TV host: Hello
TV Host: Mr. Deltchev, a year ago you were a guest in the studio of Bloomberg TV and you made the forecast that the real estate market will continue to slow down and it will even come to a sort of windlessness (lack of any driving force), based on the change in the monetary policy of the ECB and FED and based on the trade war between USA and China and the uncertainties related to it. Did this happen?
Deltchev: I would say "Yes". We observe movement of the market in various directions with one strong quarter and the next not so strong one. There are no sharp movements on the market. With other words the movement is not one-directional and it is not explicit. From this point of view, I would say "Yes".
In the same time the uncertainty based on the trade war between USA and China is still there, it isn't gone. There are some hopes for mutual understanding between these two economical super powers, but it is not there yet.
From other point of view, we are observing a change in the monetary policy of the FED (Central Bank in the USA).
TV Host: Right
Deltchev: All these aspects suggest a development that doesn't indicate one explicit direction of the market. I personally expect this development to continue in the next several quarters, up to a year.
TV Host: And what happens recently with this important global factor that is influencing a lot the markets and the prices of the real estate - namely the policy of the Central Banks and its impact on the liquidity and the interest rate levels.
Deltchev: This is very interesting question and I have to admit I believe we are in a very unique situation.
TV Host: Why?
Deltchev: Because…. Ok. Let me give you some data first. Since 2009 until now the net worth of the American households has increased by 49 trillion USD.
TV Host: Net worth of what?
Deltchev: Net worth of their assets, or with other words their wealth.
Based on this we have observed a pretty decent development of the American economy. Even the inflation rose above the target 2% set by the FED and it became necessary to calm down this positive development by increasing the interest rates.
Now, the Central Bank would like to keep the foundation for the positive economic development (the asset price appreciation). From other point of view, it can't afford high inflation.
So, the FED must increase the interest rates to prevent inflation. But when it does so, the asset prices react, as we have witnessed the S&P 500 plunged with 15% in December 2018. As mentioned FED doesn't want to see rapid decline in the asset prices. If this happens the FED will intervene in order to keep the asset prices at a certain level that will keep the consumer and business confidence at the necessary level for a solid economic development. The expectation is FED to decrease the interest rate with at least 25bp.
You see, there are two forces in opposite directions and FED must literally juggling to manage them.
I am expecting at least 25bp decrease in the interest rate during the upcoming FED meeting at the end of July 2019, maybe even 50 basis points. The reason is not only the decline of the S&P 500 index, but also the fact that the inflation is already at 1,6% which is below the set target of the FED. They don't need to fear too high inflation at this point of time and in May we have seen another decline of the index S&P 500 with 7% which is not positive for the economy.
Across the ocean, in Europe, we see low interest rates and expansionistic monetary policy, but we don't see significant growth.
TV Host: Exactly
Deltchev: This is based in my opinion to the worse demographic situation in Europe. We have discussed this in your studio already. The inflation is generated by the young people. When the young people are missing the consumption is not at this level that we might expect.
TV Host: It doesn't grow quickly.
Deltchev: That's right. But also, the young people are consuming without having produced anything yet. They consume entirely at credit. A person who is producing already, could consume the fruits of its labor and he/she doesn't affect the economy so much. But when a numerous young generation is entering the market for the first time, it wants to have immediately a new home, a car, a place at the university etc. And all this before they have produced anything and participated on the labor market. This causes overutilization of the production capacities in the economy and increased prices. This effect regulates over time of course. However, we don't see this effect in Europe and in my opinion, this is due to the really bad demographic situation in Europe. Brief the European Central Bank is also in a very difficult situation because it should stimulate the economy and to avoid too high inflation.
TV Host: We have discussed the situation in the USA, in the European Union, now let us move to the situation in Bulgaria. In the most recent history of our country the policy of the commercial banks is probably the most important factor influencing the movements of the real estate market. In this respect what are your expectations for the mortgage interest rates? This is something of interest for almost all potential real estate buyers.
Deltchev: Let us start with the interest rate level. Provided the large economies maintain low interest rate environment we in Bulgaria can't have much different levels of the interest rate actually. From this point of view, I am expecting the current low level of interest rates to continue and we might even see some further decreases of the interest rates down the road. It is possible.
Let me now come back to the first part of your question. Actually, the banks and the real estate are the two sites of the same coin. Few people realize this, but it is true.
TV Host: Why?
Deltchev: Because the real estate is very stable asset. The banks acknowledge it as such and they readily finance real estate. This is a significant difference to the other investment assets. You may try to finance your stock portfolio if you want to see the reaction of the bank. Even if you offer them their own stocks. You will see that it will offer you….
TV Host: Maximum 50% of the face value of the stock.
Deltchev: Yes, maximum 50% and I believe this is optimistic scenario. Unlike it the banks will offer you easily 70%-80% of the values of your real estate. In the hot phase of the property cycle the banks will even offer you 90% of the market value of the property. With other words the real estate accounts for a significant portion of the balance sheet of the banks. Consequently, the events on the real estate market determine to a large extend the health of the banks themselves.
From the other perspective the real estate is a capital-intensive investment asset. It needs financing for its proper development. Most people actually buy real estate with a bank financing. The pure 100% cash deals are few. In this respect the banks depend on the real estate market and the real estate market depends on the banks. These two segments of the market are in strong correlation.
TV Host: Mr. Deltchev, if we take a distance from the short-term fluctuations the real estate market experiences some long-term cycles. Where are we in the cycle at this moment? And what characterizes this phase?
Deltchev: Few people know, but there is a very stable cycle on the real estate market. It is 18 years. Small deviations of 1-2 years plus or minus are possible. However, the truth is that purely statistically since 1950 or since the end of the World War II the cycle works like a clock mechanism. It is exactly 18 years.
TV Host: And what can we read from this clock now?
Deltchev: The clock is telling us that we are at the end of the recovery phase and at the beginning of the boom phase. The interesting thing is….. The cycle itself is 18 years long which are divided in 4 years decline of the prices, 7 years recovery of the market and 7 years boom phase. The so-called boom of the market. The interesting thing is that both periods of 7 years always start with a development that actually misleads the market participants.
In the case of the 7 years of recovery of the market the initial 2-3 years are called Stealth phase, because you hardly can see the positive development of the market. The market has simple stabilized on a very low level, no further decline in the prices is observed…But nothing actually is happening. This is the period when bad debt collector companies come to the market and offer to buy the bad portfolios of the banks for 15-20% of the face value. We speak about portfolio purchases. Further down the road during the same 7 years the institutional players appear on the market. They know the cycle very well and realize that this is very good moment to enter the market. Now you can literally see and sense the recovery of the market. The last 4 years of this first period of 7 years could be so turbulent and dynamic (as they were actually in the USA) that they could cause significant price increases and increase of the interest rate. The increase of the interest rate causes (literally as a textbook example) a plunge of the stock market. We have actually witnessed one several months ago (December 2018). This causes a change in the policy of the Central Bank and prolongation of the low interest rate and its expansionistic policy.
This introduces the market in the second 7 years of the property cycle. At the beginning they start with a hesitant development. In the English-speaking literature, it is described as "Mid cycle dip". It last also 2-3 years. That's why I mentioned that I am expecting 1 more year of hesitant development of the market (we are in the dip now). The point is that we will see very abrupt upward movement when the hesitation of the market is over. It is not smooth and graduate as the exit from the big crisis. The exit from this small dip is rather quick and decisive. Then the last 4 years of the boom phase is what we remember from the period 2005-2008.
TV Host: We will barely see the same percentages and price increases, because many analysts have described it as the perfect storm. But you have described the long-term property cycle and some periods within it with negative development. How the people could tell if it is the short-term turbulence of the market or the big crisis. What type of indicators they should have in mind?
Deltchev: The short-term crisis during the property cycle are not related to the real estate itself in the most cases. They are not related to the banking sector. In the most cases they are related to quicker markets as for example the paper assets market. Basically, you should consider that the real estate market is extremely slow market. It is the slowest market actually that I know.
TV Host: Why is that?
Deltchev: Maybe because it is the largest market. It is incomparably larger than anything else that exists. The capitalization of all stock markets worldwide can't even compare with the total value of the real estate market. From this perspective the movements on this market come with a delay from one site and there are very slow from the other site. When the Central Bank take certain measures to stimulate the market, it is reflected in the real estate prices with a time delay that might reach 6-12 or even 18 months. So, I am not so convinced that the real estate market was heavily impacted by the higher interest rates in the USA during the last two years. I guess it will "recover" very quickly now after the change in the FED monetary policy.
TV Host: At the final of our discussion I would like to discuss some domestic factors that influence the property market in Bulgaria. From one site we have continuing increase of the households' income, record low unemployment and from other site we see activation of the real estate developers. Recently the national statistics reported record high number of permissions for new residential buildings. Is there a danger of oversupply?
Deltchev: For the moment "No", but with certainty there will be oversupply because we enter the boom phase. My expectations are that this oversupply will accumulate over the next years and will reach its highest point about 2024-2025 which together with the emerging problem in the banking sector will lead to the next crisis. What I mean under "emerging problem in the banking sector"? The banks could actually hardly escape this development.
I don't know if you remember in 2006-2007 we have witnessed increases in the credit in the whole banking sector in Bulgaria of more than 60%.
TV Host: It was significant, indeed.
Deltchev: 67%, the next year the figure was comparable etc. What does it mean? It means that the respective bank has significant part of its loan portfolio that is very young. The fact of a young portfolio means that it reflects the current market valuations and prices, which at the end of the boom are very inflated. When the crisis comes, exactly this young part of the bank's loan portfolio (which meanwhile could be more than 50% of the entire portfolio) starts to default*. The bank remains actually without collateral. If the price of the real estate drops with 25% and the bank has financed 90% of the market value the bank will literally remain without enough collateral. The bank starts to build drastically risk provisions, the asset quality as a whole deteriorates and so we could experience some bank bankruptcies. This is the way how we could see bank failures that we have discussed.
I want to give you some indicators that you could monitor to understand when the big crisis is coming.
TV Host: Tell us as conclusion.
Deltchev: The inverse yield curve is one of these indicators.
TV Host: What does it tell us?
Deltchev: It tells us that the short-term interest rates are higher than the long-term ones. If we have inverse yield curve it is almost certain signal that the economy is facing recession. This is one indicator. The other one that I would recommend to be monitored closely is exactly the aggregated increase of the loan portfolio in the banking sector. At the moment when the credit in the banking sector starts to grow with 50%+ percentages per annum and even 30% plus percentages p.a., it means the part of the young loan portfolio in the overall loan portfolio of the banks increases with very high speed. And this is a risk that in my opinion few banks are calculating. This is however the development that creates the highest risk for the banks in my opinion.
TV Host: Thank you very much for this commentary. Svetoslav Deltchev – expert in real estate and finance and former Managing Director of Immorent Bulgaria.
*Event of default: A banking term for an event that doesn't comply with the written loan agreement. In this case I mean the loans are stopped being serviced.