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Wednesday, 8 January 2014

Report of accountants organization Deloitte discloses financial black hole of €3.3 billion at the Dutch municipalities, caused by depreciated building ground. One problem: according to retired professor Hugo Priemus, these data are much too optimistic!

At the end of December 2013, the accountants organization Deloitte presented a research report to the Dutch government. The subject of this report: the depreciation of building ground, which is owned by the Dutch cities and municipalities.

The conclusion of this report: the depreciation on building ground for commercial and residential real estate (CRE/RRE), owned by the Dutch cities and communities, amounts to €3.3 billion in write-offs, until the year 2013.

Here are the main conclusions from the report by Deloitte Accountants (the PDF can be found at the location of the link):

In 2012, the Dutch housing market has rather deteriorated than improved. In this report, we come to the conclusion that Dutch municipalities must have taken €1.1 billion in additional losses on their building ground positions in 2012. These losses have been concentrated at a limited number of municipalities.

We also established that sales of building ground remains faltering and that the groundprices remain under fierce pressure. This in spite of the fact that municipalities stopped and also changed building projects in earlier years, based upon changing programs: from expensive, owner-occupied houses towards cheap, rented houses.

In earlier research of Deloitte Real Estate, we already stated that municipalities should have booked substantial losses with respect to the years 2010 and 2011. From the yield forecasts for 2013 and 2014, which we collected from the municipalities, it became clear that these forecasts will probably be too optimistic. Consequentially, additional losses can be expected in the coming years. Seemingly, municipalities calculated with a stronger market recovery during the creation of their yield forecasts.

On a macro level, however, the general reserves and provisions from the municipalities are large enough to cope with these estimated additional losses.

Based on the two described scenario’s in this report, future losses on building ground will mount from €0.7 until €2.7 billion. This loss would be added to the cumulative losses from the years 2010 – 2012, which have already been booked: €2.6 billion in write-offs plus €0.7 billion in vaporized future profits.

In the first half year of 2013, the number of building permits has dropped by 30%. This is an important indicator for the forecasted sales of ready-to-build building ground and it shows that the short term building production will not recover. This fact will lead to lower municipal revenues from the sales of building ground.

Besides that, there has been a year-on-year price decline of 4.5% for existing dwellings. This leads to enduring pressure on municipal building ground prices. There is also a shift visible from expensive owner-occupied dwellings towards rented houses and cheap owner-occupied dwellings. This will also reduce the future revenues from the building ground.

One of the most important risks is that pressure remains on the height of municipal prices for building ground. One should take into consideration that a total of €34.1 billion in forecasted future yields has already been processed into the forecasted budgets of municipalities. Certain preconditions and assumptions about the value of building ground and the future development of the value have been processed in these budgets.

Due to the limited time, I have only written here the most important conclusions of this report. This whole report, however, is a 'must-read' and I strongly advice everybody who masters Dutch, to download it.

Here are a few tables mentioned in this report:

Financial effects of the crisis on municipal ground corporations
Data courtesy of: Deloitte Real Estate
Click to enlarge
Financial position of municipal ground corporations
Data courtesy of: Deloitte Real Estate
Click to enlarge

(Forecasted) expenses and  earnings from municipal building
ground from 2009 - 2015
Chart courtesy of: Deloitte Real Estate
Click to enlarge
Although the conclusions of Deloitte in the aforementioned research study were already very disturbing, they didn’t go far enough in the eyes of the retired professor Hugo Priemus, with a chair in ‘system innovation of community space development’ at the Delft University of Technology.

When I asked him what brought him to reckon with additional losses of €3 - €4 billion at the municipalities, he wrote me the following lines:

Dear Mr. Labruyère,

It is my opinion that another €3 – €4 billion should be depreciated on municipal building grounds. The cause is the [aforementioned – EL] research study of Deloitte, called 'Financial situation at the municipal ground corporations', on which I have made some comments. Please read the enclosed Op-Ed that I sent to the Volkskrant on 7 January 2014.

Here is a translation of the almost integral Op-Ed by Hugo Priemus (I don’t know if this op-ed is actually placed in the Volkskrant, but I have the Dutch original in my possession):

Municipal building ground should be depreciated with billions of euro in additional write-offs.

By Hugo Priemus, retired professor, Delft University of Technology

December 2013, the report “Financial situation at the municipal building ground corporations” has been presented by Deloitte Real Estate. This report has been written on behalf of the Association of Dutch Communities (VNG) and the ministries of Domestic Affairs and Infrastructure & Environment.

Deloitte establishes that until 2013, communities lost €3.3 billion as a consequence of write-offs and vaporized future profits on their ground positions. For the future, further losses will be expected, amounting to either €0.7 (quick recovery scenario) or €2.7 billion (gradual recovery). 

The differences between the various municipalities are quite big. Municipalities that had a cautious building ground policy in the past, are mostly ‘home safe’ these days. However, municipalities which maintained an aggressive and expansive building ground policy, are now in deep financial trouble, as their building plans have become totally unrealistic.

For the situation until 2013, as described by Deloitte, the research study sketches a quite reliable picture, even though communities did not disclose everything. A substantial limitation of the study's value is the fact that private ground positions and “public/private partnership” relations have been left out of the equasion.

Practice learns that private parties in such a partnership are often able to transfer their financial risks to the municipalities, which (on their behalf) often didn’t reckon with the financial consequences of these risks.

Some critical remarks should be made with respect to the forecasted future results: 
  • First, the two scenarios seem to be chosen quite randomly. A grim scenario, in which economic recovery is not due for the time being, is missing in the study. There is enough reason to add such a scenario:
    • the special levy for landlords and building cooperatives, as established by the Cabinet Rutte, will lead to stalling investments in rented housing;
    • the building industry for owner-occupied dwellings will not recover, due to the more stringent conditions for mortgages and the fact that the Dutch banks have to establish higher buffers on their balance sheets;
    • Besides that, the demand for shopping and office space has eroded structurally: municipalities have insufficient means to build schools, libraries and community centres.
  • Second, in the meantime the building output in Residential Real Estate has dropped to 40,000 dwellings in 2013 from 60,000 in 2012 (of which 60% was demanded by the building cooperatives). Forecasted demand in 2014 is 30,000 – 35,000 dwellings. The need for housing increases actually, but the effective demand is lagging, due to inadequate financing possibilities. When we add the disastrous year 2013 to the analysis of Deloitte, we should add an additional €1.0 billion in depreciations.
  • Third, Deloitte showed us the enormous delay in the municipal reactions to the crisis. This crisis hit our country in 2008, but the first depreciations only followed in 2010. Even today, municipalities react slow. 
    • No further depreciations might be expected before the municipal elections of 19 March 2014. Afterwards, there will be plenty of those depreciations.
    • Now that civilian and utility building projects have totally stalled, additional depreciations will be inevitable in due course. 

When it will become clear, what I presume, that many private parties have only taken a ‘performance obligation’  clause in their contracts with the municipalities and not a ‘result obligation’ clause, many municipalities will be confronted with enormous financial setbacks.

Based on these considerations, I expect at least €3 to €4 billion in additional depreciations on municipality-owned building ground. The general reserves and provisions of the municipalities will show considerable declines. Once, the situation will become better, but not in due course yet.

I have very little to add to the words of the professor. The Dutch municipalities and cities started an ‘arms race’ for building ground in the beginning of the last decade: the sky really seemed the limit and cities that didn’t build new houses, industrial zones, shopping malls or commercial buildings were losers in the eyes of their more assertive colleagues.

And now… the party is over and the taxpayer will foot the bill for this municipal greed and stupidity and the total lack of supervision by the provinces and central government! 

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