Andreas Dombret: The German real estate market - cause for concern?
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, to Haus & Grund Deutschland, Berlin, 28 January 2015.
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1. Introduction
Dear President Kornemann,
Ladies and gentlemen
It's a great pleasure for me to speak to you today. I gladly accepted your invitation to Berlin
given the important influence that you - along with the German tenants' association
"Deutscher Mieterbund" - have on the German real estate market. This is the first time I have
taken part in your panel discussion, although I did once address the annual meeting of Haus
& Grund in Frankfurt at the invitation of Mr Conzelmann.
I am therefore pleased to have this opportunity to explain the Bundesbank's perspective on
the German real estate market. Let us begin by taking a look at the economic situation in
general - after all, economic conditions impact strongly on the real estate markets.
2. German economy in good shape
The German economic situation is not as bad as some might think. On the contrary, the
German economy remains in good shape. Enterprises in Germany have their costs under
control, their debt is not particularly high, and they have an attractive range of products to
offer the global markets. Moreover, German economic activity is supported by consumption.
Unemployment is low, households are not burdened by excessive debt and real wages are
rising appreciably owing to low inflation.
In our December forecast we expect Germany's real gross domestic product to rise by 1.0%
this year and 1.6% next year. However, the price of oil has fallen sharply since we prepared
that forecast. If oil prices persist at their current low levels, economic growth could prove to
be markedly higher this year and next, since the low price of oil has the effect of a small
stimulus package.
At the same time, we have for quite a while now been witnessing very low inflation rates,
both in Germany and throughout the euro area. And we can expect them to continue for
some time to come. This undoubtedly poses a serious challenge for monetary policymakers.
After all, we seek to achieve for the euro area inflation rates of below but close to 2% over
the medium term. To help us move closer to this target, the ECB Governing Council last
Thursday adopted a programme for the purchase of government bonds.
As you know, the Bundesbank takes a critical view of this government bond purchase
programme. In our opinion, monetary policymakers are not under any acute pressure to act,
as the low inflation rate is mainly attributable to falling energy prices. For the next two years,
we are expecting inflation to pick up gradually; certainly, there is no sign of deflation.
What is more, government bond purchases are not simply a monetary policy instrument like
any other where the euro area is concerned. They entail risks which we believe are not
outweighed by the expected effects. At least the ECB Governing Council has agreed on a
number of constraints to curb balance sheet risks, so that there will only be joint liability for a
small portion of the programme. This will mitigate at least some of the problems which
government bond purchases entail.
However, this additional monetary policy easing could have undesired side-effects. For
instance, the low interest rates could encourage many investors, in their search for yield, to
turn to assets they previously avoided due to the associated risks. This makes the
emergence of price bubbles more likely, which could cause problems for the stability of the
financial system.
And the real estate market is one of those markets where a search for yield can lead to
exaggerations. That's why it is worth taking a closer look at this market.
3. Real estate markets - an important part of the economy
Price bubbles are always especially problematic when the purchase of the asset is financed,
above all, through credit. Real estate is a case in point. Residential mortgage loans account
for 43% of all loans to the private sector in Germany.
Property prices and lending can develop mutually reinforcing, destabilising feedback effects.
When prices in the real estate market rise, banks - in the assumption that this trend will
continue - may grant additional credit, fuelling price increases further. Of course, that only
goes well until the bubble finally bursts.
The faster and lower prices then fall, the more loans cannot be repaid. This compromises the
banks' profits and stability - and when the banks sneeze, the whole economy catches a cold.
The crises affecting other countries in recent years have made this patently clear.
Which is why we are watching the real estate market very closely indeed. And this begs the
question: do we see a price bubble in the German real estate market? Is there cause for
concern?
4. The current situation in the real estate market - no bubble
Three different circumstances would have to coincide for a price bubble to form in the real
estate market.
First, a self-sustaining increase in prices which leads to prices that are no longer
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justified by economic fundamentals
Second, excessive growth in mortgage lending
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• Third, an easing of banks' credit standards for mortgage loans
Let us then consider the threat of a price bubble by examining these three ingredients.
The first question is: do we see an excessive increase in prices? All in all, price dynamics in
Germany over the past 20 years have been moderate compared with the rest of the euro
area. However, we have seen prices climb fairly steeply in some parts of Germany since
2010 - although the rise in prices did slow down slightly in 2014.
Since 2010, prices have risen by an average of 7% per year in Germany's seven largest
cities. Housing prices have increased in medium-sized towns and cities, too, although only
by just over 5% per year. The equivalent figure for Germany as a whole is 3%. What we are
seeing, then, are marked regional disparities with regard to price increases.
Does that add up to a price bubble? For Germany as a whole, the answer is no. For the
years 2010 onwards, we cannot identify any growing, substantial overvaluation of housing.
The rise in prices reflects, at least in part, a catching-up process following a period of weak
price growth that persisted for quite a number of years.
However, we assume that residential properties were probably overpriced by as much as
20% in large and medium-sized towns and cities up to and including 2013, while overpricing
in the seven major cities was probably even somewhat more pronounced in 2013. Price
dynamics in the German housing market have, however, weakened appreciably.
To sum up: property price developments present a mixed picture, but the bottom line is that
it's not particularly worrying.
What about the second ingredient for a property price bubble: lending? First of all, it has
undoubtedly become easier to finance a property purchase thanks to high liquidity levels and
low interest rates. Today it's possible for investors to obtain funds at very favourable
conditions over a very long period. The weighted average interest rate for new loans over all
maturities is 2.3%. Another factor is the low returns on alternative investments, which are
encouraging some to seek a crisis-proof, ostensibly safe and higher-yielding investment -
turning real estate into what has been dubbed "concrete gold". Yet investors should always
bear in mind that higher yields are accompanied by higher risks.
Thus, the volume of mortgage credit to households has risen steadily since 2010, albeit
initially at a moderate pace. In November 2014, year-on-year growth was just shy of 21⁄2%,
and gathered pace in the last quarter in particular - in Germany even more so than in the
euro area.
On the whole, however, mortgage loans have not risen excessively. Purely in terms of
volume, banks' vulnerability has increased only slightly. Which brings us to the third
ingredient of a price bubble: the credit standards by which mortgage loans are granted.
Is the risk incurred by banks with new lending greater today than it was a few years ago? A
survey of 116 selected German banks conducted by banking supervisors provides a more
detailed picture. The survey in question focuses on 15 towns and cities where property price
increases were particularly strong and nine where they were about average in the period
2009 to 2013. The findings present a picture of the impact of the dynamic price trend on
lending activity.
And here, too, we cannot see any signs of trouble brewing. On the contrary, the banks report
that they did not ease their credit standards. Conditions were more favourable for some
customers due to the further decline in interest rates; the risk premiums that the banks priced
in remained stable, however. Ultimately, credit standards for loans to households for house
purchase remained unchanged in Germany, while they were eased slightly in the rest of
Europe.
Yet this does not mean we can unreservedly sound the all-clear. This is because the special
survey also reveals a fairly large share of loans with what we might refer to as high German
sustainable LTV ratios (Hochausläufer) in the "attractive towns and cities" segment. With
such mortgages, the loan is greater than the mortgage lending value, that is the value the
bank calculates in respect of the property serving as collateral. Loans of this kind do not
necessarily give cause for concern in each and every case: the borrower's high level of
available assets or income can have a risk-mitigating effect. Nevertheless, the fact that such
loans account for a large share of all mortgages does indicate that there might be structural
vulnerabilities in the German banking system to crises on the real estate market.
The German Pfandbrief Act (Pfandbriefgesetz) restricts the German sustainable
loan-tovalue ratio (Beleihungsauslauf) to 60% of the mortgage lending value for loans that are
eligible as cover for mortgage Pfandbriefe. However, it is of limited effect as only one-tenth of
residential mortgage loans are used to collateralise German mortgage Pfandbriefe. Building
and loan associations implicitly limit the German sustainable LTV to 80%. Nevertheless,
there is a lot of scope for mortgages with high German sustainable LTV ratios. Banking
supervisors will be taking a closer look at this in future.
5. A look ahead - potential dangers
Ladies and gentlemen, we have taken a look at three criteria for property price bubbles: price
trends, lending and credit standards. And none of these point to destabilising developments.
But the ECB's decision to purchase government bonds on a grand scale has marked the
beginning of a new era on the capital markets and we must bear this in mind. Liquidity is
rising and interest rates are falling. Yet this means that there is also an increased risk of
asset price bubbles - not least on the real estate market. The world has thus become a
rather more dangerous place for property investors.
The situation on the real estate market also hinges on the currently relatively favourable
macroeconomic environment. If macroeconomic conditions were to deteriorate and the
default rates for residential mortgage loans were to rise, German banks would stand to make
considerable losses. This is the conclusion that banking supervisors drew from the special
survey that I mentioned earlier.
We simulated various scenarios and found that, given an isolated shock on the real estate
market, banks would still be able to meet regulatory capital requirements. If the banking
environment were otherwise favourable, banks could compensate for an isolated shock of
this nature with profits in other lines of business.
However, an isolated shock on the real estate market is rather unlikely. Empirical studies for
the United States and other OECD countries instead indicate that real estate markets and
macroeconomic developments are closely interlinked.
And in the event of a recession that extends beyond the real estate sector or even of a
general financial crisis, cumulated losses could considerably impair banks' internal capital
adequacy. My colleague on the Executive Board, Claudia Buch, mentioned this back in
November 2014 when we presented the Bundesbank's latest Financial Stability Review.
Looking further ahead, there is yet another danger looming that we must keep in mind: the
possibility of an interest rate reversal. To address interest rate risk, borrowers are
increasingly opting for long-term loans with fixed interest rates, while banks are able to
adequately hedge against risks arising from these longer interest rate lock-ins.
Nevertheless, both investors and banks must use the current low-interest-rate environment
responsibly. And of course we should not forget that hedging against interest rate risk comes
at a cost to banks. As a rule, loan contracts should only be signed if borrowers can continue
to repay them even at higher rates of interest.
And, in light of current events, there is another danger that we should not overlook - that of
foreign exchange risk. The discontinuation of the minimum exchange rate for the Swiss franc
and the subsequent appreciation thereof may create difficulties for borrowers who have
taken out property loans in Swiss francs. If default rates were to rise, banks could run into
difficulties.
However, unlike in Austria or Poland for example, loans in Swiss francs play only a minimal
role in Germany. According to current figures, property loans in Swiss francs account for only
around €2 billion of the entire volume of property loans of over €1,000 billion in Germany. We
thus see no need to be overly concerned.
6. What can we do?
Even though the risks emanating from the real estate market currently appear to be low, we
must still be prepared for all eventualities. Financial supervisors need to be prepared in case
a bubble should emerge on the real estate market.
It is thus crucial that we have tools at our disposal to contain the corresponding risks. This
means that, in the end, it will be up to the central banks to step in and spoil the fun just as the
party is in full swing.
Over the past few years we have begun putting together such a toolbox. We are currently
closely examining a number of new tools to ascertain the precise effect that they would have.
However, before we can use such tools, we need a fitting legal basis. The central body for
systemic financial supervision in Germany, the Financial Stability Committee, is working on
this at the moment. In the next few months, it plans to present the Federal Government with
recommendations on establishing a legal basis for the use of these instruments.
However, elected politicians are also currently planning measures which I believe are
headed in the wrong direction from an economic perspective. The cap on rents that is to be
introduced in the near future aims to protect tenants in "overstretched housing markets"
against sharp rent increases. Wealth distribution considerations are clearly the prime
motivation for this move.
From an economic perspective, however, the measure is problematic as rising property
prices are a sign of scarcity. They create an incentive to build new properties and thus
increase the supply of housing. Regulatory intervention weakens this mechanism and thus
ultimately prevents our society from having access to sufficient and affordable housing.
From an economic perspective, I therefore do not believe that the cap on rents is a suitable
means of combating potential excesses on the real estate markets. The same is true of
political initiatives to limit the conversion of rented apartments into owner-occupied
apartments. This would constitute a major intervention into property rights and would make it
more difficult for existing tenants, who have the right of first refusal, to own property.
7. Conclusion
Ladies and gentlemen, let us conclude. We started with the question: Is there currently a
price bubble on Germany's real estate market? For Germany as a whole, the answer is no.
We do not believe the current price increases to be problematic, lending is not rising
excessively and credit standards have not been eased. Based on these three criteria, we do
not consider there to be a property price bubble.
But, ladies and gentlemen, experience from other countries has shown that high liquidity and
low interest rates create an environment which is often conducive to the formation of asset
price bubbles. Thus the likelihood grows over time, and the ECB's purchase of government
bonds will only fuel this growth further. There is no storm raging now but the winds are
picking up, and last week the work of banking supervisors became yet more challenging.
But as Adam Posen, President of the Peterson Institute, said last week in an interview:
"Germany must not take the rest of Europe hostage just to fight a bubble on its own housing
market". Instead he advised banking regulators and supervisors to address the problem
directly. And that is precisely what we shall do.
However, each and every investor is ultimately responsible for being risk-aware in their
actions. And, according to a survey by Ernst & Young, the vast majority of property investors
expect risk appetite to grow.
I would caution against increasingly turning to risky investments to obtain that bit more profit
while interest rates are low. At some point, interest rates will rise again, and then the financial
burdens stemming from property loans will not be the only thing to increase. Both borrowers
and lenders have a duty not to ignore this risk. In the current environment, banks should
exercise particular caution when granting property loans.
The Bundesbank will fulfil its responsibilities. We will continue to closely monitor the real
estate market, mortgage lending and the banks granting these loans and take action as soon
as necessary.
Thank you very much.