Russians get set to go in the red

Howard Gethin announces the birth of the Russian mortgage market

This year may well prove to be a watershed in Russia's property market, with the proliferation of mortgages - which may be even more profound than the move to a free market in 1991.

Russia's mortgage stock is minute - estimated at less than 0.1% of gross domestic product, or 29bn roubles ($1bn), according to a February 2003 World Bank report. This puts Russia far behind developed economies and other emerging markets. For example, the World Bank estimates that the European Union's mortgage stock is roughly 53% of GDP, while in South Korea it is 14 %. The implications of a huge expansion in the mortgage market are clearly enormous, not only for real estate and banking but for the wider national economy, to say nothing of how it will affect the lives of millions of ordinary Russians.

Not surprisingly, financial institutions are increasingly studying the market for mortgages in Russia and devising mortgage programmes, as new legislation and an increasingly buoyant economy further improve the prospects for a viable future market.

The real estate market has functioned without mortgages since 1991, when a mass-privatisation of housing took place soon after the fall of communism. Most residents received their apartments from the Government in the early 1990s, creating a huge stock of property owners who could buy and sell as they liked.

There were no mortgages in 1990s Russia because interest rates were extremely high, and banks were far too busy making fortunes lending to the chronically cash-strapped Federal Government to consider lending to individuals. The banking system was also notoriously unstable, and lurched from one crisis to another with alarming frequency.

Neither was there the necessary legal framework for mortgage lending or the financial instruments to support it. Few Russians even had a basic credit history, transparent personal finances, or jobs stable enough to guarantee regular repayments.

Russia's fledgling mortgage market is taking root at a time when Moscow in particular is enjoying a property boom that has driven house prices to record levels, giving the city the highest real estate returns in Europe, according to a recent survey by PricewaterhouseCoopers and the Washington based Urban Land Institute. This is mostly due to external factors such as the overall health of the Russian economy, the lack of alternative investment vehicles, and the slow growth in supply of residential building.

Two main factors are currently inhibiting the entry of more mortgage lenders into the market - legislative faults and a lack of financial instruments to finance loans.

Legal discrepancies on the protection of residents are a significant factor in the banks' reluctance to enter the market. A Federal law 'on mortgages' allows a borrower to be evicted from his residence if he fails to maintain payments on it. However, Russia's Civil Code contains clauses which do not permit a resident to be evicted from a property if it is his sole place of residence, and is not being used for commercial purposes, which effectively negates the effect of the Federal law.

'This contradiction is widely debated, but has not been resolved,' says Oleg Dmitrienko, mortgage manager of Absolut Bank.

Repeal clauses

President Vladimir Putin has spoken recently about the need to repeal such clauses, and legislation is pending which will remove this anomaly. There are no less than 36 amendments prepared for legislation which will affect the development of mortgages and residential construction, according to Denis Grishukhina, the chief manager of the Federal Agency for Residential Mortgage Credit (AIZhK), which is working to promote mortgage development in Russia.

A set of Bills on developing mortgage credit will be submitted to the State Duma later this year, including amendments to the civil and housing codes, Russian deputy prime minister, Vladimir Yakovlev, said in January. A meeting of a task force for mortgage crediting with participation of representatives of the Government, the banking sector, Russian regions and construction firms took place in the spring of this year in order to put forward recommendations to the Government.

More significant is the lack of a suitable financial system to back lending - hence, the reason for the main lenders (DeltaCredit and Raiffeisen Bank) being Western banks. DeltaCredit is financed by the US-Russian Investment Fund, and ZAO Raiffeisen Bank Austria is a daughter company of RZB Group. As such, both have access to external sources of capital. The International Finance Corporation (IFC) approved an $80m loan to Raiffeisenbank Austria in June 2003 for mortgage loans in Russia.

Lack of long term financing is one of the principal factors holding local banks back, Grishukhina says.

'Russian Banks possess a surplus of short term capital - less than five years,' Grishukhina notes. 'But mortgage credit is generally offered for 15-20 years, and the AIZhK envisages this increasing to even 30 years.' A law was passed on mortgage securities in November 2003 which would have ensured a flow of long term funds to this sphere.

'But it was the result of compromises and, like all such compromises, it has a series of flaws,' Grishukhina adds. 'In particular, the models of mortgages most usual in the West are mixed up in this law, in such a way as to complicate the situation for banks issuing such securities.' Others share this view.

'It is clear that the law is just a first step towards the creation of a domestic securitisation law in Russia' and that additional regulations, including from the Russian Central Bank, would follow, says Vladimir Dragunov of Baker & McKenzie in Moscow. 'Whilst the new law is not perfect, nobody expected it to be so.'

Limiting growth

The residential construction industry as a whole also faces problems which are limiting its growth in Russia. A lack of suitable large plots of land within areas of developed infrastructure is a big problem in many cities. One reason for an explosion in prices in Yekaterinburg around the year 2000 was a conflict between building companies and the local administration over who should bear the costs of extending roads and utility supplies to new areas where building was underway.

Construction companies in the city had to pay 15% of the value of the building under construction into a city fund for utilities development and moving people out of dilapidated housing. The builders refused to bear the cost, stopped building, and prices of real estate in the city increased faster than anywhere else in Russia for a short time.

Finding a way of spreading the cost of developing such infrastructure between state, municipal authorities and private investors is another precondition for helping the market develop.

Developers complain that procuring land plots is plagued by excessive bureaucracy.

'It is no secret that to start building a house, you have to get around 150 different permits,' Grushukhina says. 'It is necessary to reduce this number and, at the same time, to introduce a procedure where sale of land is carried out in open auctions.'

Despite these problems, mortgage lending is starting to take off. Maria Abramova, an estate agent for Best Nedvizhimost in Moscow, estimates that around 20% of her clients are buying with mortgages, and this will rise to 40% in the next two years. Even this figure is misleading, however, as it reflects the trends in the capital and not nationwide - if the rest of Russia is included, probably less than 2% of buyers have access to mortgage credit.

Russia's Vneshtorgbank has recently entered the mortgage market, and another two or three banks are thought to be considering a move into lending in the next year.

Currently, there are around 12 lenders issuing mortgages, of which two, DeltaCredit and Raiffeisen Bank, have the lion's share of the market. At the end of 2003, DeltaCredit had made around 2,000 loans and Raiffeisen around 600, but only for properties in Moscow and St Petersburg.

The terms for borrowers are sufficiently stringent to rule out most potential Russian borrowers even if they wanted to buy, which is another reason the market is so small. Rates from most lenders are around 10%-15% in dollars or euros (higher in roubles), with a minimum 30% downpayment on the purchase price of the property. For a typical three-room flat in Moscow, that downpayment would mean around $30,000 - and rising fast.

Most mortgages are maximum 10 years duration, and not all lenders will grant loans for newly-built properties or those under construction, though more are doing so. Borrowers generally need a transparent credit history of at least two years, including proof that their tax affairs are in order - not something that is widespread in Russia, where tax evasion has hitherto been accepted by most people pretty much as a common sense necessity rather than a crime.

Not surprisingly, a disproportionate number of mortgage buyers in Moscow are foreigners working in the city. Foreigners enjoy the same property rights under Russian law as locals, and if they buy their property with the aim of living in it for five years or more, they enjoy the same tax concessions. According to the new tax code that came into force on 1 January 2001, home buyers can deduct from their income tax 1m roubles ($3,000) paid for purchase of housing in Russia, plus all interest payments on the mortgage for its full term.

The implications for Russia if the mortgage market does kick off will be profound. Not only would it provide a major boost to the financial system in the country, and greatly increase the amount of cash available in the housing market, but it could completely change the way millions of Russians relate to credit, and spend a major portion of their income.

The danger is, however, that if supply side problems with real estate are not addressed, a sudden increase in available capital, thanks to wider mortgage access, will result in sustained price rises in a market that has already seen spectacular inflation this year.

Howard Gethin is a business journalist based in Moscow, Russia.