Caspian Business Journal

The Anatomy Of A Bubble: The Kazakh Real Estate Crisis Re-Visited

This article appears in the November 2009 issue of the Caspian Business Journal. As a treat to our potential readers, we have included it in its entirety here. For more actionable business information and original analysis on the countries of the greater Caspian region, register online today. The flourishing Kazakh real estate market was one of the most promising sectors for investment in Central Asia. Symbat Abilkhassimova takes a deeper look at what went wrong, and what life after the bubble looks set to bring.Absolute, one of the most prominent real estate companies in Almaty, has been analyzing the market using data gathered by the leading real estate advertisement newspaper, Kreesha. They came up with a city-average index that indicates the average real estate price in Almaty. It may not be rigorously scientific or even very sophisticated, but this index is nonetheless the one most widely used by Kazakh real estate buyers and sellers. An examination of this public index over the period of the real estate bubble offers valuable insights into the causes of the rise and fall of property values in Almaty.

At the beginning of 2003, 1 sq.m in Almaty cost $360. Throughout 2003, the index rose, eventually passing the $500 mark. From spring to mid-2004, amid rumors of a government sponsored property construction program, the market saw a downturn. The fear was that government sponsored properties would be offered at around $350 per sq.m, well below the market value. Demand went down and sellers were forced to lower their prices. But potential buyers quickly realized that it was going to be some time before the program was implemented and government subsidized housing would be available. Again the index started to rise, growing in a linear fashion until mid-2005. A period of sharp growth throughout the second half of the year meant that by December, the index had hit $1,500.

Pattern of growth

A breakdown of the absolute changes in the index between 2003 and 2005 makes the pattern of growth even clearer. At the beginning of 2003, the index was valued at $360. By the beginning of 2004, this figure had risen to $680. For the same period in 2005, the index was valued at $985. In other words, the index grew by roughly $310 each year. Then, in the middle of 2005, the linear character of the index was disturbed. There was a sharp growth in the second half of 2005 which continued until February 2006, when the index rose to $1,700. From then until now, the index’s behavior has been non-linear. At the end of 2006, the index had shot up to $2,800. The growth from the previous year was $1,300 – four times more than the average yield for the 2003 to 2005 period. In the first quarter of 2007 the index kept soaring, eventually peaking between March and April when the average cost per sq.m in Almaty reached a staggering $3,700. As local journalist Ivan Voitsekhovsky reported at the time, the price was unrealistic and in no way did it correspond with the consumer ability to pay[1]. It was pure speculation.

Building the bubble

With commercial banks doling out “easy” mortgage loans to absolutely everybody, it became possible to over-value property. “Property is always valuable” became an oft-heard mantra. The media encouraged people to invest in real estate, while banks such as Kazkommertsbank churned out eloquent statements on the growth of mortgage and consumer loans [2].

One private investment mechanism, non-existent during the Soviet era, became a reality: investors stopped drawing on their own funds and instead chose to borrow from banks. An investor could take out a mortgage loan, purchase a new property from a construction company before it was built at a discount price, wait for the property to gain value as the construction project finished or just neared completion, sell the property after a short period of time, return the loan to the bank, and net a good profit. From an investment stand point, these types of deals were extremely attractive – money was effectively made from thin air.

This growing bubble was reminiscent of the simple pyramid schemes of the early 1990′s. But while those pyramid schemes were blatant chimeras, this widespread construction boom concealed its pyramidal nature behind real constructions visible for all to see on the streets of Almaty. A few weak voices, trying to warn people about impending disaster, were drowned out by the ubiquitous adverts and the joyful shouts of new millionaires.

The problem was rooted in the borrowing procedures of commercial banks. They were borrowing money from the West for the short-term, before distributing it to construction companies through mortgage holders for the long-term. Mortgage loans could even be signed at bus stations. Similar to the so-called “ninja” loans in the United States, borrowers were under no obligation to prove their financial stability. Any clear loan discrepancies could be covered by even more borrowing from the West, which was eager to access this new market.

It was so easy for buyers to access these mortgage loans that they didn’t care about the real value of the property. This caused an expected sharp growth of prices in the prime or new construction real estate market. Realizing the market situation, some home-owners who had not planned to sell their homes started to offer their sub-prime or existing properties for high prices. And the myth about “continuously rising property values” was born. Once the belief was circulating, the human propensity for euphoria and mania did the rest of the work.

As the new construction market expanded, many people saw their old properties destroyed to make way for new apartment complexes. These property owners were given compensation based on the market value of their apartments at the time. An average two bedroom apartment in a microrayon (residential district), that cost $10,000 would be bought by a construction company for between $50,000 and $60,000 [3]. This meant that they now had an enormous amount of money which they invested in another property, either on the prime or sub-prime markets. This additional trend further encouraged people to believe in the high value of the properties. This is how the bubble was built, and it was only a matter of time before it burst.

Bursting the bubble

So what exactly was behind the collapse of the real estate bubble in Kazakhstan? The US mortgage crisis. It led to a decrease and then a complete shut down on access to loans from the West to Kazakh commercial banks. International rating agencies, like Standard and Poor’s or Moody’s, decreased the ratings of almost all of the leading banks in Kazakhstan, including Kazkommertsbank [4]. Borrowing from the West became increasingly difficult and the time had come to pay back existing loans. The mortgage-construction pyramid, which foreign investors and local second level banks had played an active role in building, started slowly falling apart. Unrealistic inflated property pricing was primarily down to improper policies at banks and construction companies coupled with a thirst for “easy money”. The US mortgage crisis only initiated this market fall. Even if the foreign crisis had not taken place, the Republic of Kazakhstan had a bigger pyramid which would have fallen anyway. The consequences of this fall could have been even more severe.

History tends to shy away from hypothetical “if” scenarios, but let’s imagine for a second what we would probably have seen if the bubble had never existed. Going back to 2005, the annual growth rate was $310 per year. We can reasonably assume that growth would have continued at this steady rate each year. For those who are wondering why the index should grow at all, the answer lies in inflation. Put simply, everything becomes more expensive and property is no exception.

Learning from the linear index

The linear index assumption is a strong model characteristic. In real life, the dynamic of the index is influenced by a number of different factors: the development of a construction field, the financial situation in a country, the social programs geared towards population support, banks’ financial priorities, inflation etc. But generally we can assume that the index maintains the same level of growth.

It is clear that the model of index behavior excludes those factors which led to this bubble so the linear model is a good way of measuring “how it would be if we were different”. The difference between the real picture and linear model is our natural mentality. The graph above shows how the linear model almost overlapped with the real growth line during the period between 2004 and 2005. Starting mid-2005, however, these two lines go their separate ways and from then until today, those two lines never cross again. Since the middle of 2005, we have been living in a non-linear world. Everything that lies above the linear model is our bubble.

Life after the bubble

Reports suggest that foreign investors are skeptical about the potential for economic recovery in Kazakhstan [5]. There are reasons to be circumspect, such as:

• Second level banks have to pay back billions of dollars to western creditors
• Second level banks have increased interest rates on deposits, mortgages and are trying hard to attract people’s savings
• From the point of view of western investors, banks have “good” credit portfolios (mainly filled by mortgage and consumer loans)
• The general rating of the country and banks has decreased, making it almost impossible to receive credit and refinancing from the West
• Given the current situation, people are in no rush to deposit their saving in the banks
• Construction companies owe banks significant sums of money which they cannot return due to ongoing construction projects
• Construction companies owe “new apartments” to mortgage owners, but they remain half-built. They cannot finish them due to a lack of funds

But there are also reasons to be optimistic:

• The government has been very clear about how funding should be used, with money directed towards the completion of construction projects rather than towards covering other company deficits
• Oil prices are growing rapidly
• Other Kazakh exports that are not tied to the construction industry, such as gas, gold and aluminum, are doing well
• Contracts with foreign investors are under review to ensure a more rational use of the country’s natural resources
• Some banks have been bought by foreign investors or are in the process of negotiations

While the Kazakh economy may have trembled, it wasn’t destroyed. After sellers had quenched their thirst for easy money and potential buyers lost access to abundant mortgage loans, the bubble naturally burst. In the absence of easy money, the supply market started to show its “real market nature” and began to self-regulate. Supply returned to a normal level, in line with the index.

Banks are in debt. Construction companies are in debt. And many homeowners are unable to pay back enormous mortgage loans. An inevitable wave of collateral returns to banks and auctioning is approaching, and bank mergers or even bankruptcies are also possible. Construction companies will have to restructure their activities in order to satisfy at least some of the mortgage owners who are waiting for their homes to be built. In this situation, those banks, construction companies and homeowners on waiting-lists no longer have any influence on the market.

The real estate market, left without funding from banks and without construction companies, has started to focus on real buyers who have their own rather than borrowed funds. The only buildings on the real estate market are old (secondary) properties. Interestingly, in the absence of easy money, investors quickly left the market and the market has found an equilibrium. Given these developments, we can expect to see linear growth in the market. The country’s ratings will slowly increase again – oil, uranium, gold and other natural resources have not yet run out. Banks, as in the U.S., have decreased expenses, asked for help from the government and returned to their normal day-to-day operations. Loans will once again be offered but under very strict conditions.

The worst of the bubble (or pyramid) is behind us. Whether the same mistakes will be made again remains to be seen.

Footnotes:

[1] http://bubble-kz.blogspot.com/2007/06/blog-post_08.html

[2] http://en.kkb.kz/attach/Presentations_190308_1/FY2007_InvestorsPresentation.pdf

[3] http://www.kn.kz/analysis.php?id=187

[4] http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSL1987875520080319

[5] http://silkroadintelligencer.com/2009/09/03/foreign-investors-remain-sceptical-about-kazakhstan