Economic conditions are a significant risk factor in real estate investment that cannot be ignored. Fluctuations in the macroeconomic landscape constantly impact the real estate market. During economic booms, rising incomes fuel increased demand for real estate, both for personal use and investment. This leads to a corresponding rise in housing prices, increasing the profit margins of real estate investment.
Conversely, during a recession, unemployment rises, incomes decline, and both the willingness and ability to purchase property decrease. This weakens demand in the real estate market, potentially leading to falling housing prices and potentially significantly reduced returns on investment, or even asset value losses. Economic cycle fluctuations are difficult to accurately predict and control, and the uncertainty and risks associated with real estate investment are self-evident.
Classification
Since real estate finance primarily focuses on real estate financing services, the risks associated with real estate financing can be categorized as follows:
- Risks in Real Estate Financing Services
This area presents a number of risks, primarily manifesting in the following:
- Credit Risk
This is the risk that the principal and interest of a real estate loan may not be recovered on time, or even at all, due to the borrower (real estate developer or residential consumer) being unable or unwilling to repay. Real estate companies face credit risks due to a lack of stable revenue streams and uncertain repayment capacity. Furthermore, banks face issues with their credit rating methods and lending decisions. This latter risk can arise from errors in the pre-loan assessment of borrowers' creditworthiness or from changes in circumstances after the loan is granted. Credit risk in real estate finance primarily arises from real estate developers experiencing difficulties selling commercial properties, resulting in cash flow problems, poor management, severe losses, or even bankruptcy, leading to their inability to repay. It also arises from residential borrowers being unable to repay due to reasons such as unemployment, income reduction, unexpected expenses, or death.
- Liquidity risk
This risk arises from a lack of sufficient cash and other readily convertible assets, leading to the inability to repay maturing debts and meet customer deposit withdrawal requests. Liquidity risk in real estate finance stems from the rapid growth of real estate lending by Chinese financial institutions, imbalanced loan ratios, weak operational and management capabilities, and deteriorating asset quality. There are two types of liquidity risk. The first is primary, meaning that the proportion of medium- and long-term loans in the asset structure is too high, resulting in insufficient cash and treasury bonds to meet withdrawals, and a lack of timely means and channels for cash withdrawal, leading to insufficient liquidity. The second is secondary, driven by credit risk. In real estate finance, real estate is often used as collateral for loans. When borrowers fail to repay on time, the lending bank must dispose of the mortgaged real estate to recover the debt. If the real estate cannot be sold, the bank will lack cash to meet withdrawals, which can also create liquidity risk.
- Asset-Liability Structure Risk
Since the asset structure in real estate financing is typically dominated by medium- and long-term loans, if the financial sector's liability structure is dominated by demand deposits, liquidity risk may arise. However, if the liability structure includes more stable sources such as provident fund deposits and special housing savings deposits, structural risk can be reduced.
- Asset Quality Risk
If a high proportion of loans are of poor quality (overdue, unrepayable, and uncollectible), lending banks face the risk of poor profitability. Asset quality risk in real estate finance is related to the borrower's creditworthiness, the macroeconomic situation, and the specific loan processing (such as the method used to provide repayment guarantees, the ease of selling the mortgaged property, and whether the mortgaged property is overvalued).
- Interest Rate Risk
If deposit rates rise, loan rates fall, or if deposit and loan rates move in the same direction but the interest rate spread narrows, these can all pose risks to operating profitability. Real estate financing, especially residential financing, often has longer maturities. The more frequent and significant interest rate fluctuations occur over long periods, the greater the interest rate risk.
- Inflation Risk
Because the real interest rate is calculated by subtracting the inflation rate from the nominal interest rate, inflation can cause the real interest rate to fall, potentially even to negative levels, while the nominal interest rate remains unchanged, exposing banks to risk. Inflation risk is generally greater with fixed interest rates than with floating interest rates, as the latter tend to rise with inflation. If loan rates are fixed while deposit rates fluctuate, banks face greater inflation risk, and the long-term risks of real estate finance also increase inflation risk.
- Exchange Rate Risk
If foreign exchange appreciates while the domestic currency depreciates against foreign currencies, the burden of foreign-denominated debt will increase; conversely, foreign-denominated assets will actually reduce foreign exchange purchases and sales. Foreign exchange receipts and payments also carry risks, and when real estate finance involves borrowing foreign debt or importing foreign exchange, it also faces foreign exchange risk.
- Other Risks
Real estate finance also faces other risks, such as the risk of declining economic returns or even losses due to poor management, operational risks arising from other errors in business operations (such as calculation errors, spelling or printing errors, errors in document review, inadequate theft and robbery prevention, and leaks of confidential information), legal risks arising from inadequate attention to legal provisions during business operations, risks from changes in national policies, risks in real estate fund transfers and settlements, risks in real estate insurance, and risks in real estate trusts.