Authors: Vicente Nieves/Javier Barriocanal

Source: El Economista

Change is in the air for the real estate sector. Recently, there has been a cascade of warnings (from the ECB, Bank of Spain, etc.) about a shift in the real estate market, driven by sharp increases in interest rates and economic slowdown. The latest organization to join this chorus is the International Monetary Fund (IMF), which warns of the risk of a “sharp” correction in housing prices, especially in economies where variable-rate mortgages are more prevalent, such as Spain, where variable-rate mortgages have historically been significant.

Since the end of the 2007 financial crisis, housing has enjoyed a global cycle of rising prices, which has intensified in recent years due to lower interest rates, economic recovery post-pandemic, and changes in household preferences (which placed greater importance on housing during COVID-19).

Now, many of these factors are reversing or at least losing their impact. The pillars that have supported rising housing prices are shaking, and some economies are already experiencing initial corrections, while others are showing clear signs of slowdown.

“As central banks around the world aggressively tighten monetary policy to address price pressures, rising borrowing costs and stricter credit standards, along with high housing valuations, could lead to a sharp decline in housing prices, especially in countries with a higher proportion of variable interest rates in mortgage debt,” warns the IMF’s Financial Stability Report.

A Market Turnaround

The IMF highlights the rapid pace of these changes. In recent years, the economy and all indicators seem to have turned into a rollercoaster: from the sharp economic decline during COVID to the strong recovery of 2021; from the deflation of 2020 to the high inflation of 2021 and 2022; from historic highs in stock markets to this year’s declines; and from historic increases in housing prices to the looming threat of a significant correction.

The IMF report explains that the transmission of tighter monetary policy and higher interest rates to residential mortgage markets has been very swift in the U.S., with the average 30-year fixed mortgage rate reaching highs last seen in 2008.

In other countries, global growth in real housing prices had already moderated by late 2021, with substantial differences between and within regions. For example, real housing price growth (adjusted for inflation) was around 11% year-over-year in Central and Eastern Europe in Q4 2021, while it was significantly lower in emerging regions of Asia, Latin America, and the Middle East and North Africa.

The IMF warns that declines could be very sharp: “In a very adverse scenario, real housing prices could fall by nearly 25% in emerging markets over the next three years. In advanced economies, real housing prices could drop by more than 10%,” the report concludes.

“These risks could be greater in a scenario of strong tightening of global financial conditions, which could increase the likelihood of a recession in the coming years,” say IMF economists. Tobias Adrian, IMF Financial Counsellor, notes that “risks to housing markets are rising… Many potential borrowers are being pushed out of the market. Housing valuations could adjust sharply in some market segments,” he warns.

Lower Financial Risk

Despite this, the overall risk to the financial sector seems contained. Even if housing prices correct, it does not appear that the real estate downturn will lead to a total financial crisis like the one in 2007-2008. Today, banks’ balance sheets are more resilient, and household debt is lower than it was back then, so the economy is expected to withstand a correction in housing prices.

“Although the severity and macroeconomic implications of a shock originating in the housing market will crucially depend on the degree of correction in housing prices and the distribution of household debt, some key mitigating factors are the stronger capital position of banks and more conservative lending standards since the global financial crisis,” the report says.

“As a result, the potential spillover effect through the banking sector in the event of a major housing price correction is likely to be more limited than in previous recessions. That said, risks may be emerging in other parts of the housing sector, especially in the United States, where non-bank financial institutions have begun to play a more significant role in the securitized mortgage market,” concludes the IMF.

Beyond Real Estate

Not only housing will pose a risk to financial stability. The tightening of monetary policy is testing the entire constellation of risky assets in financial markets. “Financial vulnerabilities are high for governments, many of which have rising debt, as well as for non-bank financial institutions such as insurers, pension funds, hedge funds, and investment funds,” warns the report.

The increase in interest rates has added to tensions in certain segments of the financial market. “At the same time, the ease and speed with which assets can be traded at a given price have deteriorated in some key segments due to interest rate and asset price volatility,” says Tobias Adrian. He explains that “this market liquidity scarcity, along with pre-existing vulnerabilities, could amplify any rapid and disorderly reassessment of risk.”