Why risks are increasing in the Swiss real estate crowdfunding sector

Real estate crowdfunding platforms saw dramatic growth, raising more than $662.2 million (CHF 597 million) in Switzerland last year, a 16% increase over the previous year.

The pandemic acted as a catalyst, prompting investors to shift and withdraw capital from riskier investments (e.g. equities) into more stable investments (bonds and real estate). Since many crowdfunding platforms have an entry hurdle of only $1,100 (CHF 1,000), this asset class became increasingly popular.

Since residential real estate, which is the primary focus of Swiss real estate crowdfunding, has almost always increased in value over the past 50 years, it is easy to understand why it is so attractive and considered a safe haven by investors. However, a prolonged bull market always leads investors to become complacent and temporarily or permanently forget the risks associated with a changing market landscape.

One of the largest platforms, Crowdhouse, with a track record of over 150 units, has more than 60% of investors’ capital in areas where the vacancy rate is approaching 2% and growing. Swiss apartments are experiencing the highest vacancy rate since 1998. In fact, property prices in certain rural areas, popular crowdfunding targets, are approaching the end stage of growth and will soon face devaluation as both supply and demand pressures increase. Macro conditions are forecast to deteriorate further. As more and more investors realize the reality of the market, we are likely to see a hard landing in this segment of the market.

In contrast, the forecast is surprisingly favorable in downtowns and business districts, where vacancy rates are 18-20 times lower than in rural areas. In addition, there are certain structural advantages that keep vacancies sustainably low, mostly at the expense of remote commuter neighborhoods. The COVID-19 crisis has only exacerbated this trend as low-income workers (most of whom live in rural areas and commute to inner cities) leave Switzerland.

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Dynamics of the housing market

Ultimately, any market dynamic can be explained by supply and demand. When demand exceeds supply, value goes up and vice versa. To understand housing market dynamics, there are two complementary models that explain them: Equilibrium and Boom/Bust.

In the last decade, Switzerland experienced falling and even negative interest rates, which stimulated lending and consumption and discouraged saving. A gigantic amount of money had to flow somewhere, and it flowed into various assets, including real estate.

The equilibrium model works as follows in the real estate market:

Low-interest rates made the cost of borrowing low. Low borrowing costs stimulated real estate buying activity.
Buying activity drove up prices and stimulated development activity. Development activity increased real estate supply, but demand changed little as population growth never exceeded previous levels. Market oversaturation causes rents to fall. Falling rents lower real estate prices. As prices fall, developers will stop building in the overdeveloped areas and move to the more lucrative land.

However, this model is too simplified for the real estate market. Equilibrium theory says that as oversupply falls, prices fall and eventually demand catches up. In practice, even with falling prices, demand cannot magically grow unless more people are born or have moved into the market. This led to a complementary boom/bust model that dives into the underlying investor psychology and explains value fluctuations more vividly.

The boom/bust model works as follows:

During bull markets, all market participants (i.e., developers, investors, and lenders) make profits. Lenders become more eager to lend, and the terms of lending as the debt market becomes competitive.
Developers, with the increased competition, tend to take on riskier projects as long as investors continue to buy them. Investors themselves tend to misjudge risk in a booming market and continue to buy properties.
Since underlying occupancy demand has barely changed, vacancy is on the rise. However, this is perceived as a temporary problem, so the party continues until they are not.

At the tipping point, the cycle reverses: As vacancies rise, due to limited demand, rental income falls. Lenders become less eager to finance new developments and leveraged purchases. Investors receive less profit and are less willing to buy new properties. Declining buying activity drives prices down. As the value of equity declines, there are more margin calls, more distressed sales that drive prices down even further, and the vicious cycle feeds on itself, creating a bust pattern.

The rural housing market is peaking

The nature of the real estate business is that there is an inherent latency (delay) built into the business model. Houses take time to be built. Houses take time to be sold. Currently, developers invest a large amount of upfront costs in anticipation of future valuation. Therefore, the danger of overdevelopment is that it is not noticed until it is too late. In addition, rents do not fall immediately when vacancy rates rise because landlords can keep apartments empty for months in hopes of finding tenants. Property prices fall even more slowly because landlords can hold onto their inventory for a longer period of time without incurring huge costs. Only when the entire market panics do they decide to liquidate, and by then it is almost too late.

External factors can often prolong the bull market and mask the inherent weak fundamentals associated with the market. For example, access to cheap credit has extended the bull market in the Swiss real estate market. Nevertheless, all the signals of weak fundamentals are still present (low population growth, rising vacancy rates, huge increase in supply), indicating a top market.

What does the data say about the rural market?

Currently, vacancy rates are high only in rural areas. This could be because the central areas have much higher demand and a fixed supply, while the rural areas have the exact opposite: there is limited, transient demand and much more land that can be developed. Tenants who have the opportunity to move closer to the city center would be happy to do so, all other things being equal.

On the other hand, most urban centers are already well developed and high-rise buildings are prohibited in many areas. Redevelopment projects are heavily regulated, so the supply side is virtually fixed. So we are witnessing a population shift toward urban centers (a common theme in our time).

According to a study by PwC, most market participants expect rents in rural areas to continue to decline. However, rents for central apartments will increase, especially in desirable micro-locations, as the quality of access to public transportation is often a deciding factor for tenants when choosing an apartment.

With construction activity expected to remain strong and vacancy rates expected to rise in 2020/21, rents in rural areas are likely to continue trending downward overall. This is already reflected in the vacancy rate, which rises from 1.62% to 1.66% in 2019 and to 1.72% by Q2 2020, with a further increase in 2020. In addition, real estate lending rates are forecast to fall further this year to 1.25%, which is also expected to impact rents on current leases.

Has COVID-19 reversed the trend?

The pandemic and subsequent closures have shaped our behavior patterns. Many companies have switched to remote workplaces, allowing employees to work from home most or even all of the time. Will this have an impact on where people choose to live?

After more than half a year, the trend in vacancies has not reversed, only strengthened. As of June 1, 2020, the vacancy rate in Switzerland’s five largest cities remained virtually unchanged, while it increased from 1.71% to 1.91% in the rest of Switzerland. This further widens the gap between urban and rural areas in the Swiss housing market.

In the urban rental housing market, COVID-19 has only had a short-term impact on construction, as activity levels remain high. While there was a 21% decline nationwide in Q1 2020, most of this was recovered in Q2.

Researchers are also skeptical that companies will allow their employees to work remotely on a permanent basis after pandemics. A number of studies have shown that working from home can lead to isolation and stifle innovation. After all, ideas often emerge from the spontaneous interaction of specialists from different parts of the company. It is no coincidence that the highest value creation is found in regional clusters (e.g. Silicon Valley, Crypto Valley in Zug, Pharma Cluster in Basel). For this reason, companies such as IBM and Yahoo, which once introduced home-based work, have abandoned this model due to its perceived limitations in terms of creativity and innovation.

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(Featured image by Sonyuser via Pixabay)

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First published in Der Finanzprodukt blog, a third-party contributor translated and adapted the article from the original. In case of discrepancy, the original will prevail.

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