Housing Price Increase: Myths and Reality

I would like to start this discussion on housing prices with a phrase which very aptly describes current situation: “Chaos theory reads: the more uncertainty there is the more people are susceptible to market trends and the more is speculation the more uncertain becomes the situation”.

So what is in reality happening in the market and what is the real price of the estate property today? What are the prospects and prognosis? These questions concern buyers and potential investors. To clear the situation one should separate real and imaginary factors which influence price formation and only then prognosis can be done. Let’s start with the myths.

First Myth. The manifold increases of the cost of construction materials and consequently the cost of construction is a result of the increase of the energy prices, in particular gas.

We all remember the New Year stand-off between Ukraine and Russia and results of the negotiations according to which the price of natural gas was doubled from $50 to $95 per 1,000 m3. What was the reaction of the construction market? To find out the answer let’s look at the official documents and clarifications provided by the Ukrainian Ministry of Construction, Architecture, Housing and Utilities (hereinafter referred to as Ministry). All changes of the prices, norms, expenditures, statistical indicators, etc. are provided by the Ministry in periodical publications, namely digests “Construction Price Formation”. 28 December 2005 the Ministry issued an order on approval of the indexes of the indirect cost of the housing construction in the regions of Ukraine as of 1 January 2006. For instance, in Kyiv region such cost constituted 2,184 UAH per 1 m2 and in May this figure has increased only by 200 UAH and constituted 2 384 UAH per 1m2. Moreover, this price does not include cost of the purchase of the building site, external mains, relocations, project improvements, expensive lift equipment and others however none of the abovementioned materials is not in connection with gas price. It is generally accepted that price structure consists of two elements, in particular salary which is one third of the price and materials and equipment which is two thirds of the price. Thus, an increase of 100 % in gas prices produced an increase of less than 10% in the cost of construction materials.

Second Myth. Growth of demand for housing exceeds supply in many times.

In order to address this issues let’s examine statistic data. As of 01.06.05 the population of Kyiv was about 2,6 millions. This is the only city which had population growth in first half of 2006 equal to 5,600 people (0, 21%). Let’s suppose that the same number of people moved to Kyiv in the second half of the year. Accordingly the total annual growth of the population constituted 15,000 people.

On the other hand, according to the prognosis of the building companies approximately 1,4 millions of m2 of the housing would had been constructed and put into operation by the end of 2006. A simple calculation (average area of the flat for a family consisting of two or three people is 90 m2) shows that housing market supply is capable of satisfying housing demand of not less than 30,000 people annually.

One should not forget about housing queue of the low income people which are not able to purchase housing by their own money. However according to the Mikhail Golitsa, chief of the Main Office of the Housing of Kyiv City Administration, during the last three or five years housing queue has not increased, vice versa it has been reducing.

As for the economic component of the exceeding of the demand over the supply and as consequences formation of certain “deficit”, i.e. impossibility to purchase goods (which is an apartment in our particular case), opposite situation is observed. Acquisition of the housing at the primary market is absolutely accessible. Moreover, one can freely reserve a flat, sign a contract and buy a flat in the building which is under construction. The only issue may be your requirements and possibilities.

Third Myth. The effective mortgage mechanism has made it possible to take mortgage easily which provides another way of real estate acquisition. Thus, demand and consequently prices have increased.

One can talk about effective mortgage mechanism provided this “mechanism” is available from all banks and with regard to all projects. Otherwise, only separate mortgage deals are concerned. Indeed, banks offer mortgages only for certain buildings enlistment of which is provided by the very banks. As a rule, banks have particular interests in these specific buildings.

To start up a mortgage program developer concludes a general agreement with the creditor bank. The bank conducts audit of the documentation related to the permission for the commencement of the construction works only. At the same time the bank does not care whether the cost of mortgage is overstated since the estimate is based on market analogies. The larger is the sum of the credit and the longer is the term of the repayment the larger are dividends received by the bank. In case of the failure to pay off the mortgage bank is entitled to repossess not only the property for which mortgage was granted but as well the other property of the owner up to the full extinguishment of the owner’s debts.

Fourth Myth. Construction companies force up the prices.

This may sound quite strange however often builders are unconscious participants of the price rise. At the same time such price rise is not always what they want. Many companies suspend sales until the clarification of the facts. However when the companies see that buyers (potential investors) are ready to overpay for the same area voluntarily they rise the prices. Administration of the company cannot find reasonable explanations of such price rise however business rules and excess profit always override other considerations.

From outside, it resembles imaginary situation when you come to the shop short before it is closed and you find out that for instance all bread was sold out. Panicking you suggest larger price for the goods. Puzzled seller concludes with you sort of futures contract on the sale of bread on the next morning at the increased price though. You leave the shop happily and the seller still in a puzzle and with a smile on his face calculates unexpected profit. Next evening the same situation repeats with another buyer and with due regard to the previous price.

Fifth Myth. Purchase of real estate is a profitable and reliable form of the spare capital investment.

Indeed, this statement is not disputable if not to take into consideration fact the real estate is purchased at a fortiori overstated and not always rational price. In case your investment is one-way transaction, i.e. only investment of the money without possibility of its return then such investing is no-regret situation in any circumstances. However if you consider a possibility of the refund you have to be ready for some failures.

Sixth Myth. Legalization of the revenues attracts criminal funds into the construction market.

This is quite fair assumption provided legalization relates to the transactions of dozens of millions of dollars and supposes subsequent quickest return of “legal” funds into turnover. It is much easier and safer to commence new construction (mostly of industrial projects) which legalizes incomparable large sums than buy up hundreds of apartments with uncertain time of its turnover and unclear possibility of money refund.

What are the real reasons influencing price increase at the Kyiv real estate market?

Weak legislative base and complete inaction of the state which is principal actor of the construction market was and still remains primary reason influencing price rise.

Even today there are no precise and transparent mechanisms which would allow all market actors to operate under the same rules. From the moment of the allotment of the building site till the moment of endorsement of the project and receipt of the permission for the construction and installation works builders are under different starting conditions. And all that is left in that processes is the title of the construction market but nor the economic content of that notion.

Another component of the price rise is progressing corruption of the deputies of local self-governing bodies and officials involved in the land administration. It is not a secret that majority of the land lots and real estate property is sold to the representatives of the deputies or their relatives. Often land is allotted to the hastily registered limited liability companies which consequently are sold. Moreover, often the sold land parcels are not suitable for any kind of construction.

Great number of unprofessional and incorrect comments as well play their role in whipping up public hysteria. Such comments significantly influence general psychological state of the customers complicating already not a simple situation. As a result of the absence of arguments such “experts” base majority of their prognosis and conclusions on the analogous situations in neighbouring countries, examples of price dynamics during last years, and sometimes they talk about some sort of fantastic influx of homeless millionaires from eastern countries, etc.

One can also come across conclusions which go completely against logic. For instance, director of quite large and famous company which is specialized in the development of the residential and office real estate explains that price rise is due to the underdevelopment of the securities market. He adds also that “none of the reasonable people will invest funds into any securities. Real estate is a good alternative for the capital investment”. At the same time he forgets that today in fact all the acquisitions at the primary housing market are carried out exclusively through the interest-free bearing bonds which essentially are nothing else but securities.

What is in fact happening to the market?

Indeed enormous capacity of the construction market and demand for the civil construction accumulated through the decades had made this segment of economy most attractive for the investors. Operations on sale and purchase of the real estate and playing off the differences in prices have become a separate business with all pertinent components including advertisement. Roles of all the market actors are assigned and are well-known.

Profitable sale of goods is obtained by the owners through the maintenance of permanent demand for it or creation of a “shortage effect”.

Brokers and real estate companies become real estate promoters commenting on increasing demand for housing. At that they are only information sources which do not have any data or knowledge about future plans of the owners of this business. Ordered articles and commentaries substantiating price rise are in fact the instruments used for demand generating.

Role of the financial centers is performed by the bank institutions. Real estate transactions have enabled banks to distribute their assets successfully, to attract additional loans at the external markets and at the end to create a win win lottery which involved great number of people.

Granting loans for the real estate at a fortiori overstated price once again creates an illusion of reality of these prices. Default of the paying capacity of the population and of the possibility to maintain a loan can bring a lot of troubles for the very banks. History of the last years showed number of examples of failure of different financial schemes however people believe in what they want to believe and do not pay any attention to the many evidences which prove the opposite.

Third participant of this complicated and successful process are construction companies themselves. Having slightly increased the construction production costs and obtaining guaranteed amount of the profit they have become simple observers of “ultimate fighting”. An established and launched mechanism itself brings fantastic revenues forcing periodic sale suspension for another price correction.

Final and most important actors of the psychological race are the buyers themselves. Buying an apartment each of us strongly believes that our particular apartment is of the best value in its range and the most promising and in the near future there will be an opportunity for earning hundred of thousand of dollars for its resale. According to the decision of city authorities 15 % of constructed area will be obligatory transferred into the city ownership, then it will be sold and received money will be used for the construction. This information may show that not only you have doubts about real cost of the housing.

To conclude if we consider real estate transactions and playing off the price differences as separate business we should remember that success can be gained with the knowledge of the laws and rules of the market, its trends, with ability to predict and manage these components. Otherwise you have to be aware of another component which is risk.

If by chance you have found out that you luckily possess couple millions of dollars and you still rent an apartment or a room in the dormitory, you have to change this situation immediately - buy an apartment at any price, at the end of the day this will not affect your state.

[ "Commercial Real Estate UA ” # 7 December 2006 ]

 

Other publications:
Housing Construction Through the Purchase of Bonds. It Is Not That Simple.
Is Real Estate Management Necessity or Luxury?
How to Avoid Fraud during the Construction of Your House
Structure of the General Contract on Work and Labour
Peculiarities of the General Contract on Work and Labour