The year 2006 started on a promising note for the real estate sector when the Government of India opened the construction and development sector in February 2006, and allowed 100 per cent foreign direct investment (FDI) under the 'automatic route'. Newspapers screaming with headlines like "Real estate in India is booming" became quite common around that time. A few months afterwards, with the RBI announcing a not-entirely-unexpected 0.5% rate hike, the same newspapers are coming out with agonizing stories of the real estate sector. This has left millions of middle-class Indians, who thought property as the next big thing and were saving their hard-earned money for that, have become more confused. All real estate enthusiasts seem to be perplexed by the question - "Is it the right time to go in for a house or should I wait for the prices to fall down?" The answer to this question lies only when one tries to look into the future and take an unbiased view of the market devoid of any irrational exuberance.
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Bubble Origin
But before we look into the future we need to go back to what created the bubble in the first place. The trigger for all this was the tech boom, the capital market boom, soaring corporate profits and hence big increase in salaries (increments of 15-20%) and spread of prosperity to smaller towns and cities. Added to this were expert projections of about 30 million middle class families, each with a spending potential of Rs 20 lakh, and a shortage of 20 million housing units. It was an invitation which institutional investors from outside could not say no to! The result was a rush of foreign investors coming in droves to join India's disorganized, barely regulated market, controlled by few. Thus, a perfect broth for a real estate boom was created!
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However, industry players would like to disagree with the fact that it's a frenzy and would squarely blame the unbalanced demand and supply equation for the boom in price. Foreign brokerage consultants like Anuj Puri, managing director of Trammel Crow Meghraj Property Consultants says: "The housing finance industry has grown from Rs 287.2 billion in 2001-02 to Rs 603.54 billion in 2004-05 and is expected to touch Rs 800 billion in 2005-06. The estimated size of the Indian real estate business is US$12 billion of India's US$600 billion economy. Assuming that all other factors remain the same, prices will increase as long as there is a shortage on the supply side." cont on pg: 27
cont from pg:25
But if we buy the argument and take into consideration that demand is the cause of the price rise, then, by economic theory, it is also fueling supply. In other words, the chance to make a quick buck has lured other new players, thereby bringing more and more supply to the market. Hence, a condition of excessive supply rather than burgeoning demand will emerge in the future.
Banks' Role
Further, to have a holistic look at the real estate sector, we have to take into consideration the global and domestic macro-economic environment as well. In our world, two actors can create and take money out of thin air - the central banks and the commercial banks. Over the past year, the world's central banks have been busy draining liquidity from the system amid inflationary concern. Commercial banks got a whiff of the message that the central banks were attempting to convey, changed their behavior rapidly, and started squeezing liquidity as well.
The situation can be aptly described in Mark Twain's words, "Commercial banks lend you an umbrella, then take it away once it is raining". The low-getting-lower home loans contributed in great measure to rescue the real estate market from the prolonged, nearly seven-year slump in 2003. Now the case is quite the opposite. Prices are no longer low. Moreover, home loans aren't at their most affordable rate either. So, if the price rise has to continue, it has to be backed by genuine demand.
Meanwhile, those market speculators who used to previously dabble with stocks and did not pay much attention to the real estate market, closed in on the opportunity to make a quick killing. This worked fine for buyers who had entered the market early. But those seeking to enter the market now would not be that lucky as what's desirable is no longer that affordable.
You can no longer be confident of selling whatever property you buy at a 100 per cent premium within a year. This factor can be clearly exemplified as resale transactions have gone down by as much as 30 to 45 percent in certain catchment areas of the National Capital Region of Delhi (NCR). Though this trend has not had any significant
impact on prices yet, it may have implications in the long run.
The major reason for this drop in property prices is the huge disparity between the price at which the initial cash rich investors pays and the price that the end users are ready to shell out. End users are no longer willing to pay the prices being quoted and are subsequently moving to lesser-expensive localities. If this trend continues, initial investors in possession of high-value properties may go in for panic selling, and this will have disastrous consequences. According to a report from real estate consultants Cushman & Wakefield, the residential markets in certain areas are witnessing a rationalization of capital values, because of which the market is finally establishing price thresholds.
Vicious Circle
Sensing the imminent danger signals looming large on account of speculative tendencies, the RBI has issued fresh guidelines on exposure to the real estate sector as the increase in interest rates and down turn in real estate prices, if any, may trigger higher default rates. Besides, the continuing uncertainty over increased crude oil prices may fuel inflation, forcing interest rates to go up further, thus virtually creating a vicious circle.
Overheated Market
Genuine investors fear that like the stock market, the real estate sector is also overheated. In the last three years, prices in Delhi/NCR, Mumbai, Bangalore and other cities have increased by two to three times (see Table 1). Also, there is no link between the market price of an apartment/villa or commercial establishment and the rental income. For example in the outskirts of Delhi, the rental income of apartments is now just 2-3 per cent of their capital value - earlier, it was 5-6 per cent (see Graph-1).
Table1: Delhi Residential Capital Value
Source:Cushman & Wakefield (May 2006 report)
Graph-1: Delhi Residential Rental & Capital Values
Source: Colliers International
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Stock market and Real Estate
The volatility on the stock market in the past months has also made the investors perplexed. Every one seems to be asking, "Are we going to face the same kind of situation when the assets become highly priced?" Consultants and builders would disagree and reiterate that there is hardly any link between the stock market and real estate.
However, there is certainly a psychological impact - a dip in the financial markets tend to affect the real estate market. But the impact can't be totally negated as the real estate market might start feeling the liquidity crunch when the stock market goes through turbulence. Many developers who had planned to raise funds from the equity market, are finding it difficult to do so after the stock market fall in May this year. It specially hurt builders who have overstretched themselves in the hope of raising funds through sale of equity.
Technically Speaking
Our study shows a strong negative relationship between property prices in top cities and home loan rates. The affordability multiple, which is defined as property prices by annual income, has been rising in the last two years.
A higher multiple shows that flats are being bought by people after a bit of financial stretch. Higher the multiple, higher the chance that a prospective buyer may postpone the buying decision. Since price is a factor of demand and supply, the situation could help cool prices in the medium term.
In the past, a lot of home buying was sparked by higher affordability coming from a rise in income levels. But in the last two years, there has been a wallet pinch. The affordability multiple shows how many times his annual income a homebuyer is buying a flat. Higher the multiple, more is the financial stretch he or she has to make.
For HDFC, the second largest home loan company, the affordability factor has inched up to 4.8 times in FY06, compared to 4.6 times in the previous year. Now, it could have crossed 5. With negative correlation between property prices and home loan rates in big cities - there could be a check in demand.
Not so rosy about Foreign Investment
Big deals happening in Indian real estate or joint venture formed with a foreign partner has attracted a lot of media attention over the past months since FDI was opened to foreign investors. As the media lapped up the deal story, there are some muted concerns, which we need to look into.
Opening up of the sector has exposed us to the risk of leveraged money from foreign hedge funds. A sudden pull-out by these funds, when either new opportunities emerge or their arithmetic goes wrong can send local markets into a tailspin. If big money chases real estate, spiraling property prices could create an "asset price bubble" which may eventually spook several markets.
Galloping property prices may also be unacceptable on the grounds that it makes properties unaffordable for a majority of the population. At the same time, it fans speculation and over a period even erodes some of the cost competitiveness that Indian cities have over their counterparts in emerging markets. Thus the flow of investment that we see now may well turn back to other emerging markets.
Investor behavior
In all deals across the country, developers have been bidding unrealistic values. Is there a method in this madness? Frankly speaking no! As a key ratio sale price to construction cost is very high. The sale price is usually a significant multiple of construction cost. This is going to hit the developers and the market over all. Income levels of Rs 5 lakh per annum or Rs 40,000-50,000 a month are still limited to a privileged segment of the population.
The average cost of dwelling is highly exaggerated comparing the mean population who still have no issues staying in cramped dwellings that are home to generations when prices spiral beyond their reach. That is exactly what seems to have happened in the last couple of months, when prices and interest rates rose in tandem to put homes out of the reach of thousands of potential buyers.
So what does this lead us to?
In terms of investment and purchase decision, when the prices are on the rise, there is a tendency for irrational exuberance where everyone wants to ride the bandwagon, without thinking through the implications. There is, however, need to exercise caution, as the fundamentals to any sector is very important. We have to realize that real estate at present level is in a high risk zone.
One push and it can go over the cliff. A correction in the market is imminent and may even be healthy for long term outlook of the sector. Though it is easy to predict correction, however, the most difficult part is to exactly give the time frame to when the correction will take place as all the factors have a lagged effect.
Hence the best an investor can do at present is to go for buying property if only they have a genuine end user need. Moreover, we also need to understand that real estate market is highly concentrated. So for investors another good option is to look for opportunities in greener pastures i.e. in tier 2 or tier 3 cities which has only recently seen increase in value. If we compare markets like Mumbai with Chennai, we can easily see a lot of value buying opportunity in an undervalued market like Chennai. (see Graph-2 & 3)
Graph-2: Chennai Residential Rental & Capital Values
Source: Colliers International
Graph-1: Mumbai Residential Rental & Capital Values
Source: Colliers International
Another parameter that investor can definitely look forward to when buying property is the rating of builders or projects given by accredited rating houses like Crisil etc. Since a lot of parameters are considered by these agencies it always gives a guarantee that an investor is not being duped by unscrupulous builders.
As we see property prices climb down from the dizzying heights they are now at present, end users will in the days to come benefit from this softening. Investors as a matter of fact need not panic as well as they can sit on cash and grab the opportunity to enter the market at a much lower premium. And for immediate buyers, a long term horizon of more than 5 years will help to ride the rough waves pretty smoothly.
