Cyprus property prices: an example of market failure
by George Hatjoullis
The Cyprus property market appears to have ground to a halt. In trying to update on the situation it is natural to start with Royal Institute of Chartered Surveyors for Cyprus (http://bit.ly/19U6HbR). The last RICS index publication appears to have been for Q4 2012. It may also come as a surprise to discover that prices have been steadily falling since 2009 (see Chart above courtesy of RICS Cyprus). How much further will they fall?
The simple answer is that no one knows but it is likely to be a lot more. The first problem is the banks. They will not be expanding their loan books for a while. In part this has to do with capital requirements but, as in many european countries, it also reflects a correct assessment of the present risk in lending. Unemployment in Cyprus is already high and is rising fast. Unemployment will not peak for some time. Wages are falling. Normal credit processes would preclude an expansion in lending under such circumstances.
In the meantime they must work out their bad loans. The PIMCO report (http://bit.ly/11om1c4) provides a graphic account of past bad lending practices that has led to the accumulation of bad loans.The loans were made on the basis of cross-collateral and co-guarantees rather than any credit assessment of the borrowers capacity to service the loan. Unpaid interest was added to the loan and booked as income. As long as the value of collateral grew at least as fast as the accumulated interest all was deemed satisfactory. Until now, when the value of the collateral is at best indeterminate but almost certainly less than the outstanding loan. The workout of these loans is the job of the ‘bad banks’ that have been set up. If they try to realise the collateral, property prices will collapse in front of the sale. If they try to collect from the co-guarantors, bankruptcy figures will rise even faster. Their only option is to take possession and let the properties (most probably to the borrower). These banks will, by default (no pun intended), become property management companies. It will take a long time to workout these bad loans in this way. In the meantime loan provisions will erode earnings and capital. This will also be true of the good banks, as more loans go bad. The banking crises is not over yet.
What about foreign investors? This category was in part responsible for driving up prices and facilitating this giant Ponzi scheme. Even if the tiresome issue of title deeds is resolved, many may not return for a while. There are many question marks for the foreign investor. When will prices bottom? When will Cyprus banks be safe? Will Cyprus survive in the eurozone or even EU? It is unlikely that foreign investment will help Cyprus property before prices have fallen far enough to justify the remaining risks.
The first likely outcome is that volume of sales will dry up. This is bad news for estate agents and property valuation companies. It is also bad news for government that earns revenue from property transactions. Of course, the government can make this up via the new property taxes. So the investor that avoided the banking crisis by investing all in ‘immovable’ property now faces taxes on property that cannot be sold except at much less than was previously thought (if at all). Selling immovable property in Cyprus was never popular because of the high capital gain taxes imposed. This is much less of an issue now and going forward I imagine!
Cyprus property has experienced a market failure, a concept introduced in earlier blogs on Abeconomics. It is simply not functioning and it may well take some time before full functionality, or what passes for functionality in Cyprus, is restored. In the meantime property prices are indeterminate, which will make the job of constructing indices rather tricky. If the indices are based on actual sales prices there may be insufficient sales to be meaningful. If the indices are based on asking prices they may seriously overestimate the true market. The logical thing for an individual to do is wait but of course this just makes the macro situation worse.