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Commentary

Reader Comment: Sea of Red For Real Estate Lenders

Two comments that piqued my interest, on the CRR Hike post:

Indian IT will be in X roads..and India will have a sub prime crisis of its own since many of these IT wizards have taken home loans of the order of 20-30-50L for a salary of 20-50-100K and believe me, not a soul will pay that outside the a/c halls of IT. So, what will happen – simple default and banks will employ goondas to sell the flats in B’lore/Noida/Hyd/Chennai. There will be a glut and when all this is over, there will be a sea of red.

And a concerned reader writes in:

When do you think this problem will happen in India. All the IT companies are talking of good growth for next 5 to 10 years so this [roblem might not happen at all. Your comments please.

The theory is: The real estate sector has been propped up folks who’ve picked up houses at fairly high loan-to-value rates. Outside of IT, where growth looks good, people will not be able to pay such high loans back, and then defaults and recoveries will hit bank bottomlines.

So the question is: Are these assumptions true? It may be that realty prices are out of whack with reality. [That’s putting it nicely] But price was never a problem. Flats were overpriced even at 1500 per sq. ft., but people continued to buy. The reason: Someone would be willing to pay Rs. 2,000 and then 3,000 and even 15,000 for the same square foot. So if I am a fool today, I can easily find a bigger fool tomorrow.

Now we’ve reached a point where it doesn’t look like prices can get MORE out of whack. So the investors have vanished. Prices haven’t come down because builders have gotten complacent; in the last four years they never had to do this much fighting to sell property. Usually properties would get sold out in the instant they released the rumour that they will construct sometime in the future. Now people spit on their posters. I guess builders are hoping that they can get some suckers to buy at this price, before they are forced to lower rates.

With salary hike quantums going down, and general job insecurity, people aren’t going to commit to higher EMIs – when the future gets more uncertain, people take lesser risks. So prices need to come down to attract investment.

Now if rates are lowered on under-construction apartments, what happens to the guys that bought them a while back? They get pissed off when they go upside down (loan value greater than current price of house). This may happen inspite of the black money cushion because of the structure of such agreements, where the black money changes hands only when the house is ready.

Now defaulting isn’t legally bright because all loans are recourse loans. Meaning the banks can sell your house, and if that falls short of your loan they can make you sell other stuff you own, to recover the difference. But since litigation takes time and the RBI doesn’t like goonda tactics, a default may take an enormous amount of time to turn around. [Note also that people may gather their own set of goondas to counter any bank pressure, something the banks haven’t really accounted for]

So if people are very likely default on going upside down, and banks have a recovery problem on the upside-downs, then yes – banks are going to be hit quite badly. Because they can’t pass off the risk easily like they did in the US through Mortgage backed securities. (but ICICI did sell bad personal loans to Arcil recently)

But firstly I don’t see huge defaults in primary residences – as people generally don’t default on the houses they live in. I don’t have any data on how much “investor” (second or n’th home) interest there is in new housing, but it seems to me that big cities – NCR,Mumbai, Bangalore, Hyderabad – have much more of these. In Kerala there is a lot of NRI interest. Defaults are more likely if people don’t have to stay in the house and if they haven’t paid too much in “black” for it. In Bangalore it does seem to be the case – the other places don’t (yet) apply. (Loan to rent ratios are so ridiculous there is no point discussing them)

Secondly the implicit assumption that a good IT sector means highly paid Indian employees is fallacious. Companies like TCS, Infosys and Genpact have big investments in China, Philippines and Eastern Europe. They may grow their profits by increasing their focus in such locations rather than India. Which is actually negative for the guy trying to sell Real Estate to Mr. Infosys-Employee-That-Just-Got-Outsourced.

So I think banks have to worry about the wage levels and employment growth of IT companies whose employees they lend to, and not the growth of the companies themselves.

Now here is the last factor: Construction costs. Typical costs of construction, in 2002, was about Rs. 500 per sq. ft. Today it’s 1500 per sq. ft. That’s cement, steel, tiles ceramic, etc. Now these are cyclicals so they will come down, and second, they are commodities whose price the government is keen to lower to counter inflation. Let’s assume that the prices come down to a neat Rs. 800 per sq. ft. in a couple years. Land cost is already going down, so in two years, the cost per built up sq. ft. (considering FSI and TDR prices etc.) will likely be Rs. 600; even lower for those that held property for a long time. So to make a profit, a new developer will be able to sell houses for 1,400 to 1,800 per sq. foot. This destroys the model for current houses which sell for two or three times that. What happens then?

It’s a complex cycle, but there’s only one answer. Going down.

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