exemption for real estate companies, as a way to combat speculative resale;

2. Limitation on the amounts of rent advances and guarantees, as a way of facilitating the population's access to long-term leases;

3. Increase in the amounts charged in IMI for buildings in areas of urban pressure (100% if it is an AL, 35% if it is a long-term lease);

4. 300% increase in IMI for properties that have been vacant for more than a year, or in ruins, and 30% for degraded properties.

And even though the PRR will be used to reform the public housing stock, together with the municipalities, as a way of responding to families, with the goal of building 26,000 new dwellings for those who do not have access to decent housing.

The government also expects to present the new basic housing law shortly, which will include measures for: “there is more urban land, to promote more housing; put vacant homes back on the market; tax incentives for leasing”.

In addition, there are voices in opposition to the government, such as Mariana Mortágua, who in a recent interview with ECO, states that the best possible political action for an increase in the housing supply, rather than imposing rent ceilings and limiting the AL , is to oblige landlords to place vacant properties on the market.

But these political ideas are not exactly new either. There has always been legislation more or less in this direction (mandatory maintenance work, IMI penalty, etc.). But it has always failed to execute... is this the one that will have practical effects?

On the demand side

As Portugal is “a country of landlords”, with a tiny rental market, an immediately relevant aspect is the cost and ease of access to bank credit for families and investors.

At this point the issue of liquidity does not seem to be of concern. National banking has very low transformation ratios and the volume of loans granted has been growing in recent years. But the issue of default, with the rise in interest rates, is worrying - which can lead to an increase in the volume of defaults and renegotiations forced by the current legal framework (when the effort rate is greater than 36%) .

It will always be a negative move for banks (with the introduction of grace periods and extension of amortization periods), but it all depends on the number of contracts reached and the accounting devaluation of mortgages. Here, the banking sector can always adopt a risk-mitigating attitude and start making access to finance more difficult.

As for the cost of bank credit, we have to consider the strong increase in euribor rates, as a result of the normalization and adaptation of the ECB's monetary policy and, on the contrary, possible movements to conquer market share in banking, translated into spread decreases.

This process is ongoing, let's see how it stabilizes, but for now, the balance weighs more on the penalizing side of interest rates.

Another relevant ongoing process is the inflationary one.

This has increased the cost of construction materials and reduced the purchasing power of families and investors. Which will negatively impact demand.

Bubble in the housing market about to burst. Yes or no?

First, it is necessary to understand if in fact a “bubble” has formed.

The widespread perception, in the sense that there have already been several warnings about the rapid expansion of house prices in recent years, is that yes, there is a speculative bubble. Which, for many, is enough of an indication that “something is going to go wrong” soon.

But how big is the problem? Or the size of said bubble? If it happens, is it a price drop of around 10%, 50%, more?

This value is fundamental to understand how many houses/families, owners/investors, may see the market value of their asset fall below the contracted mortgage (those who bought/invested more recently in housing using bank credit are at greater risk).

If this number is too large, banking assets will be depreciated and we will have a new banking/financial crisis, drying up liquidity and stopping investment…

But for that to happen, what signs can we expect?

First, as a matter of mistrust, demand retracts and investors withdraw from investment intentions. It's "wait and see". The end of the euphoria phase (during the last crisis, the confidence in construction index provided by INE showed consistently negative values since the early 2000s, being -30 in 2007 and -65 in 2013).

Afterwards, the number of transactions declined sharply (between 2007 and 2013, the acute period of the last crisis, the purchase and sale contracts concluded for urban, rustic and mixed buildings fell by 50%).

Finally, confirmation arrives: those who really need to sell must do so at a lower price to attract buyers with financial capacity and risk tolerance. We are in the “depression” phase. Few believe in the market.

It is worth remembering that, once you get here, the availability of “targets” for investment and/or family use decreases a lot. In the last crisis this was noticed (those who have good assets and don't need to sell, wait...) and we were coming from a construction production volume like never before. If it were with the current environment, how many “afflicted” would enter the market “at a discount”?

But, as the saying goes: “only when the tide is out, can you see who was swimming naked”.

And what to expect from the macroeconomic environment?

1. Investors in recent years have been in a crazy demand for “yield”. With interest rates on time deposits paying zero and yields on lower risk bonds at derisory values, there are few alternatives perceived as safe.

Real estate was a great escape to profitability.

But the landscape has changed.

The world's central banks, in order to combat threatening inflation, began to raise reference rates, leading investors to reassess the risk/return of their investments.

2. Families will have a resilience test already during this year, 2023.

With mortgage installments skyrocketing and the cost of living simultaneously rising (due to the arrival of inflation in force), many family budgets will have to be revised.

3. The economy and employment are also fundamental variables for the behavior of the real estate market.

According to the most recent data from INE, the Portuguese economy has already avoided a recession. But a slowdown in activity is notorious and investor confidence is wavering. As for unemployment, it increased to 6.5%.

4. Carefully monitor the ease with which the bank grants credit. So far it has been relatively easy, but if it changes, there will be many "afflicted" who suddenly discover that they were over-indebted (developers, investors and families).

There doesn't seem to be enough evidence to believe in an immediate “debacle” in the real estate market. But the euphoria may have worn off.

The macroeconomic and political environment of recent years, extremely favorable to real estate investment, may have already started a change, or just been interrupted.

We will see how the fundamental variables will behave in the coming months.

Finally, if we had to make a few quick recommendations for this year, they would be:

• Do not stop your (good) projects, but keep your debt at comfortable levels;

• keep some liquidity available to grab good opportunities that arise;

• sell assets that are not profitable, or that are not in line with your investment strategy.

Good Business! Good year!