Having worked in Indian real estate for the last 8 years in multiple roles (investment banker, consultant, fund manager and business development) & across the major participants of the industry (Property Consulting Firm, Investment Bank, Private Equity Fund House & Real Estate Developer) I was always intrigued by lack of major corrections in real estate prices in India unlike those in western countries.
When Sub-Prime crash happened in the US in early 2008 I was in the US. Those days and until early 2010 wherever you could go in the US you would have seen “For Sale” hoardings. Prices in some counties had crashed by over 60-70% in east as well as west coasts. I was told scenarios were not very different in Europe as well. So why such a crash didn’t happen in India?
In the last 2 years we can see rising inventory levels (Bangalore the “Best performing” market has over 27 months of inventory) across all metros. Developers are under stress as sales are at all time low. In fact there are hardly any sales in regions like NCR. Southern markets like Bangalore & Chennai too have very weak sales. When I spoke to few top builders Q-o-Q & Y-o-Y sales are down by up to 50% depending upon product category. However, as usual, prices haven’t come down. Why?
Let’s analyse few major items to understand why developers wont reduce prices to improve sales:
1. Easy Access to Liquidity – You would be surprised to know in this gloomy market Private Equity investors had invested record $3 Billion in Indian real estate. All big boys such as Piramal Group, Edelweiss and ASK Group have raised and/or deployed $1 Billion+ funds each in top metros. When liquidity is easily available to refinance loans why reduce prices? You would surprised to know that almost all PE investments in residential sector were debt deals. In most of these borrowing cost of funds is between 17 to 30%. So you would ask why developer pay lenders such a high cost but do not reduce prices to move sales? Answer lies in the below three points.
2. Buying Land – Land is the most important raw material for developers & accounts for almost 30% of total project cost. Unfortunately this is beyond the control of developer as either govt agencies or private landowners hold land. Developers either buy land (more prevalent in the North) or they do Joint Development Agreement (JDA)with landowners (more prevalent in the South). So if they buy land they need to pay money upfront while in JDA they construct area in the project for landowners at their own cost.
So to raise funds for land cost developers usually raise money from private equity investors or private individuals. Cost of borrowing for land acquisition is upwards of 20% and can go as high as 30%. From the day the developer buys the land to the day the developer launches the project the lag in time could be up to 2 years depending upon city. However interest or return “meter” of investors starts from the day they dole out the cheque to the developer. So to pay out these investors over the project tenure from the project cash flows would be extremely challenging if the prices do not keep going up from qtr to qtr. So you can see there is hardly any room to reduce prices as returns to investors is fixed.
3. Black Money – Real estate is the biggest sucker of black money in India as compared to other industries as it is much easier to utilise “cash” in real estate. Developers need “cash” for bribing govt officials for approvals or land related matters as well as for paying landowners who need “cash” to avoid or reduce capital gain tax on land transactions.
So even if there are poor sales developers are not cash starved as there is plenty of black money in the system for them to survive for long. Hence unlike developers in the western countries developers in India don’t go bust in poor market scenarios. So if developers have access to cash why would they reduce prices?
4. Lack of understanding of cash flows & NPV– Remember Finance 101?? “A $ today is worth more than a $ tomorrow”. Unfortunately developers do not understand or choose to ignore this simple concept. So in a slow market they prefer to hold on the inventory and wait for prices to go up in future. Logic is – “pay extra to lenders NOW and realise more when market improves TOMORROW”. Sacrifice cash flows at the cost of higher sales price realisation.
5. No control on other raw materials cost – Developers have no control over prices of commodities such as steel, cement, labors etc which form bulk of project cost. As steel & cement sectors are going through consolidation we will see prices going up only. A typical project tenure is between 3 to 5 years. Imagine if the developer sells bulk of unit at a fixed price on the day of launch he is exposed to cost uncertainty for almost 5 years which he may not be able to pass on to the existing buyers. Any increase in the cost of raw materials have to be passed on to the new buyers to neutralise its loss on previous buyers in the same project. Thus prices have to go up to manage project cost & delivery of the project.
All of us would love to see reasonable prices of real estate & expect price corrections, which as discussed above, may not happen in the given circumstances. Real Estate has become unaffordable for majority of Indians which inturn is not good for the industry.
I believe following steps, if taken, can help in reducing prices:
1. Reduce approval timeline for developers – Govt should enable single window clearance for all approvals. If the approval timeline reduces by 50% I am sure we can see a price correction of 5 to 10%, if developers choose to pass on the cost saving to end buyers.
2. Reduce endless refinance options available to developers – This shall force developers to reduce prices to some extent. By diluting restrictions such as minimum amount & area for investments under FDI in real estate GoI has done great disservice to buyers as developers have no motivation to reduce prices as they have now more partners to manage cash flows. Sone restrictions should be put on both NBFCs and Debt Funds.
3. Govt to create land banks – Govt of India is the biggest hoarder of land, most of which are lying unutilised. If GoI can auction land parcels in most of metros I am sure private landowners shall be forced to correct their unreasonable demands for land prices.
4. Adoption of latest technology – Latest technologies like Pre-Cast methods have cut down construction timeline globally by over 50-60%. This can reduce interest outflow on borrowings which in turn can be passed on to buyers.
Comments are welcome!