Right time to buy properties

I met few developers in Bangalore yesterday. With inflation cooling off to 5.9% last week, India may see interest rates in the range of 7-8% in the next 6 months. This should be music to ears of both buyers and developers. Moreover, the persistent decrease in the general price level of commodities especially cements is likely to bring down the cost of construction. With real estate developers expected to further cut prices over the next three months, experts feel that this is the best time to let their indecisiveness work to buyers advantage.

Good time for retailers?

With the prices coming down, I believe this is a great opportunity for retail companies to expand their footprints. Commercial property prices and rentals have come down in all metros. They should plan to lock-in their ventures with the developers for the next few years. This would help them to improve their profit margin due to lower rentals until they are able to achieve decent economy of scale.

Real Estate - What next?

This is a terrible time for real estate developers, who have excess inventory, are short of capital and very low demand, but a great time for buyers with cash at their disposal. In a bearish market, where there is a poor demand for products, customer is the king! The same is true for property buyers. Remember the time when developers were asking exorbitant (ridiculous is the right word!) high prices for their properties. Their greed is over now but it is the time for YOU, the buyers, to be greedy.

This sector has already seen price corrections and will see another correction soon. Developers are in deep trouble because not only funds have dried up but also demand has gone down. People who booked properties this year are delaying or canceling their orders. These firms are facing acute problem of servicing their debt obligations (They raised huge capitals to fund their ambitious pan-India projects). There is some fear in the market that even big developers are on the verge of defaulting loan payments.

Bangalore Real Estate Expo-2008
I went to attend Real Estate Expo in Bangalore on October 25th and 26th. Mantri Developer was the only big developer out there while rests were Tier-2 and -3 developers, which had only couple of projects to their credit. As expected I found very few people compared to last year. It appeared to me that things are not going great for the big as well as local developers. Most of their completed projects are yet to be sold. If you remember the scene in the last few years, projects used to get sold the day it was launched! Alas, those days are over. When I spoke to these developers, however, none of them was willing to accept it. They appeared confident, at least were pretending to be, and optimistic about their new projects, which they were planning to launch soon. But, one thing was clear that most of their projects were behind schedule, at least by six months.

Do’s and Don’ts in the market
Ask for heavy discount on finished apartment. You could ask for up to 30% discount. Real estate developers are in deep red and will want to sell off all the finished products as soon as possible. However, buy ready to handover properties only. If you can delay your plan, wait for another 4 to 5 months. Prices would come down by another 15-20% over this period.

Do not buy any under construction property because the chances are high these developers may not have enough fund to complete these projects. Mid-tier developers are the worst affected because they may not have enough resources to fund their projects. Expect to see a delay of 2 to 3 years on most of the projects that were announced this year. “Over the night flyers” have quit the market and this is a great news for the consumers.

Employment scenario in the sector
Diwali sales are down amid the ongoing financial crisis. Buyers have adopted wait and watch approach which I believe is the right thing to do in the bear market. Some analysts believe the sector would see layoffs in the coming years. In the current scenario, developers can not sustain a huge workforce that was created during the boom time. So top realtors like DLF and Unitech might be forced to reduce their workforce by 5-10% to cut costs while mid-tier developers may layoff around 15-20% of their manpower. Moreover, executives at these firms got huge salary increments previous years which may now be reduced. There will be some effect on ancillary businesses as well. Consulting or Investment Banks or Private Equity firms which specialize in providing real estate specific advisory services would face the heat as well. So we will see lesser recruitment by these firms.

However, some analysts believe that there won’t be many layoffs in this sector because there is a scarcity of real estate professionals (compared to mature markets) in India. Second, new areas to work for especially for real estate i-banking people (REITS and real estate derivatives, the latter will take perhaps some more time). Third, fundamentals of Indian economy are still strong that will lead to higher growth, create more people with high disposable income, retail revolution, etc.

Outlook
The next couple of years would be slow for the industry. There is a genuine excess supply in the market which needs to be absorbed quickly to match it with the demand. This will lead to further price correction. Interest rates have started coming down which might ease some pressure on buyers’ shoulders to borrow from banks. This would give some boost to the demand for the residential properties. However, as long as there is a negative sentiment among buyers, both domestics and internationals, the demand would grow slowly, forcing speculators out of the market. The demand for commercial properties will depend on the outlook of US and European countries. If they go into deep recession, IT/ITES companies (which consumes 75% of commercial real estates) will have lesser growth and hence less demand for commercial space. Hence, both global as well as domestic factors will decide the future of industry.

Sub-prime Crisis: What is it all about?

Sub-prime crisis is the current financial crisis (considered as the worst ever since World War II) characterized by acute credit crunch in the global capital markets. This liquidity crunch is not only because of shortage of funds or higher interest rates but also because of mistrust among banks that have forced banks to stop lending to each other. Banks do not know whether other banks have enough cash and liquidity to survive to pay back the loan; thus, affecting the critical inter-banking operation in the economy. This has affected the liquidity in the market and made highly leveraged banks difficult to operate and survive.

Inter-Banking market operation
Open market operations is a tool used by Fed (RBI’s equivalent in the US) to regulate money supply in the economy. U.S. banks and thrift institutions are obligated by law to maintain certain level of reserves, which is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10% of the total value of the bank's demand accounts.

For example, assume a particular U.S. depository institution, in the normal course of business, issues a loan. This dispenses money and reduces the bank's reserves. If its reserve level falls below the legally required minimum, it must add to its reserves to remain compliant with the regulation. The bank can borrow the requisite funds from another bank that has a surplus in its account with the Fed. Thus, this operation is an extremely powerful tool not only to regulate liquidity in the economy but also for the survival of these banks.

Now imagine what will happen if banks stop lending to each other. Banks will not be able to match their assets and liabilities by borrowing from banks having surplus. Thus banks that have high liabilities or are highly leveraged (e.g. Lehman, Wachovia and Washington Mutual) will go bust!

Sub-prime home loan
Let me explain what does sub-prime loans mean. Prime home loans market refers to individuals with very good or excellent credit records or ratings and to whom banks lend directly. Sub-prime market refers to individuals, who have poor credit record characterized by unstable income. Thus, banks or other lending institutions would not lend money to such individuals. So, how will such individuals get home loans to fulfill their great American dreams? Here enters- financial institutions (FIs), which have excellent creditworthiness. These FIs take loan from banks at lower interest rates and break these loans into a lot of small home loans and lend them to “sub-prime” lenders at much higher interest rates. Thus, FIs make profits on the spread (difference between the lending and borrowing interest rates) by taking higher risks. This home loan market is called “Sub-prime home loan market”.

How this crisis started?
Many believe that sub-prime crisis is direct fallout of the US credit culture. i.e. borrow as much as possible way beyond the means. In 2008 the average household debt was 130% of the average income and average household owned 12 to 13 credit cards. Mind blowing! Isn’t it? The problem primarily began with the US keeping its interest rates very low for a very long time, thus encouraging Americans to go in for housing loans, or mortgages. Lower interest rates encouraged buyers to take on bigger loans, and thus bigger and better homes. Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%. This was fostered by federal government to increase ownership among minorities and poor.

With the American economy doing well at that time and housing prices soaring on the back of huge demand for real estate and bigger and better homes, financial institutions saw a great opportunity in the mortgage market. In their zeal to make a quick buck, these institutions relaxed the strict regulatory procedures before extending housing loans to people with unstable jobs and poor credit records. Few controls were put in place to handle the situation in case the housing bubble' burst.

The crisis began with the bursting of the United States housing bubble. A slowing US economy, high interest rates, unrealistic real estate prices, high inflation and rising oil tags together led to a fall in stock markets, growth stagnation, job losses, lack of consumer spending, a virtual halt to new jobs, and foreclosures and defaults. The sub-prime loans were given by FIs at floating rates. With rising interest rates in the US, EMIs for these individuals also started increasing (what we see today in Indian market) and sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping out their net worth. Their mortgage-backed securities were almost worthless as real estate prices crashed.

The moment it was found out that these institutions had failed to manage the risk, panic spread. Investors realized that they could hardly put any value on the securities that these institutions were selling. This caused many a Wall Street pillar to crumble. As defaults kept rising, these institutions could not service their loans that they had taken from banks. So they turned to other financial firms to help them out, but after a while these firms too stopped extending credit realizing that the collateral backing this credit would soon lose value in the falling real estate market.

Why Investment Banks like Lehman Brothers went bust?
Earlier I talked about how FIs like Investment Banks made profits on the spread (difference between the lending and borrowing interest rates) by taking high risks on the money borrowed. This provided huge incentive to these FIs to borrow and lend as much as possible creating huge “leverage” on the books. During the time of housing boom, this was considered as Mortgage Backed Securities (MBS) portfolios typically received high credit ratings with minimal defaults. Since Investment Banks do not have the same capital reserve requirement as Depository Banks, they borrowed and lent amounts exceeding 30 to 50 times their net worth i.e. their leverage on the books were between 30 to 50 compared to depository banks’ leverage of less than 15.

Now, housing market started declining by the end of 2005 and went bust in 2007. This along with increasing delinquencies and foreclosures by worried customers led to the decline of housing prices and in turn the value of MBS. Investors became concerned and in some cases demanded their money bank, resulting in margin calls (immediate need to sell the MBS portfolios at fire-sale prices) to pay them. At such high leverage (between 30 and 50), many FIs suffered huge losses, bankruptcy and merger with other banks. With this, MBS portfolios became extremely risky and hence “untouchable” and banks stopped buying or trading them. Their values plummeted further and all those institutions who have bought them suffered huge losses and created panic and acute liquidity concern in the market across the globe. Lehman Brothers had a leverage of 31 and hence went bust because it didn’t have enough cash to service margin calls by its creditors.

Effect on the economy
This severe liquidity crunch led to several negative effects on the economy. This ripple effect was seen not only in the US but also in the European Union because all these rich and big banks in the US and Europe invested heavily in these Mortgage Backed Securities (MBS) during the boom time. Banks stopped or became extremely reluctant to lend money to companies which have to either delay or stop their investment plans.

This has led to increase in unemployment and drop in the consumption. The financial crisis as we know caused a panic in the market and stock market declined heavily. Most of the US people have their investments either in real estate or stocks. As both these investment tools suffered heavy losses, average household value/income decreased sharply causing panic among citizens. In the coming years we might see major world economies such as US and Europe in recession.

Why India market fell?
Once investments by the FIs in the US turned bad, more money had to be invested back, to maintain that fixed proportion i.e. to match assets and liabilities on their books. In order to invest more money in the US, money had to come in from somewhere. To make up their losses in the sub-prime market in the US, they went out to sell their investments in emerging markets like India where their investments have been doing well.

So they started selling their investments in India and other markets around the world to maintain enough liquidity in the US economy and for their own operation. Since the amount of selling in the market was much higher than the amount of buying, the Sensex began to tumble. Additionally, crude prices were in the range of $120-150 which caused inflation to rise in double digit forcing banks to raise their interest rates. Thus, higher rates seriously affected real estate, automobile and banking firms’ operations and their stock crashed. Moreover, there were some rumors that even Indians banks had some exposure to these risky MBS and hence, banking stocks were among the worst hits. The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar. The stock market will continue to tumble as long as there is huge selling pressure from these FIs.

Bail-out
This crisis is now spreading from sub-prime to prime mortgages, home equity loans, to commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans), to leveraged loans that financed reckless debt-laden leveraged buy outs, to municipal bonds, to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk are indeterminate and underlying assets value is hundreds of trillions of dollars.

This is a total systematic failure which needed an urgent and high level attention across the world. Thus, we saw a $3 Trillion bail-out from central banks in the US and EU. Let’s keep our fingers crossed and see what future holds for us!

Indian Real Estate Sector

I published an article on Indian Real Estate couple of months back in a leading magazine. Two days back, I revisited this article and decided to start a blog on Indian real estate sector - What it was, where it is now and where will it go from here. A small piece of the entire article is here:

India Real Estate
The size in terms of total economic value of real estate development activity of the Indian real estate market is currently US$40-45bn (5-6% of GDP) of which residential forms the major chunk with 90-95% of the market, commercial segment is distant second with 4-5% of the market and organized retail with 1% of the market. Over next five years, Indian real estate market is expected to grow at a CAGR of 20%, driven by 18-19% growth in residential real estate, 55-60% in retail real estate, and 20-22% in commercial real estate.

Long-term outlook
Long term industry outlook remains attractive: We believe that long term industry outlook remains attractive, on account of increasing urbanization, growing nuclear families and the increasing number of Indian middle class. Fundamentally, strong GDP growth, increasing tourism traffic and increase in per capita income coupled with lower interest rates shall improve the outlook of the sector in the medium to long term.

Key Drivers of Real Estate
1) Economic Growth
- GDP growth rate of ~8-8.5%
- Double-digit income growth rate for the next 3-4 years
- Income growth should improve affordability, driving demand for residential units
- Lower interest rates

2) Demographics and Urbanization
- Positive demographic trends - middle class or the aspirers to show a CAGR of 10.4% to reach 124m in 2013 compared to 46m in 2003
- Urbanization – UNDP forecasts urban population will constitute about 40% of total population by 2030 from the current about 28%
- Indian household families moving from joint families to nuclear families

3) Favorable Interest Rate and Fiscal Incentive
- Housing loan interest rate, despite the recent rise, continue to remain low compared to 15-16% in the 1990s
- Easy availability of finance
- Fiscal incentives offered on owing a residential house is also a significant demand driver

4) IT/ITES Growth
- Strong IT/ITES growth should drive demand for commercial space – FY07-10 CAGR of 23% as a result of 568 000 employee additions; Indirect contribution to residential demand as well
- They consume about 75% of the commercial space

5) Organized Retail and Hospitality Demand
- Organized retail penetration level at 4.1% is lowest compared to other emerging markets
- Economic growth and changing demographics should increase retail penetration levels
- Strong tourist arrivals should spur demand for hotels across India. Foreign Tourist inflow is forecasted to show a 20%+ CAGR to reach 10m by 2010 compared to 4.4m in 2006
- Room shortages have resulted in a sharp jump in average room rates – Rs7,559 at end-FY07 vs. Rs2,004 in FY03; Approx. 105,000 hotel rooms are available in India

Future outlook of the sector
The real-estate sector offers a US$80bn-100bn opportunity over the next three years. Higher economy growth and rising income level will lead to higher demand for both residential and commercial properties. An easy and huge availability of capital will enable real estate developers to meet the demand.

Growth in the next decade should come from Tier II/III cities
- Higher real-estate prices in Tier I cities coupled with manpower and infrastructure issues may force companies to look at Tier II and Tier III cities for expanding their operations
Tier I cities- Mumbai, Delhi and Bangalore
Tier II cities- Kolkata, Hyderabad, Pune
Tier III cities- Nagpur, Ahmedabad, Indore, Lucknow, Jaipur
- Within the next three to six years, towns and cities such as Chandigarh, Jaipur, Mysore, Indore, Coimbatore, Vishakhapatnam, etc are likely to see an increase in real-estate demand from the IT/ITES sector
- According to Nasscom’s projections, Tier II and Tier III cities, which account for about 29% and 5% of the total commercial space in FY07, respectively, will increase to 44% and 20% at the end of FY17