Risks associated with real estate and mortgages (2024)
Due to the current environment and the rise in property prices over many years, the risk of overheating on the market remains high. The biggest risks for the institutions supervised by FINMA are in the areas of credit risk and market (i.e. valuation) risk.
Mortgage lending by banks in Switzerland continued to rise and reached around CHF 1.2 trillion in June 2024; growth rates in the investment property segment are still higher than in the residential segment. Insurance companies and pension funds also engage in mortgage lending, but their market share is low at 3% and 2% respectively of the overall mortgage market. Insurance companies’ market share has even been declining for several years. However, life and general insurers generally increased their exposure to real estate in the low interest rate environment of recent years. The volume of mortgages amounted to 24% of the investment portfolios for life insurers and 8% for general and health insurers. Life insurers therefore have a substantial exposure. In addition, real estate funds also invest directly in property. 75 Swiss real estate funds with net assets of CHF 68.45 billion are currently under FINMA’s supervision. The Swiss real estate funds mostly invest in Swiss property.
Mortgage credit risk is two-fold:
Firstly, there is a risk that customers are unable to meet their interest and amortisation obligations, resulting in a credit default for the lending institution. The risk of default is higher when affordability is worse, i.e. the higher the ratio of ongoing expenses (interest, amortisation and living expenses) to the borrower’s income. Principlesbased regulation of the affordability calculation has led to banks having considerable leeway with the affordability criteria, as they can define these themselves. For example, FINMA frequently observes that the projected interest rate is set too low or the affordability limits too high. This can mean that the banks overestimate borrowers’ credit capacity. On top of this, many banks grant too many ETP loans, i.e. loans that are outside their own lending criteria. These are loans that are granted even though the borrowers’ financial assessment deems them to be not affordable. Under the self-regulation system, these cases should represent an exception. Overestimating credit capacity and frequent ETP business can increase credit risk and runs counter to cautious and prudent lending practices. FINMA deploys its supervisory tools to understand the lending criteria at institutions that have come to its notice and will impose capital surcharges where required. However, the requirements for credit capacity and affordability are still principles-based even under the revised self-regulation. FINMA will continue to keep an eye on how principles-based regulation is being applied in this area and – depending on how the risks evolve – may consider imposing rules-based regulation.
Secondly, there is a risk that the value of the property that serves as collateral for the loan falls in the event of default and the lending institution therefore incurs losses. The conditions for further price increases in the residential segment are still in place. The Swiss economy is growing moderately, the rate of housebuilding is low, immigration remains consistently high, and inflation is falling. There are higher risks in the commercial property sector. Due to the continuing trends towards working from home and online shopping there is a process of structural change underway in the office and retail segment with high vacancy rates in some regions. To minimise valuation risk, financial institutions should value properties cautiously and require borrowers to put up sufficient equity and agree adequate amortisation payments. The banks’ self-regulation only sets minimum standards in this area. Due to the risks, FINMA recommends that the banks do not raise the loan-to-value ratios for investment properties, including buy-to-let mortgages.
FINMA conducted a survey of 27 banks and 18 insurers on real estate valuations and found that many institutions do not regularly validate or critically review the valuation models they use. Standards and requirements for valuation models are not covered by the Capital Adequacy Ordinance and are dealt with by the industry’s own self-regulation. The institutions have been informed that they are expected to carry out appropriate and regular validation of their models. Under the revised self-regulation for banks, which enters into force on 1 January 2025, valuation models must be validated at least once a year. Finally, FINMA surveys show that the minimum capitalisation rates used to value investment properties are sometimes set at low levels, which can lead to high valuations. This in turn increases the risk of a downward revaluation of the properties pledged as collateral.
Financial institutions that invest directly or indirectly in real estate are exposed to valuation risk, i.e. the risk of price movements. For insurers, the mark-to-market valuation of the balance sheet in the Swiss Solvency Test (SST) means that a downward correction in property prices reduces the value of assets and leads to a deterioration in solvency. In real estate funds significant corrections in property prices lead to rising borrowing ratios, which could result in the fund exceeding the maximum loan-to-value thresholds for real estate funds under certain circumstances. If the fund is confronted with redemptions by investors at the same time, liquidity risk also rises sharply. The fund can then be forced to raise liquidity in a challenging market environment to reduce the borrowing ratio and enable it to honour investor redemptions in a timely manner. This can often only be achieved by selling properties and can lead to the fund being liquidated in a worst-case scenario.
A real estate crisis would clearly have a serious impact on the Swiss financial centre. FINMA stress tests show that it could result in total losses of well over CHF 10 billion. A number of banks would hold too little loss-absorbing capital to cushion the losses from their mortgage portfolio. The expected losses would be particularly high in the investment property segment, above all in the commercial segment. These segments are very interest-sensitive, which is why they also display higher loss rates in FINMA’s stress scenarios. Due to the risks, FINMA recommends that the banks do not raise the loan-to-value ratios for investment properties, including buy-to-let mortgages. Some banks are also active in real estate markets abroad, where interest rates have risen much more sharply than in Switzerland. In these countries, valuation losses could therefore have a bigger impact on credit quality, and FINMA expects the banks to carry out appropriate risk management in the segments concerned.
(From the Risk monitor 2024)
