Introduction
Real estate investment is known as an exceptional and beneficial asset class that offers investments with attractive returns. Nevertheless, the asset real estate, being physical and illiquid, is highly exposed to changes in financial regulations and cash flow availability. The damage from the 2008 financial crisis was estimated at more than $15 trillion – this is approximately 20% of the global product. Dominguez et al. (2012) asserted that the 2008 financial crisis was rather a consequence of a lack of regulation of financial systems, which caused a global economic downturn in highly developed countries. The 2008 global financial crisis reiterated the importance of financial regulation and liquidity modifications; it has an impact on investment outcomes. After the 2008 global financial crisis, regulatory developments at both national and international levels were triggered to stimulate economic growth and avert future economic crises. This research questions to what extent financial regulation changes and liquidity improvements affect real estate investment returns. That study attempts to shed light on the linkage between financial regulation, liquidity amelioration, and real estate investment returns by a rigorous investigation. The research will use empirical data from different real estate markets, considering multiple financial regulatory factors, including LCR, NSFR, and changes in the liquidity aspect in Basel III.
Relationship between Financial Regulation and Real Estate
There is a significant relationship observed between investment returns earned out of real estate and financial regulation. As Battisti et al. assert in 2020, it is through financial assistance that most of the link is established. Mortgages and real estate financing are the two areas in which financial regulation has been particularly emphasized. The banking sector is the key factor that impacts the real estate business, as these firms are always lending money. However, these regulations are designed to provide stability and reduce the systemic risks present in the financial system; nonetheless, the influence these policies might have on the profits earned from real estate investments might differ based on the situation in question. The accessibility to mortgage loans and the way in which they are presented by the regulations that direct lending procedures is a sensitive issue. These are the regulations that cover such parameters as loan-to-value ratios, debt-to-income ratios, and criteria of underwriting.
Besides, Jiang et al. (2020) note that rules regarding securitization and the capital requirement of financial institutions influence the real estate lending size and the cost of real estate financing, which further affects the real estate market. Similarly, the FCA, which is the financial conduct authority, made a recent set of recommendations for supervisory slotting in the year 2013. These recommendations were focused on standardizing default risk assessment models used by banks in decision-making about extending loans to clients (Gimblett, 2015). The Financial Conduct Authority (FCA) in the UK is the regulator that controls and supervises the behavior of financial companies in order to make sure that consumers are protected, the market is clean, and fair competition is ongoing. Lenders and intermediaries with a license to sell mortgages must comply with the rules established by the Financial Conduct Authority, which is committed to uprightness in business and consumer protection.
Also, it sets market standards on the grounds of open and fair conduct of agents across different financial markets, which boosts confidence and trust, thus influencing investment returns. Another legislation that has been added to the list of laws that shaped real estate is BASEL III, which was initiated in 2009. The BCBS has designed Basel III standards in collaboration with central bankers from various countries, as well as bank supervisors. These policies aim to make banks safer and more resistant to all forms of risk. To prevent the occurrence of bank failures in the future, this global financial rule, based on Hoesli et al. (2017), empowers banks to strengthen their central, capital, and provision ratios, as well as supervisory authority.
Interest rates regulation and return on real estate investment
Interest rate directly regulates one of the areas impacted by financial regulation. Real estate prices have sadly reflected the negative correlation between interest rates. The CAPM method is widely used to determine the cost of capital by considering the systematic risk and expected values of investment. Modifications of the rules regulating the money market will likely redefine how existing lending situations, together with the variable interest rates, are affected. This may cause a change in the risk attributed to the real estate investments. If liquidity requirements are tightened, banks may have less access to loans and incur higher borrowing costs. This could result in more significant borrowing costs for real estate investors, which would raise the required return on investment and thus lower the profits that can be made from real estate investments. Because of the low interest rates, people looking for investment can qualify for larger loans, which results in a more excellent supply of cash, pushing up the price of real estate (Ojiambo, 2010). Banks may limit their lending capacity and raise borrowing costs in the future by holding more liquid assets, which tightens credit conditions. Consequently, as a result, the variety of possible financing alternatives is reduced since the costs of borrowing money are increased.
Explanation of Liquidity Reform Measures and their Purpose
Liquidity reform measures are regulatory actions taken by authorities to improve the liquidity management practices of financial institutions and protect financial stability. This is aimed at ensuring that banks and other financial institutions have enough liquidity (readily available money) to meet their daily functions, whether the markets are normal or there are challenges. Liquidity Coverage Ratio (LCR) is a ratio, according to Murphy (2022), of highly liquid assets that a financial institution holds to keep its stability and to maintain its short-term ability to meet its obligations. The LCR regulation stipulates that liquidity coverage ratios (LCRs) should not be less than 100% to prevent funding shortages and enable banks to cope with market disruptions.
Net Stable Financing Ratio (NSFR) evaluates the longevity of banks’ funding sources over an extended period. The NSFR was designed to assist the banks in stopping their excessive dependency on risky and volatile financing sources so as to provide a more stable and dependable financial institution. NSFR aims to reduce the probability of liquidity mismatches and strengthen the banks’ long-term funding resilience by encouraging them to have a relatively stable financing base. The capital adequacy ratio is a liquidity reform principle that serves to improve financial stability and resilience in the financial sector by strengthening capital management and curtailing credit provision. The objectives of the liquidity reform are to prevent liquidity crunch from happening and to improve the capacity of financial institutions to fend off liquidity challenges.
The influence of Liquidity Reform on the real estate market and the investment revenue.
Capitalization charge is a very important metric that is one of the tools used by investors while deciding to invest in real estate and is directly linked to interest rates. A ratio, namely Capital Adequacy Ratio, is employed to see the institutional capital in proportion to the risk-weighted assets. This evaluation seeks to ensure that the organization will not bow to financial stress and remains stable. Thereby of the stringent capital requirements, the borrowing ability of the financial institutions will be restricted, which will lead to insufficient credit supply for real estate investors, which will result in loss of options for investments, which in the end will finally result in a decrease in investment returns. As Sagi (2020) asserts, the capitalization rate is a function of the market price and income flow of a real estate property.
For instance, let us consider a hypothetical multi-family residential condominium block with a total rent of 100,000 GBP and costs of 30,000 GBP. This would result in a net profit of 70,000 GBP (100,000 minus 30,000), the difference between the total rent and the expenses. If this asset has a market fee of one million British pounds, its capitalization charge may be seven percent. Investing in such a project would result in more significant returns in a financial system with a high-interest rate than a low interest rate. The appeal of real estate investments is diminished when interest rates are low; hence, governments should strive to maintain interest rates at reasonable levels to encourage growth in the real estate industry.
The Interaction between Financial Regulation and Liquidity Reform in the Real Estate Sector
Property rights having certain unique characteristics also have great impacts on economic growth. It may be affected by changes occurring in financial regulations concerned with the stability of the financial market, loan funding options, interest rates, expenses, and the like. The connection between financial regulation and liquidity reform in the real estate market is the impact of funding availability on the sector (Allen & Gu, 2018). Stringent capital requirements lead to a rigorous examination of loan security and possible risks for real estate loans. The growth of lending conditions leads to the narrowing down of the credit supply and the access to bank loans, thus hampering the possibilities of investments. Amendments to liquidity regulations like LCR (liquidity coverage ratio) or NSFR (Net stable funding Ratio) may cause additional funding costs as banks increase their lending rates on loans with the intention of holding more liquid assets to meet the stipulated requirements while maintaining financial stability. Adding more expenses for real estate investment loans decreases the number of profitable investment options accordingly to higher financial costs so that the investment income will be lowered.
Financial regulation and market liquidity reform aim at the creation of an effective equilibrium and a reduction of market risks. A well-implemented risk management infrastructure and liquidity resilience in economic institutions is a good way of creating a more stable real estate market. The market equilibrium that is improved and stabilized through the use of enhanced financial instruments decreases the incidents of downturns and rate fluctuations, allowing real estate investors to invest in a relatively stable environment. Prudential regulations requiring banks to maintain adequate capital and cash as reserves decrease the chances of liquidity problems and widespread dysfunctions that influence real estate property prices. Money supply is one of the other main focus areas of financial regulation among the interest rate policies. Money supply (total amount of money in circulation) is an important factor in determining the overall performance of an economy. The principal financial institutions, in their turn, exploit many tools to set the pace of money circulation in the economy. There are processes of supply and demand that interact with each other while the central bank influences the banks. It is said that in the Keynesian theory, monetary policy changes would affect the economy through interest rate changes. An increase in money supply reduces the interest rates and hence reduces the financial cost of real estate development. A lower interest rate will lead to a rising in the value of financial and physical assets, which in turn will make wealth increase gradually (FengYun, 2020).
Impact of Financial Regulation and Liquidity Reform on Real Estate Investment Returns
Regulation and liquidity improvements influence the cost of capital for real estate significantly. Stepped-up regulations can lead to heightened borrowing costs as banks may need to raise their capital requirements and keep more funds in liquid reserves. Thus, the property loans may become more expensive, or the applicants might be charged more, which would decrease the investment returns. Higher financing costs impact whether the real estate investments are profitable and limit the number of projects investors can pursue. Regulatory measures that will govern liquidity changes may limit access to loans for real estate investments.
Banks are less likely to provide setbacks than they are under more stringent lending criteria and tougher capital requirements. This, therefore, brings down the total available credit in the market, and it becomes harder for real estate investors to access finance (Hofman & Aalbers, 2019). Lack of credit can limit the ability of creditors available for investment, thus resulting in a decline in possible investment profits. Financial regulation and liquidity changes of their kind are aimed at increasing market stability and minimizing systemic risks. The real estate industry is stabilized when financial institutions have principal and liquidity restrictions enforced. An increased market stability could potentially reduce the odds of sharp drops and swinging prices that prevent good returns. A stable market creates forecasts and reduces the probability of sudden value changes in real estate investments. In addition, amongst so many investors the willingness and the trust of the investors are increased, which results in an interested investment in this field. Inefficient or weak regulations may undermine the trust of investors, hence influencing the extent of investment activity as well as returns.
Challenges and Opportunities Real Estate Investors Encounter as a Result of Regulatory Changes
Real estate investors often rely on funding from the financial services sector. Tough regulation of liquidity and financial rules might cause investors to suffer stricter lending requirements and higher borrowing costs; thus, it becomes easier for them to get financing secured. The high capital requirements in the banking sector work to reassure and stabilize the industry, thus limiting leverage for investors. Lower leverage limits the possible profits from investments, and investors may be required to allocate more money, which in turn may affect overall profitability. Financial regulatory and liquidity reforms are established to make transitions more stable, though the market turbulence may persist. Changes in the market may affect real estate investment returns, and this is observed more for assets held for a short period. While financial regulatory reforms and liquidity improvements have some downsides, these serve to stabilize and increase the transparency of the market, attracting more investors to the real estate industry and offering regular investment opportunities that bring higher returns for the investors. Financial regulation and liquidity reforms encourage risk management techniques of real estate investors that are characterized as being cautious. Resultantly, investors prefer capitalizing on less risky opportunities and opt for a consistent dollar-return strategy using a diversified approach.
Conclusion
The last decade has witnessed the implementation of many regulatory measures as a response to the 2008 financial crisis, with the aim of enhancing financial stability and lowering systemic risk. Financial regulations, in general, are the rules and laws that control financial institutions. In contrast, liquidity reforms are the specific ones that are designed to ensure that financial sectors have enough assets to avert the liquidity disruptions caused by fluctuating market circumstances. Liquidity reform implies putting such as tools such as capital adequacy ratio, liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and efficiency theory into practice. These measures include trade-off capital requirements, intensive risk management practices, and more transparency to the extent of mitigating the possible negative effects of liquidity in the financial markets. Real estate is one of the major sectors that are of great significance to economic growth and development. FSB has considered crypto assets as a physical and illiquid asset.
Financial regulations and liquidity change pose challenges and can affect the profitability of real estate investments. Regulations that govern the finance sector affect mortgage lending and the conditions under which it is lent. The FCA supervises financial industries’ bad model assessment. Through the Basel III norms, banking systems become more resilient, thus reducing risk. The Capital Asset Pricing Model (CAPM) is a financial model that uses systematic risk to estimate the risk premium for an investment. The tightening of banks’ liquidity requirements, as one of the banks’ main reasons for restriction of lending capacity, results in a high cost of financing and limits real estate investors’ access to credit. Therefore, it adversely affects the possible investment choices and results in reduced investment returns. Market stability and financing availability increase serve to enliven real estate; therefore investors have better returns.
References
Allen, F., & Gu, X. (2018). The Interplay between Regulations and Financial Stability. Journal of Financial Services Research, 53(2-3), 233–248. https://doi.org/10.1007/s10693-018-0296-7
Battisti, E., Creta, F., & Miglietta, N. (2020). Equity crowdfunding and regulation: implications for the real estate sector in Italy. Journal of Financial Regulation and Compliance, 28(3), 353–368. https://doi.org/10.1108/jfrc-08-2018-0109
Dominguez, K. M. E., Hashimoto, Y., & Ito, T. (2012). International reserves and the global financial crisis. Journal of International Economics, 88(2), 388–406. https://doi.org/10.1016/j.jinteco.2012.03.003
Gimblett, K. (2015). UK Development Finance Review 2015, IPF Short Paper 27. Investment Property Forum, London.
Hoesli, M., Milcheva, S., & Moss, A. (2017). Is Financial Regulation Good or Bad for Real Estate Companies? – An Event Study—the Journal of Real Estate Finance and Economics. https://doi.org/10.1007/s11146-017-9634-z
Hofman, A., & Aalbers, M. B. (2019). A finance- and real estate-driven regime in the United Kingdom. Geoforum, 100, 89–100. https://doi.org/10.1016/j.geoforum.2019.02.014
Jiang, Y., Ho, Y.-C. (Chad), Yan, X., & Tan, Y. (2020). When Online Lending Meets Real Estate: Examining Investment Decisions in Lending-Based Real Estate Crowdfunding. Information Systems Research. https://doi.org/10.1287/isre.2019.0909
Murphy, C. B. (2022, June 20). How the Liquidity Coverage Ratio – LCR Helps Banks Remain Solvent. Investopedia. https://www.investopedia.com/terms/l/liquidity-coverage-ratio.asp
Ojiambo, E. O. (2010). The Effects of Interest Rate on Borrowing and Investment to the Low-Income Earners: A Case Study of Standard Chartered Bank Kampala. Ir.kiu.ac.ug. https://ir.kiu.ac.ug/handle/20.500.12306/11326
Sagi, J. S. (2020). Asset-Level Risk and Return in Real Estate Investments. The Review of Financial Studies. https://doi.org/10.1093/rfs/hhaa122
write