Spain 
Italy 
Greece 
The Bank of Portugal Warns of “Signs of Overvaluation” in Housing Prices
6 June 2018
In its latest analysis of the financial stability of the Portuguese economy, the Bank of Portugal warned that “some signs of overvaluation” have begun to appear in real estate prices in the residential market.
“Some signs of an overvaluation” in real estate prices in Portugal, especially in the residential segment, have started to emerge, the Bank of Portugal warned in its Financial Stability Report, published on Wednesday. For the moment, looking at the available data, the Bank of Portugal believes that the indications of overvaluation are “very limited”, but added a warning: “the duration and speed of price growth may imply risks to financial stability in case of the persistence or reinforcement of this dynamic.”
For the first time, the real estate market was the subject of a dedicated chapter in the Financial Stability Report. In the previous edition of its biannual report, the Bank of Portugal said in December 2017 that the available data allowed “the conclusion that there is no overvaluation in housing prices in Portugal,” despite the existence of excessive assessments in certain geographical areas.” The banking regulator’s opinion seems to have changed:
“After a period of falling prices in the residential segment, some signs of aggregate price overvaluation began to appear in the second half of 2017. Although indications of aggregate overvaluation are very limited, the duration and speed of the price growth may pose risks to financial stability in case of persistence or reinforcement of this dynamic.”
The change in the Bank of Portugal’s analysis was justified by the disclosure of indicators that were not yet known at the time of publication of the last report. However, looking back, the institution led by Carlos Costa stated that the first “signs of overvaluation” began to emerge in the second half of 2017.
There are also “signs of some recovery” in commercial real estate after the sharp fall between 2007 and 2013, “but [prices] are clearly more contained than in the residential segment.” The analysis of the commercial segment is not based on the same diversity of data that exists in the residential market since the commercial real estate market is largely monitored by private international companies that have less data regarding Portugal.
What is driving the “overvaluation”?
The Financial Stability Report assesses the risks in the following light: to what extent could developments occur that put the country’s financial stability at risk, in particular, the Portuguese banks? On this topic, the Bank of Portugal pointed out that “there is no evidence that domestic bank credit is the primary determinant of the increase in prices in the Portuguese market.” The transactions are being completed, in general, with equity and foreign investment, driving the asset inflation.
How is the valuation index calculated?
The Bank of Portugal uses an indicator which is produced by the European Central Bank (ECB) and uses four additional sub-indicators – two with more pronounced statistical components and two based on asset valuation models. The first of these statistical indicators is based on the price-to-rent ratio and, also, the ratio between housing prices and household incomes (price-to-income). A long-run average is made between these two ratios and deviations from the long-run average indicate whether there is (and to what extent) undervaluation or overvaluation. To these data are added more complex asset valuation models, which take into account factors such as economic growth and the level of interest rates.
With house prices recovering to levels close to those recorded in 2008, the Bank of Portugal acknowledged that this is also partly a symptom of “improving household income and falling unemployment”, as well as favourable financing conditions, with the “low level of interest rates” and a “lower degree of restrictiveness in the criteria for granting housing loans.”
However, there is also a “strong dynamic in the tourism sector, in particular, local accommodations” and a lot of “demand from non-residents, partly associated with residence permits.” The Bank of Portugal also noted that it is mainly (85% in 2017) the transactions of existing properties that have raised prices, not the purchase of new homes.
“The dynamics of the real estate market in Portugal has been largely driven by tourism and the entrance of non-resident investors, making it vulnerable to changes in global risk perception,” the Bank of Portugal noted. To date, the influence of foreign investors has been beneficial to banks (and to financial stability): “on the one hand, it facilitates the sale of real estate held by credit institutions and, on the other hand, contributes to a decrease in NPLs associated with secured real estate loans.”
What if the good conditions reverse themselves?
Problems may arise, however, if the trend reverses:
The emergence of events of a geopolitical and economic nature, such as the imposition of protectionist measures, could lead to an abrupt global reassessment of risk premiums. This process could result in a marked slowdown in global economic activity and trade and, consequently, in external demand for the Portuguese economy. This will have negative effects on the Gross Domestic Product (GDP), consumption and investment, and exports, especially on tourism.”
If a scenario occurs where tourism-related revenue drops, affecting local accommodation revenues, this “could lead, in the first instance, to difficulties for borrowers servicing their debts, and, secondly, to reduced sales of real estate assets and consequent price correction.”
This is why, according to the Bank of Portugal, “although Portuguese banks are not the main driver of this market, a sharp decline in real estate prices would have negative effects on the banking sector.”
What worries the Bank of Portugal, specifically, is that much of the foreign investment in the Portuguese real estate market is being made by investment funds, for which the regulator has very little amounts of information. How are they funding themselves, with capital or with debt? What incentives do they have to sell more or less quickly if the market stagnates or reverses? These kinds of issues are very important because they can determine to a great extent whether or not there can be a sudden market correction.
According to data provided by the Bank of Portugal to the Observador, in the year 2017, 76% of real estate deals by foreigners involved investment funds, and 7% were made by Real Estate Investment Trusts whose long-term intentions are not easily identifiable. Only 7% were made with pension funds, which are generally considered longer-term investors.
Real estate price alert comes days before “preventive measures” come into effect
The Financial Stability Report came just a few days before the Bank of Portugal’s preventive recommendations for housing and consumer loans will come into effect at the beginning of July. The recommendations established limits on the amount of a loan in relation to the value of the home (loan to value, or LTV) and limits on the monthly instalments for individual clients, depending on their income. There were also (average) limits on the maximum duration of loans.
The recommendations, which were announced on February 1, came “in an environment of a loosening credit standards, with historically low interest rates, an economic recovery and rising real estate prices, whereby the Bank of Portugal is seeking to ensure through this measure that credit institutions and financial companies do not take excessive risks in the concession of new loans and that borrowers have access to sustainable financing.”
Original Story: Observador.pt – Edgar Caetano
Photo: Miguel A. Lopes / Lusa
Translation: Richard Turner