By Brenna Hughes Neghaiwi and Rupert Pretterklieber
ZURICH (Reuters) - Nearly four years after a 1930s telephone switchboard centre was transformed into 18 industrial-style loft apartments in Zurich's Wiedikon neighbourhood it is still not fully occupied.
With rent plus utility bills of just over 5,400 Swiss francs per month for a three-bedroom apartment, the development by part of Swiss bank Credit Suisse <CSGN.S> is indicative of a real estate rush which is raising regulatory red flags.
A search for yield driven by Switzerland's negative interest rates has driven investors to build up their residential property portfolios and commission new luxury complexes.
But although the country's vacancy rates have hit their highest levels in more than two decades, Swiss banks have upped mortgage lending as more investors seek to cash in.
This is causing alarm among Swiss authorities who warn banks could be exposed when interest rates rise from the abnormally low levels used by the central bank to rein in the Swiss franc.
"A real estate bubble is the biggest asset risk on the banking side," one regulatory official said. "The investment property, buy-to-let segment is definitely overheated."
Vacancies on rental apartments more than doubled in nine years and the Swiss National Bank in June suggested implementing "targeted measures" for residential investment property lending.
In an indication of the dependency on low interest rates to sustain demand, UBS <UBSG.S> says nearly one in five mortgage applicants in Switzerland is looking to rent the property out.
With rates for ten-year mortgages at below 2 percent, compared to an average of around 5 percent from 1960 to the onset of the financial crisis a decade ago, creditors and investors are exposed to the risk of not being able to refinance their loans when interest rates do rise.
But with insurers Zurich <ZURN.S>, Swiss Life <SLHN.S> and Axa Winterthur, along with a number of pension funds, offering 10-year rates of 1.3 to 1.4 percent developers have pressed ahead with their building bonanza.
TENANTS IN DEMAND
The stresses are most apparent in rural areas such as Remigen in the Aargau canton, where high-end projects have failed to find tenants, developers are offering discounts and bonuses, including rent-free introductory offers.
"There are regions where I wouldn't build anymore," said Anton Affentranger, chief executive of Implenia <IMPN.S>, Switzerland's largest construction firm, which converted the Swisscom building that Credit Suisse took on in Zurich.
"I wouldn't build out in the sticks," he added.
Credit Suisse's Real Estate Switzerland group, an investment vehicle for pension funds which focuses on residential properties, saw its portfolio grow by nearly 13 percent to 7 billion francs from June 2014 to June 2017.
But while its vacancy rate nearly doubled to 8.2 percent, its generated returns -- although down 11 percent over a three-year period -- remain comparably attractive at 4.59 percent.
What is worrying some property market analysts is that while rents have fallen, purchase prices have risen, posing a persistent affordability risk and bringing back memories of a late 1980s Swiss real estate bubble which triggered a damaging banking crisis in the 1990s when it burst.
It now costs the equivalent of 30.7 annual rental payments to purchase a comparable home, according to UBS's second-quarter real estate bubble index, the highest purchase-price-to-rent ratio in a 36-year survey and above the previous peak of March 1989 at almost the height of the earlier real estate bubble.
"There will have to be a price correction in the investment business. The appetite for real estate investment is so large that it's caused large distortions," Axa's <AXAF.PA> head of Swiss real estate, Ernst Schaufelberger, said.
"Many private (investors) are taking on a lot of debt."
There are also concerns about affordability for commercial borrowers, with ratings agency Moody's saying more than half the loans granted failed banks' own self-regulation tests .
These tests assess whether a mortgage would remain affordable -- calculated as no more than a third of a borrower's gross income or a third of net rent on investment properties -- should interest rates rise to 5 percent.
"For residential investment property held by commercial borrowers, 51 percent of loans transgressed this guideline in 2017, up from 37 percent in 2016," Moody's said.
"A sharp fall in house prices may result in collateral values no longer covering the value of the loans, which would imply outright losses for the bank in the event of default."
The Swiss National Bank has said new rules boosting capital requirements for domestic-focused banks of systemic importance should help cushion against any fallout, but there is growing concern that the government may also need to step in.
"All major financial crises have been precipitated by a real estate crash," the regulatory official said, adding the big question was how sharp the correction would be.
While many banks agree that prices have reached a high level and that certain lenders have been over-generous in granting loans, they see the worries as overblown.
Switzerland's third-largest bank, cooperative lender Raiffeisen [RFSHW.UL], is the country's biggest mortgage lender and issues nearly one in four Swiss mortgages.
"I'm of the opinion that one can more or less close one's eyes and sleep easily," Raiffeisen Chief Economist Martin Neff said. "There are one or two cases that require targeted action, but I don't see a need for a broader market warning."
(Additional reporting by Angelika Gruber; Editing by Alexander Smith)