Mortgages: limits of the permissible

MORTGAGE LENDING MARKET TRENDS

• Russians are continuing to take out loans to buy residential real estate, despite the fact that interest rates are actively growing and prices are not declining. This has been a record year in terms of mortgages issued. In 10 months of 2023 alone, the volume of the mortgage portfolio in Russia grew by RUB 3.5 tln, or 25%. The hiking of the key rate, which among other things, intended to restrain the mortgage boom, has on the contrary further stimulated mortgage issuances, the increase in the number and volume of which is, of course, associated, among other things, with banks and developers using various tools to artificially stimulate demand.

• In their current guise, preferential mortgage programs have resulted in explosive growth of real estate prices, and, as a result, to lower affordability of housing, especially for citizens with below-average incomes. Far from all citizens and families who are in need of housing were able to take advantage of these programs prior to the mortgage boom as they did not possesses enough funds to cover the mandatory 15% down payment.

• Increasing the size of the down payment — one of the adjustments to preferential programs — will lead to an even greater reduction in the affordability of housing among the population. At the beginning of 2020, it was necessary to have savings in the amount of 15% of the cost of housing in order to make the down payment, but now — taking into account the rise in prices — on average in Russia a buyer needs to cover around 50–60% of the cost in real estate prices as of the beginning of 2020 (40–50% in Moscow). Furthermore, inflation (especially for essential goods and services, which form the bulk of family budget expenditures) largely eats up the positive effect of citizens’ income growth.

• The exacerbation of the housing availability problem needs solutions. It is likely that one will be the construction of social housing for citizens of special, mainly preferential, categories. At the same time, if budget funds are not used, there is a high probability of active development of the rental market due to the fact that those who managed to purchase real estate for investment purposes (and not to improve their own living conditions) before the rise in prices will rent it out to those who did not.

• The quality of the mortgage portfolio remains high (the share of overdue debt was no more than 0.4% as of November 1, 2023). However, ACRA notes a slowdown in borrowers’ early repayment of mortgage loans from August to October 2023, amid growth in deposit interest rates.

• The continuation of preferential programs in their modified form will result in the mortgage portfolio growing within 10–15% in 2024. It is highly unlikely that these programs will be canceled after July 1, 2024 due to the substantial contribution of the construction sector and related industries to Russia’s GDP. At the same time, in order to put an end to the mortgage boom, a gradual winding down of existing programs while maintaining the social focus for preferential categories of citizens, regardless of where they live in country, would be an optimal exit strategy.
  
  

WHEN NEW RECORDS REPLACE OLD ONES

Contrary to normal logic, 2023 will be a record year in terms of issuing mortgage loans. In 10 months of 2023 alone, the volume of the mortgage portfolio in Russia grew by RUB 3.5 tln (+25%). For comparison, growth in 2022, 2021, and 2020 amounted to RUB 2 tln (+17%), RUB 2.5 tln (+26%), and RUB 1.7 tln (+21%), respectively. Previously, such dynamics were viewed as extremely aggressive. Citizens continue to take out mortgages, despite the fact that interest rates are actively growing and prices are not declining.

The current main factors of active demand are: 1) citizens’ desire to prevent depreciation of their savings against the backdrop of growing inflation, 2) the population’s need to improve housing conditions, 3) the desire to purchase housing using a mortgage before the next increase in interest rates and the down payment and/or while preferential programs and developers’ promotions are in effect, 4) decreased interest in savings in dollars and euros due to the strengthening of the Russian ruble, as well as in speculation in the securities market.

Figure 1. Mortgage issuance is growing despite higher rates

* Besides mortgages for secondary real estate, non-SCPAs¹ include loans for ready housing sold by developers using state support and mortgages for single-family homes.
Sources: Bank of Russia, ACRA

¹ Shared construction participation agreement

Paradoxically, the higher the rates offered by banks, the higher the demand. The frenzy observed in the mortgage lending market is causing more and more concern every passing month. The Bank of Russia also sees risks in these trends, however, the regulatory measures that it took in the past have not created the desired effect. The increase in the key rate, designed, among other things, to curb the mortgage boom, on the contrary, increasingly provoked and continues to provoke lending, which, of course, is also happening through the use of various tools to artificially stimulate demand. For example, a number of major mortgage lenders strived to maximize issuances prior to the hike of the macroprudential buffers on October 1, 2023 by using their ability to offer rates at below the market level. Active demand was also facilitated by the actions of developers, who, in order to prevent a decline in the value of real estate properties, created an artificial housing deficit (by offering apartments for sale in small groups only) and also proposed various ‘beneficial’ discounts. The consequences of these actions — further growth in the price of housing, and, as a result, its lower affordability for the population — are asocial, although from a business point of view they are completely justified.

WHO IS PAYING FOR ALL THIS?

The steady hiking of the Bank of Russia’s key rate from the end of July 2023 by more than two times to the current 16%, besides other things, puts pressure on the state budget due to the fact that, under the preferential mortgage programs, the amount of ‘compensation’ for income lost by banks provided by the state indirectly depends on the level of the key rate. Therefore, part of taxpayer money goes toward covering the different between the market and preferential rates². The main beneficiaries of this are banks and developers.

Preferential programs in their current form have provoked sharp growth in real estate prices, which, in turn has led to a decline in the affordability of housing, especially for citizens with below-average incomes. Mortgages at a low rate were largely taken advantage of by investors who purchased several properties at once, or by citizens who, even without preferential rates, could afford high-quality debt from banks. At the same time, far from all Russian citizens and families who are in need of housing were able to take advantage of these programs prior to the mortgage boom as they did not possesses enough funds to cover the mandatory 15% down payment. While families/citizens who indeed need to improve their living conditions were saving up for their mortgage down payments (although some took out consumer loans for this purpose, which made their debt burdens especially high), housing prices grew rapidly to the point that even the preferential rate became economically unfeasible for borrowers (in terms of the size of the monthly payment). Taking into account inflation and the rising cost of home improvements, the social effect of the implementation of preferential programs is very ambiguous.

In order to stop the mortgage wheel from spinning, a modified form of the preferential programs was launched on December 23, 2023³, and conditions for provision of mortgages are now stricter. However, fires are always easier to prevent than to put out, so side effects will also come into play.

In particular, the size of the down payment for all preferential programs is being increased to 30% (with the exception of family mortgages, which has been kept at 20%). At the beginning of 2020, it was necessary to have savings in the amount of only 15% of the cost of housing, but now — taking into account the rise in prices — on average in Russia a buyer needs to cover around 50–60% of the cost in real estate prices as of the beginning of 2020 (40–50% on average in Moscow). Household incomes have, of course, also increased, but the rate of their growth is not comparable with the increase in the cost of housing (since the beginning of 2020, i.e., over 3.5 years, the cost of primary real estate in Russia as a whole has increased by 88%, and in Moscow by 52%). We should also not forget about inflation (especially for essential goods and services that make up the bulk of family budget expenditures; spending on food alone, on average in the country, accounts for around 33% of consumer spending), which largely neutralizes the entire positive effect of growth of citizens’ incomes. In the context of higher down payment requirements and the increased cost per square meter, mortgages are becoming less and less affordable for the average citizen. Rising interest rates, in turn, make monthly mortgage payments even less comfortable.

² In September 2023, the maximum amount of subsidies received by creditor banks under preferential programs was reduced by 50 bps.
³ A complete termination of preferential programs seems inappropriate due to the significant (about 8–10%) contribution of the construction sector and related industries to the country’s GDP.

Table 1. Mortgage down payment, in 2020 prices

Another modification under consideration is the maximum allowable debt-to-income ratio (DTI), which, taking into account the preferential loan, should not exceed 50%. However, this requirement may further reduce the chances of the average Russian citizen obtaining a mortgage loan due to the financial constraints applicable to the borrower.

Demand for mortgages in the secondary housing market has been declining since August 2023 mainly due to rising interest rates. The still valid preferential rates on mortgage loans in the primary residential market look more attractive to borrowers against the backdrop of the average minimum rate for secondary real estate, which, according to ACRA’s estimates, was 16–17% at the beginning of December this year. In this regard, the current share of mortgages for primary real estate slightly exceeds half of the total volume of mortgage loans. Most likely, this situation will remain as long as the preferential programs continue to have such a large-scale nature and the key rate is high. The secondary real estate market will regain popularity after the preferential programs become more focused and rates begin to fall. An opportunity to move into an apartment or house straight away is often important to borrowers. In addition, in the case of secondary market properties, there is no objective need to make repairs, which also saves borrowers’ money and allows them to service mortgage loans better.

At the same time, it is worth noting that the currently noticeable increase in interest rates on mortgages for secondary market properties does not lead to an increase in the monthly mortgage payment mainly due to the longer effective periods of issued mortgage loans. The absence of DTI growth allows banks to maintain loan issuances.

At the end of Q3 2023, the average price difference for new and secondary market real estate in Russia was 42% (while before the start of preferential programs, as of April 1, 2020, it was as low as 17%)⁴. After the Bank of Russia’s key rate begins to decrease (according to our expectations, in H1 2024), this difference will begin to shrink; however, most likely, the price growth of secondary market properties will be much higher than the correction in the primary real estate market. Therefore, all other things being equal, home affordability, which has decreased on the back of preferential mortgage programs that have affected not only the primary market, but also the secondary real estate market, will not increase in the future. The way out is likely to be the construction of social housing, which will be granted to citizens of special categories, mainly welfare beneficiaries. Another way out, but without using budgetary funds, is likely to be the fast development of the residential rental market, since those who managed to purchase homes for investment purposes before the rise in prices will rent them out to those who were unable to improve their housing conditions.

and what about lenders?

It is noteworthy that the quality of the mortgage portfolio is not deteriorating: the share of overdue loans remains low (no more than 0.4% of mortgage loans as of November 1, 2023). Of course, this is explained by the portfolio growth outpacing the growth of overdue debt (over the past 12 months, by 30% and 4%, respectively), as well as by a significant proportion of borrowers with a low DTI. As mentioned above, due to the weak focus, preferential mortgages were and continue to be in high demand among a fairly well-off part of the population, which also improves the quality of the portfolio of mortgage loans.

A factor that may negatively affect the portfolio quality to some extent in the future is the slowdown in early repayment of mortgage loans observed in August to October 2023 (according to ACRA’s estimates, such a low rate of early repayments has not been observed for at least the last three years). At the same time, banks have grown their mortgage portfolios in expectation of relatively rapid early repayments (the average repayment period of mortgages was about seven years).

The slowdown in early repayments may indicate that it has become more profitable for borrowers to hold temporary free cash in banks, especially if the mortgage was granted at a preferential interest rate, since the increase in interest rates affected the profitability of bank deposits and current accounts. However, at present this factor does not cause concerns in terms of deterioration of the mortgage portfolio quality since it is not significant for banks. The intensity of early mortgage repayments will increase as soon as the key rate goes down. More tangible negative consequences are possible if the slowdown in early repayments is associated with an increase in households’ expenses for essential needs, including due to rising prices, which simultaneously leads to an increase in DTIs.

Figure 2. Early repayment is not beneficial at high rates 

ACRA expects the life of mortgage loans to increase regardless of the above factors, since borrowers who have obtained preferential loans will have insufficient incentive to repay their mortgages early (the higher the proportion of such loans, the longer the real depreciation period of the portfolio). Borrowers who have taken out subsidized mortgages at or slightly above zero percent will have even lower motivation, since inflation is likely to exceed these rates. In addition, mortgage borrowers have already ‘paid’ for this rate by purchasing a home at an inflated price. To do this, they had to apply for a loan with the longest possible effective period and choose a smaller apartment and, possibly, of lower class and/or in a cheaper location.

The Bank of Russia, in turn, draws attention to the risks of deterioration in the quality of the mortgage loan portfolio, which is traditionally one of the least risky banking products. The regulator notes that fast growth of mortgage loans was accompanied by an easing of banks’ requirements for borrowers. In particular, according to the regulator, the share of mortgage loans granted to borrowers with DTIs of more than 80% has almost doubled in the past two years, and approached 50%, while loans with a small down payment (up to 20%) exceeded half of all mortgage loans issued in Q3 2023. This situation is most likely a consequence of the steps that banks have decided to take in the face of rising rates and tighter macroprudential standards. Not wanting to lose profits, credit institutions and developers have again resorted to artificial stimulating demand among the population.

Sooner or later, the easing of requirements for borrowers and the accumulation in the banking system of mortgage loans issued to borrowers with high DTIs and/or loans with low down payments will certainly lead to a deterioration in the quality of the loan portfolio. However, the extent of the problem will not threaten individual banks or the banking sector as a whole as long as housing prices are not allowed to decrease in one way or another. This situation is not beneficial to banks, developers, property owners, or the state. It is beneficial only for those who have not yet managed to buy their own home, but still hope to do so.

A PLEASANT HARMFUL ADDICTION

A complete end to the preferential mortgage programs is extremely unlikely after July 1, 2024. Their extension will allow banks to increase mortgage portfolios next year within 10–15%. At the same time, mortgage programs will become more focused, which, coupled with stricter requirements for borrowers, will negatively affect the volume of mortgage business (however, the effect will manifest itself in the longer term, but for now — at the end of 2023 —banks, developers, and borrowers, strive to make deals as soon as possible).

In the scenario of cancellation of preferential programs, there is a risk that the difference between mortgage rates for primary and secondary market properties will become minimal. Considering the fact that, all other things being equal, the advantages of new residential properties are not enough to pay 1.5x more per square meter than for previously-owned homes, the price of newly constructed residential buildings will begin to decrease. At the same time, prices for secondary housing will increase due to rising demand. The longer the preferential programs are in effect, the more difficult it will be to stop them. The best way out is a further smooth curtailment of the programs while maintaining socially oriented areas for subsidy beneficiaries regardless of their home region in Russia.