What is underwriting in real estate and why do real estate developers go for it?
Sumit was looking to purchase a
property in Noida and he missed out on the opportunity to book a flat with reputed developer last time because within 2 days of the launch, the project was sold out. He had made up his mind not to miss such opportunities next time. However, even after keeping an eye on new project launches, he missed out again and now the only option left was to book the apartment with channel partners, underwriters, or brokers.
Why does this happen? He questioned…and even wondered…”I read an article last time, and it said…real estate demand is dropping”. How come, these new projects are sold out within a day or two of their launch??
The reason behind the selling of these new real estate projects in a day or two is not the actual demand but artificial demand. Real estate developers use the services of their nexus of brokers and financiers who underwrite these projects.
Real Estate project underwriting in its broader term means sharing the risk of the developer. Brokers or financing houses underwrite the real estate project, which means they have taken on the risk of distributing/selling the project. Should they not be able to find enough investors or customers, they will have to hold some stock themselves. Underwriters make their income from the price difference between the price they pay to the real estate developer and what they collect from investors or from broker-dealers who buy portions of the offering.
With the help of this nexus, developers start making claims that their projects are sold out. With underwriting, developers are able to create a situation wherein they let prospective buyer believe that there is demand for the project and that they should buy the property now or else the prices will go up shortly. And this normally creates a herd mentality among end-users and they have no other option but to buy the property.
Why underwriting is not good for real estate sector in India
The demand thus created by the nexus of builders and underwriters clearly sends the signals to the market that “All is well” with realty sector and demand is robust. However, for a given city the actual
demand supply equilibrium can be understood by studying and analyzing the capital value appreciation and rental yields. If demand is robust, it should reflect in the rental yields as well. However, what we see in most Indian cities is the fact that rentals have not kept pace with the capital value appreciation. The artificial demand created by the builder-underwriter nexus keeps the capital value of housing stock unjustifiably high.
- Prices keep on moving up despite the sluggish market economy and demand
We keep reading from various leading research agencies about the amount of unsold stock lying with the developers and how it has increased over the last quarter or year. There is hope that prices might come down to reasonable level. And all of us sit on the fence hoping that prices are going to come down, but what happens is actually opposite. Prices are always going up. Demand or no demand, prices in real estate sector in India move only in one direction and that is up. There is never a correction. Why? Well, coupled with the limited launch of new supply, holding up of existing inventory keep the prices firm. Finally, the buyer gives in and the cycle continues as usual.
Housing is a basic need where one dreams of having a house with certain features and specifications. In reality, buyers are forced to buy whatever is available at prevailing market prices. There seems to be no choice whatsoever for buyer to buy a piece of land and construct his own property due to high prices.
- Non preferential allotment
There might be people who might have contacted the developer early and would have thought of booking an apartment at their desired floor with best available view. However, this wishful thought may not come true due to underwriting of the project as it may be blocked by underwriters in bulk bookings.
- Housing is treated as an investment class rather than a basic need
People or businesses with deep pocket and unaccounted income invest in some of these projects to park their money. There are instances when one individual or business house owns multiple residential properties. Whereas the land allotted by civic authority to builders should have served the purpose of creating housing supply for the needy at justifiable price, what we see is the mad rush by people to own multiple properties. And this builder-underwriter nexus serves this well by allowing
cash component in property dealings.
A builder offloads its stock to underwriters and then an underwriter sells the stock to end-users or investors. Based on the artificial demand created, builder keeps on increasing the prices periodically (monthly or quarterly). The underwriter then sells the property at lower value than the current builder price. The premium charged by the underwriter is usually paid in cash by the investors. And this leads to a circle wherein an investor with
unaccounted income invests in property and the cash amount received by the underwriter is again pushed back into buying of another housing stock.
Are there any solutions to this builder-underwriter problem?
Yes, there is a solution. Whenever a real estate developer sells, it should be made mandatory by law that the buyer information will be made public. By having the buyer information, not only will this lead to actual demand but may also put a curb on entering of black money into real estate sector. But, will the authorities pay any attention to this? We don’t know and this is where the
Real estate regulatory bill has also failed. Read more on
real estate regulatory bill in the next column.
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