What impact does interest rate have on the state of real estate sector in India?

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

18th December 2013 was keenly watched by the markets and industries alike, particularly the real estate sector in India. RBI governor was to announce the monetary policy and interest rates hike was expected because of the stubbornly high inflation prevailing in the economy. However, to the surprise of all and sundry, Raghuram Rajan refrained from rate hike and brought smiles to the market and industry.

Commenting on the policy, Real estate major DLF Group Executive Director Rajeev Talwar said: "It's a welcome step. This is the first sign of recovery. If government can release food stocks to contain food-based inflation then possibly in coming time RBI may be able to take more steps for recovery of the economy. RBI governor has taken a bold step by keeping the rates flat." Most other real estate developers and consultants welcomed the step. So, what kind of impact can interest rate have on property sector in India, let’s explore.

• Firstly, what are interest rates?

Consider an investment portfolio having investments in all productive activities in the economy based on their respective share of the economy to the total value of all productive activity in the economy, the rate of current earnings on such a portfolio would be equivalent to the real rate of interest. Such a rate would also be the rate required by economic units to save rather than consume from current income. This is also the minimum rate of interest that any investor, be it in realty sector, would least likely expect from their investments. Therefore, when RBI announces that Repo rate would stay unchanged at 7.75%, it was welcomed by the industry.

• Relation to inflation:

In addition to the real rate of interest, a concern that all investors have when making investment decisions is how inflation will affect investment returns. Inflation in India is particularly high; however, of all the commodities which form the basis of calculating inflation, the food inflation has been highest. And RBI was worried about curbing the inflation which eats into returns on investments or future incomes. However, RBI’s view is that most of the concern for inflation is the supply side and having had excellent monsoon would probably bring the inflation down due to bumper crops. Therefore, Rajan refrained from raising interest rates.

• Effect of interest rate on real estate supply:

Real estate supply is the addition of new stock of housing, office spaces, retail spaces, etc. to the market. Now, when a real estate developer decides to bring that supply to the market, he/she has to justify at-least the real rate of return on his/her investment. If the returns are low, investors would rather save their money than invest in realty projects. Therefore, when interest rates are low, it encourages builders to invest in real estate projects rather than save their money. At the same time, they can borrow funds from the market at lower rates and thereby cost of building real estate projects come down. Additionally, the debt servicing for the leading real estate developers come down and there is renewed excitement for all the real estate players. Financing real estate projects involves borrowing on a long-term or short-term basis. Because large amounts are usually borrowed for property development, financing costs are significant in amount and weigh heavily in the decision to develop real estate projects. Therefore, the lower the financing costs, the better it is for builders to bring new supply to the market.

• Effect of interest rate on real estate demand:

The demand for housing or commercial property is generally determined by the population growth, household income, household preferences for other goods and investments, and the interest rate that must be paid to finance the loan. Now, an individual who is looking to invest in a property will certainly evaluate his/her financing costs and higher the financing costs, the less likely, that individual would be to refrain from investing in property. For example, an individual buys an apartment at Rs. 30 Lacs. He procures a loan of Rs. 20 Lacs for 20 years at 11%. The EMI or monthly payment will be Rs. 20643.77. However, as we noticed today, State Bank of India has recently reduced their lending rates. And even a drop of 50 basis points or 0.5% would bring down the EMIs from Rs. 20643.77 to Rs. 19967.60. Thereby, cost of financing goes down by Rs. 676.17 a month or Rs. 8114.04 a year. Hence, bringing interest rates down encourages buyers to invest in property.

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• Desired Scenario:

Having the desired equilibrium between inflation and interest rates will lead to the growth of realty sector where both suppliers and consumers of real estate feel encouraged in participating.  And this will eventually lead to the overall growth of the Indian economy.

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Understanding interest rates and its impact on home buying decision!

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta
 

Buying a home has always been a cherished dream for an individual. The very thought of staying within the four walls that belong to you is very enthralling. The home that one owns provides not only the physical comfort but also emotional and psychological security which, in turn facilitate peace in life.

The dream of purchasing a home has remained intact; what has changed over the years though is age profile of buyers. Not long ago, purchasing a home would be a reality when a middle class man is on the verge of retirement. His life- long saving could be barely enough to finance the coveted asset. The balance could be pooled in by relatives and friends.  However, the time has changed now. Thanks to the wave of financial reforms and robust banking sector today. A young man out from the college and grabbing a promising job will soon be found to survey the real estate market to book a house.

The relationship between the financial sector and real estate today is complementary in nature even though the banks may be viewed as having upper hand in terms of being fund providers. It would not be an exaggeration to assume that majority of the transactions in the real estate market in India is being financed by bank loans. In such situations where bank loans have gained so much of importance in our lives, it becomes a necessity to understand the nuances attached with them.

Interest Rate:

A home loan seeker is confronted with a myriad of jargon. The most common and yet the most critical among them all is interest rate. Understanding interest rate and impact of its movement on the loan amount is crucial in making an informed decision.

Interest, to put it simply, is a kind of fee charged by lender of funds from the borrower. This fee or the interest may be computed at a “fixed” or “variable/floating” rate. So, if Rahul takes a loan of Rs. One Lac from a bank for period of one year at a rate of interest of 10%, it means he needs to refund Rs.1, 10,000/- at the expiry of one year (Rs. One Lac is the principal amount and Rs.10, 000/- is the interest).

Eligibility to avail home loans:

Banks and Housing Finance Companies are cautious when they lend. There are certain prudential norms which they follow while sanctioning a home loan. One of them is that the bank would restrict its exposure up to 80% of the value of the asset in respect of residential house property subject to the eligibility of the buyer. How the eligibility is determined and what role level of interest rate plays are interesting aspects to discuss.

In a typical home loan application, a bank would consider the following while determining the maximum amount of loan that can be sanctioned:

1. Gross Salary/month
2. Net Salary/month
3. Value of property 

An example:

Let’s take an illustration. Amit, a young software engineer in his mid twenties wishes to buy a house in Delhi NCR. He zeroes in on a property in Noida. The description of property is as follows:

• Builder: Sky Builder
• Area of Flat: 1000 Sq. Feet
• Rate/Sq. Feet (All inclusive): Rs.5000/-
• Payment Plan: Construction linked 
• Construction Period: 2 years 

Equipped with such information, the bank would put a threshold limit of Rs.40 Lac (Rs.50 Lac X 80%) on the loan amount that can be sanctioned against the property. Now it needs to evaluate eligibility of Amit based on his income profile. Banks make such evaluation on the basis of their own criteria which may differ from bank to bank. However, as a general rule, banks consider around 40-45% of net salary of an individual to be needed to service EMI.

The following example shows eligibility of Amit in three interest rates scenarios.  It has been assumed that in all three situations, Amit’s salary remains same and there is no change in any variable except in interest rate. In situation-I, where the interest rate is 10.50%p.a., Amit’s loan eligibility works out to be Rs.40 Lac. This is a perfect situation for him as he needs Rs.40 lac only and the maximum amount that the bank is ready to disburse is also Rs.40 lac. However, the situation is not so comfortable when there is a spike in the interest rate from 10.50% to 11.50% p.a. (situation-III).  Keeping the EMI amount almost at same level, there is a decline in the loan eligibility amount to the extent of Rs.2.55 Lac. The reason is simple. Given the hike in the interest rates and no corresponding increase in the income level of the individual, the banks would like to maintain their risk exposure at existing level. Hence, there is a reduction in the loan amount. A decline in the interest rates would be a spurt for the banks to increase the loan eligibility. This however is subject to overall ceiling with respect to asset value.

EMI:

Interest rate movements also cause substantial variability in the EMI that we pay. The table below is quite self-explanatory:

Hope this time when news channels flash the story of how RBI Governor is contemplating to tinker with the interest rates in its monetary policy review, you would not be so clueless about its probable impact on your home loan.  So watch out for it with the analyst in you.

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Repo rate and its impact on bank's lending rates to home loan customers for buying property in India

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

To control inflationary pressures, RBI increases repo rate. And it is quite evident from the short term and long term graphs; whenever repo rate is increased, it impacts growth of the industry. And in recent times, one can correlate the slowdown in real estate transactions with increase in repo rate.

Latest short term repo rate changes by Reserve Bank of India

History of repo rate changes by Reserve Bank of India

Whenever, repo rate is lowered it encourages individuals and companies to invest because of lower cost of borrowing.

For example, the debt on balance sheet of 11 real estate listed firms on BSE stands at Rupees 42000 Crores. Even a drop in repo rate by 1% reduces the debt servicing by Rupees 420 crores per year. That’s massive for real estate developers given that other input costs are rising.

Similarly, for a home loan seeker who has taken 50 Lacs rupees of home loan, drop in repo rate results in substantial savings on EMIs.

Loan amount – 50 lacs
Bank interest rate – 11%
Tenure – 20 years
EMI – 51609

Loan amount – 50 lacs
Bank interest rate – 10%
Tenure – 20 years
EMI – 48251

Which means, monthly savings of rupees 3358.

Therefore, just like any industry, real estate sector including the developers and customers are keeping an eye on RBI’s monetary policy and are batting for lowering of interest rates.

Repo rate and its impact on banks lending rates to home loan customers from Green Realtech Projects Pvt. Ltd

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Can development of Secondary Mortgage Market help fix the housing shortage in India?

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

As has been documented on numerous occasions about the shortage of housing in India, till 2012 (as per the census results) the housing shortage in urban areas stood at 18.78 million units**. About 99% of this housing shortage pertains to the economically weaker section (EWS) and low income group (LIG) categories. That’s a whopping number and constructing those many housing units for growing urban population will take enormous effort on the part of government, private businesses, and finance ministry.

Providing low cost housing finance to plug the housing shortage is seen as the key ingredient. However, most banks use traditional products such as using funds from deposits to finance long term housing loans. Therefore, to provide housing on a scale as large as in India, the concept of secondary mortgage market may well soon be adopted in India. In this article, we will briefly talk about the secondary mortgage market and why it is difficult to implement in India.

What is a Secondary Mortgage Market:

The secondary mortgage market is active in developed economies such as USA, Europe, Japan, Australia, etc. The primary function of this market is to provide a mechanism for refilling funds used by mortgage originators (Banks, Housing Finance Companies, etc.). This, in turn, enables them to maintain a flow of new mortgage origination during periods of rising and falling interest rates. They may accomplish this by selling mortgages directly to government agencies or private entities. Or they may form mortgage pools and issue various securities, thereby attracting funds from investors who may not otherwise make investments directly in mortgage loans. Hence, much like any corporation raising funds for doing business, the primary goal of mortgage originators in today’s market is to replenish funds by reaching broader investor markets.

In addition to direct sales of mortgages from originators to investors, many large mortgage originators found that they could place mortgages in pools and sell securities of various types, with mortgages in these pools serving as collateral. With the assistance and expertise of investment bankers, large mortgage originators can then issue securities in small denominations which would be purchased by many more investors. Firms with smaller mortgage origination volumes could continue to sell mortgages directly to government agencies, which in turn would create large pools of their own and issue securities.

Many types of mortgage related securities have been developed in recent years. The number and types of securities are continuing to increase as mortgage originators, investment bankers, and government agencies continue to innovate and reach investor markets that provide the ultimate sources for many of the funds used in new mortgage origination. Major types of mortgage backed securities are:

1. Mortgage backed bonds (MBBs)
2. Mortgage pass through securities (MPTs)
3. Mortgage pay through bonds (MPTBs)
4. Collateralized mortgage obligations (CMOs)

Why it is difficult to implement in India?

RBI recently came out with a report listing down the reasons for non-implementation of secondary mortgage market in India:

1. Low Investor Base
2. Cultural factors
3. Poor capital market infrastructure
4. Regulatory environment
5. Legal hurdles
6. Lack of proper accounting standards
7. Taxation
8. Poor quality of assets
9. System deficiencies
10. Lack of standardization

Road Ahead:
It is clearly evident from the discussion above that development of secondary mortgage market in India is inevitable given the scale of housing stock that needs to be provided. And sooner, we as a country fix some of the issues facing secondary mortgage market; the better it is for growing urban population and economic growth of the country. In 2011-12, the housing loan disbursed to individuals stood at Rs. 68221.12** Crores. With secondary mortgage market in place, this disbursed loan amount can achieve the global levels. And at the same time, provide a mechanism for transparent debt markets.

** Source: National Housing Bank

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What impact will RBI move of changing currency notes printed before 2005 and coming Loksabha Elections have on Real Estate sector in India?

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

• Land purchase may slow down due to RBI move to change currency notes printed before 2005

We all are aware of the fact that virtually all land deals whether large or small takes place with huge amount of money paid in cash to avoid stamp duty charges. Now, Let’s assume, there is a land transaction that is going to take place between party A and party B and the market price of the land is rupees 5 crores. As per the circle rates, the land price comes out to be rupees 2 crores. The remaining 3 crores will be paid in cash by party A to party B. Given that, RBI has announced that currency notes before 2005 needs to be exchanged. In this situation, Party B is not going to accept cash amount with currency notes printed before 2005. Therefore, it puts pressure on party A to exchange his/her currency notes with the banks. And in certain instances, party A may not be in a position to go to banks for the exchange of currency notes due to the fear of income tax authorities taking note of such huge levels of unreported income. However, it is yet to be seen what impact will there be on realty sector, but there is all the likelihood of fewer land transactions due to the RBI’s latest move to change the currency notes printed before 2005.

• Elections and real estate

Elections are a democratic phenomenon, which happens every 5 years in India. There are two kinds of election namely assembly elections for respective states and general elections for parliamentary system in India. All political parties whether small or large, regional or national strive hard to win elections and form the new government. It is commonly known that to win elections, political parties use all kinds of methods from announcing distribution of laptops, offering cycles, to free subsidies. The idea is to target the voters with such schemes in order to swing the pendulum in their favor.

And to win these elections, large amount of money is spent on advertising, organizing rallies, pamphlets, banners, press, traveling to various constituencies. About Rs 10,000 crore was spent in Lok Sabha campaign in 2009. And according to some estimates, this time that figure will be between Rs 15,000 crore and Rs 20,000 crore. There is no hidden fact that, the huge amount of money required is spent in form of cash. So, where does this money come from? Well, political parties will claim that this money is raised from their followers, supporters. Who are these followers? To put it bluntly, there is no free lunch here. All these so called followers who provide cash to political parties will like to claim their spending if the party they support comes in power. These claims may vary from allocation of natural resources, tax benefits, subsidies, dissolved cases, etc.

Now, how are all these followers able to provide such large amount of cash to these parties? We all know that in India even though most businesses claim to do business by the rule of law, but in reality they do under report their income and it is that income that is ploughed in real estate, gold, or elections. All these sectors have the unending capacity to absorb unaccounted cash. Therefore it is fair to say that when elections are round the corner, the investment in gold or real estate may dip and funds may be diverted towards elections.

• Impact of elections on property sector in India?

As observed earlier that during the time of elections, the funds are diverted towards political parties’ election campaign. And the sectors that suffer the most are real estate and gold. Large amount of unaccounted cash is provided to these political parties which until now would have been parked primarily in real estate. In fact, during election times one can notice the increase in distress sale activity in real estate. Since, huge amount of money is required for elections; properties worth millions are sold at below market rates to generate sufficient cash for elections. It is also highly likely that real estate developers will cut down on new launches of housing units or commercial real estate and will solely focus on selling the existing inventory.

• Should I buy the property during election times?

From the end-uses point of view, it is possibly the best time to buy. One can focus on buying from secondary market or resale market. As suggested earlier, there is strong likelihood that distress sales will increase and it presents end-users with an opportunity to buy at lower rates. However, buying in secondary market means, one has to pay huge amount of property value in cash. It is also the good time to negotiate hard with the developer if one is buying directly from the developer.  Since developers are only focusing on clearing the existing inventory, it presents end-user with an opportunity to bargain hard and get substantial discounts on the property.

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Why US like sub-prime (housing) crisis will not happen in India?

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

If one were to observe the recent trends across real estate sector in India, he/she would realize that market is slow. Damn slow. From increasing unsold stock of housing units to slowdown in office space absorption across major cities in India, the trend has been depressing to say the least. Will it lead to price correction? Yes, we predict so, read "Real Estate Bubble in India" to get a sense.

However, question to be asked is “will prices fall so dramatically that it leads to US like sub-prime crisis”? And the answer is BIG ‘NO’. Why? Let us explore!

First of all what is a sub-prime crisis?

It was about 5 years ago, some of us were in business schools and the shocking news of Lehman Brothers going bust filled the classroom. Most of us were new to business jargon like ‘sub-prime’, ‘securitization of home loans’, ‘derivatives’ and therefore could not grasp the solid reasoning behind the banking crisis. However, as days passed by, we began to understand this better by discussing with professors; peers; and reading articles. One of the better anecdotes that explains US sub-prime (housing) crisis goes like this:

“Linda is the proprietor of a bar in the city. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around and as a result increasing numbers of customers flood into Linda's bar. Taking advantage of her customers' freedom from immediate payment constraints, Linda increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Linda’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank's corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide.

No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top-selling items.

One day, although the prices are still climbing, a risk manager (subsequently of course fired due to his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Linda's bar. However they cannot pay back the debts. Linda cannot fulfill her loan obligations and claims bankruptcy.

DRINKBOND and ALKBOND drop in price by 95%. PUKEBOND performs better, stabilizing in price after dropping by 80%.

The suppliers of Linda's bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor.

The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties (and vested interests). The funds required for this purpose are obtained by a tax levied on the non-drinkers”.

Well, simply, replace unemployed alcoholics by home loan seekers, Linda with a housing company, and throw in a mortgage company and investment banks with all their financial engineering skills. And what you had was major financial crisis.

Why can’t it happen in India?

Reason 1: Black money

Yes, it’s actually true that no matter how much we curse the existence of black money into the real estate sector, but it actually won’t allow a sub-prime (housing) crisis to happen in India. In US, banks started to lend 100% of home value at lower rates in initial years (known as teaser loans in India) to borrowers and this led to default when home prices fell. However, in India, even if a bank lend 100% of home value to its borrowers, a borrower will still have to pool in the equal amount of cash to buy the house at market value. 

For example:

A housing deal takes place between a buyer and seller and the market price is Rs 80 Lacs. However, as per the government circle rates, the home value on paper is 35 Lacs. Due to high stamp duty charges, the buyer will not report the actual value of Rs 80 Lacs to the registrar office. And the seller will not report the actual value of 80 Lacs in order to save on capital gains taxes. Therefore, what we get is a property which is worth Rs 80 Lacs, is actually registered at Rs 35 Lacs. The remaining 45 Lacs is paid in cash by the buyer to the seller. So, even if the buyer’s bank offered 100% of home value which is 35 Lacs on paper, the remaining 45 Lacs is arranged by the buyer. And who on earth would walk away from this home where he/she has invested 45 Lacs of their cash even if the home prices dip.

Reason 2: RBI Policies

Reserve Bank of India (RBI) has put in place certain policy measures which until a few years ago looked conservative to many people. But these very measures will not allow the Indian banking system to lend aggressively and these measures are:

• In India Banks provide home loans for about 70-80% of property value. The remaining 20-30% has to be arranged by the buyer. Whereas, in US this norm was relaxed and banks began giving loans equal to the entire value of the house.
• In India, banks check the credit worthiness of the borrowers and lend only to people who have income records and have the capacity to pay EMIs. Whereas in US, home loans were granted to people with no documented income, job or assets. 
• In US, banks came up with teaser loans (interest rates are low in initial 4-5 years and then are aligned to market rates). Borrowers were happy to get home loans at sub-prime rates; however, they found EMIs too hard to pay as soon as the interest rates were realigned to market rates. And they simply walked away. In India, the concept of teaser loans is not allowed.
• Non-recourse debt in US. This kind of debt is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral. However, in India, the borrower is personally liable. In other words, banks can seize his/her other assets to recover their claim.

Add to these above reasons, the fundamental issues of housing shortage and emotional attachment of owning a home will make sure that housing sub-prime crisis will not happen in India.

In a nutshell:

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