The cost of living in Israel, one of the highest in the world, is influenced to a major extent by housing prices. The consistent rise in housing prices, is influenced by many factors with the shortage in supply of land, especially in areas of demand, the main but not only factor. Another significant factor is the Price Index of Inputs in Residential Building, which means that the final price of an apartments is not known to the buyers, even when signing the purchase contract.
What is the Price Index of Inputs in Residential Building?
The Price Index of Inputs in Residential Building is calculated by the Central Bureau of Statistics. It is very important for the entire construction industry and for those buying new apartments directly from building contractors because payments for new apartments are linked to it. The index is published each month and measures changes in expenses related to construction: work, materials, products and services. The index serves architects, building contractors, craftspeople and customers wanting to estimate the expected rise in price of construction contracts.
Damage to the entire production chain
Those buying apartments 'on paper' are exposed to rises in the Price Index of Inputs in Residential Building during the period between signing the agreement and completing full payment to the contractor. As the average home takes 30 months to build, the final price of the apartment can rise during this period by tens of thousands and even hundreds of thousands of shekels.
In addition to buyers, developers are also exposed the price rises in building inputs throughout the construction process for building contracts linked to the Price Index of Inputs and for buying materials and equipment. The building contractors are also exposed to rises in the Price Index of Inputs for contracts that are not always fully linked to changes in the Price Index of Inputs. Developers and homebuyers are also exposed to the risks of building contractors going bankrupt, even if the specific project includes 'protective clauses.'
In our estimation, the level of real exposure of the Israeli economy to the Price Index of Inputs is about NIS 150-200 billion. In other words, the economic cost in the rise in the Price Index of Inputs in the first half of 2022 alone was about NIS 7-9 billion.
The latest change in the Sales Law did not include a sufficient solution. Until recently, linkage to the Price Index of Inputs in Residential Building in sales contracts of apartments, mainly referred to the full price of the apartment that had not been paid so that it also included the land. An amendment to the Sales law was recently approved, which limits the linkage to 80% at most of the price of the apartment and 50% of the rate of rise in the Index, and only until the date of the apartment being handed over to the buyer as set by the contract. Even after the reduction in the cost of the apartment that is subject to linkage in the legislation, this exposure is still a problem that requires a solution, if only because the exposure is not limited to buyers of new apartments, but faces those involved in the entire construction chain, both of residential apartments and of other types of construction.
The problem has been exacerbated by the uncertainty of recent times. In the last ten years, the consumer price index and the construction input index rose moderately, but all this changed dramatically following the outbreak of the Covid pandemic. Economic uncertainty also rose due to the unexpected appearance of inflation, and the start of the Russia-Ukraine war. This is best reflected in the prices of goods that affect the Price Index of Inputs. Between January and June of this year, the Price Index of Inputs rose by about 4.4%. That is, an apartment bought six months ago for about NIS 1 million has become more expensive today by NIS 40,000 shekels, and the index is still rising.
In our estimation, we are facing a lengthy period of high uncertainty in the Price Index of Inputs. This phenomenon will of course have a direct impact on housing prices. Therefore, reducing the exposure to the Price Index of Inputs will benefit apartment buyers and may cool down housing prices.
The market won't correct itself
The current situation has several main negative consequences for the Israeli economy: an increase in the cost of living for buyers of apartments under construction, mainly young couples and housing developers, some of whom are not aware of the problem when purchasing the apartment; risk of non-compliance with the terms of the purchase agreement in view of the rising prices of the apartments, throughout the construction process; risks of bankruptcy costs of contractors and developers who have not protected themselves contractually, and an increase in transaction costs due to the existence of a risk that cannot be hedged.
Everything we have described here indicates a high demand for protection against the Price Index of Building Inputs. In other words, if it were possible to buy such insurance, it is likely that many apartment buyers would choose to purchase it, rather than remain at risk of the price of the apartment jumping by hundreds of thousands of shekels. And why would a large financial entity, such as a bank or an insurance company, not offer such protections?
In our understanding, the complexity of the index discourages even experienced financial bodies from offering insurance. The composition of the index - labor, materials and products - includes exposures that are too diverse, to too limited suppliers and non-tradable parameters that can also act in opposite directions. It represents a significant challenge for a financial body that seeks to profit from such an insurance product. So although this is a required and requested "market" solution, to the best of our knowledge, there is no financial services company willing to offer it.
It should be noted that despite the initial impression that there is a high correlation between the Consumer Price Index and the Price Index of Building Inputs, an examination of the actual data over the past ten years indicates a very low correlation (around 0.15), and changes over time. Therefore, hedging the risk by investing in bonds linked to the Consumer Price Index, which exist in the market, is not a solution.
The solution begins with the government
The government, on the other hand, has the ability and motivation to address the problem. The ability stems from the long-term horizon of its policy, so that it has the ability to "roll off" short-term risks, and also from the fact that part of its revenues from direct and indirect taxes (VAT, purchase tax) increase with the increase in the Price Index of Building Inputs. The direct and indirect motivation is to reduce the cost of living, and in particular housing prices; the reduction of banking and economic risk due to a reduction in bankruptcy costs and the postponement and reduction of demand for mortgages and credit for real estate; reducing transaction costs will increase competition in the field and the business cycles and tax revenues derived from this.
The range of solutions that the government can offer includes limiting the ability to link contracts to the index as was done in the recent amendment to the Sales Law. But the restriction is considered a significant interference in the freedom of contractual engagement and protects only some of the exposed.
Solutions such as subsidizing the cost of exposure for defined or eligible populations involve a long-term budgetary cost and in fact turn the problem from a market problem to a government problem. Another solution, given the advantages that the government has, as previously mentioned, is the involvement of the government as a "mediator" for a limited time. The government can act as a market 'jump-starter' for financial protection against the index, thus helping the market solve the long-term problem by itself.
We propose to develop a marketable financial instrument that will be issued by the government through the Bank of Israel, or by a government-backed financial institution. The instrument will provide protection against the index (for example, an option or future contract) that will be issued in a tender and traded on the stock exchange. The marketability will enable the reduction of brokerage gaps, and will enable the development of the protection market on the stock exchange or over the counter. The government will have control over the volumes of the issue, and it will be able to operate also in the secondary market when necessary, thus controlling the budget cost. It is assumed that over time, other bodies will supply protection, so that the government will be able to reduce its involvement in this market, after initiating and developing products.
Given the protection options of developers, it is likely that we will begin to see a supply of sales contracts not linked to the index. While it is likely that the price of the apartment will also weigh the cost of protection, this price will be in competition between developers. Also, buyers of apartments under construction will be able to purchase insurance against the increase in the index or part of it from financial institutions, which will be able to cover themselves against market risk.
A similar move was made in the early 1990s by the Bank of Israel in the foreign exchange market. To stimulate the foreign exchange derivatives market in Israel, the central bank tendered foreign exchange options that offered protection to those "exposed" to foreign exchange. After the market "matured", the Bank of Israel left the market and was replaced by commercial entities. It is important to emphasize that, over time, the Bank of Israel's foreign exchange hedge market startup activity did not involve significant losses or gains (there was no budgetary cost). Although, the case before us is different from the foreign exchange market (for example, the non-tradability of the underlying asset), But in general the problem is similar and so is the possible solution. שמירת התרגום
Beyond this, the existence of such an instrument would increase the government's motivation to deal with the causes of the increase in the index that are under the influence of the government and its branches, such as actions to increase competition, removing import barriers, etc.
Also an opportunity for the banks
It's possible that a large financial institution could also take up the challenge, skip the need for the government to initiate such a step, and do it themselves and profit from it. It has economies of scale and a wide safety cushion that would let it to absorb losses. These, in turn, may materialize in the first stages of launching a financial instrument in this new market due to the inherent difficulty in assessing the risk and its pricing.
This is how we have calculated the economy's exposure to the Price Index of Building Inputs
The scale of the real exposure of the Israeli economy to the Price Index of Building Inputs is in our estimation about NIS 150-200 billion, according to two main indicators.
The first indicator is an estimate based on the amount of square meters actively under construction in Israel multiplied by the estimated cost per square meter of construction. The estimate comes to about NIS 215 billion, but it also includes infrastructure and more.
The second indicator is the national accounts data published by the Central Bureau of Statistics: gross investment in construction in 2020 was about NIS 155 billion, of which about 80% was in residential and non-residential construction and about 20% civil engineering works. If we consider only residential and non-residential construction (about NIS 125 billion), and multiplying this by half the average construction time of a building (31 months, the figure for residential construction only) we get about NIS 160 billion.
Net financial exposure is, of course, affected by the financial arrangements for the transfer of the exposure between buyers and sellers, which can in some cases express an excess transfer (such as linking the amount paid including for the land) or a shortfall in the risk.
Menachem Brenner is professor of finance at New York University and creator of the VIX volatility index together with Prof. Dan Galai.
Dr. Meir Sokoler is a former Deputy Governor of the Bank of Israel.
Uri Cohen CPA is Head of Cognum Financial Consulting
Published by Globes, Israel business news - en.globes.co.il - on August 21, 2022.
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