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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.

  • Anonymous says:

    >I recently moved into Hyderabad from Bangalore and was hoping to find reasonable real estate rates within city limits. Tell you what, my colleague just bought a 2BHK 1000 sq ft at 45 lakhs + taxes extra and he told me that he was really lucky. With an experience of 7.8 years in IT, he earns like 10 lakhs gross which roughly boils down to 70k post tax and PF deductions. Now 45k is gone for EMI and 20k for monthly family expenses + car. Boy, he’s poorer than my govt job doing dad at the end of the day. Now if he defaults, who’s the end loser? That guy or myself who is holding the stock of the bank he’s lent from?? Dunno but I guess the only one who’s gained is the sucking developer.

  • techntrek says:

    >wow ur sucker theory is really a very good way of putting it – even i was amazed at how houses could sell at 45 and 50000 psf.

    i had estimated that housing is in a bubble in an older post of mine which was based on a post i read on seeking alpha comparing housing costs in delhi with californian condo crises.

    how have u based ur construction cost assumptions/calculations?

  • Deepak Shenoy says:

    >anon: Its probably worse. If your friend’s regular expenses are 65K a month, where do the irregulars come from? An annual holiday, a sudden need for personal travel or medical bills, or anything that is a one timer every year (insurance, school donations etc.) LIfe is going to be pretty tough.

    techntrek: construction cost is hearsay based on what I know and who (a number of friends constructed houses, and some are in the architect/construction business). WIll read your blog to get to that post you mention…

  • Anonymous says:

    >anon
    u forgot to mention the politician in power and the babus in the municipal offices they also earn along with the builder
    caveat emptor is the buzzword in this country

  • Anonymous says:

    >Recently Mr. Narayana Murthy had mentioned that wage costs for IT companies are just around 15%. Unless there is a real collapse of US dollars offshoring will continue. Even today only about 10% of offshorable jobs are offshored. Hence the job prospects for Indian IT workers may not be bleak as some assume. Although some IT employees may face initial hardships in paying their mortgages, they may eventually find they had made the right choice by opting for the purchase at early part of their working life.

  • Anonymous says:

    >Deepak,

    Here is another theory, Think of all all the people who joined the IT industry, since 2000, fresh out of college. Assuming the average marriage age is 28, all the 20 year old’s who joined the IT job market in 2000 are ready to get married, a big majority of this population is currently living in shared bachelor accommodation, would want a home (buy or rent)to move-in post marriage. Assuming the IT industry growth stagnates we still have a huge bunch of single men/women who will be entering the housing market over the next few years.

  • Diwakar says:

    >This article is biased – I think you missed out on the RE booming and now hoping, wishing and dreaming that it come down – for 2 reasons: 1. You are jealous of your friends/colleagues who got rich by it. 2. If it comes down – you will jump on to it since you missed it last time.

    Firstly – Construction costs will never come down – it’s not about inflation – labor rates have gone up, there is more construction so more demand so higher prices, quality has gone up so still higher prices. Secondly – RE is a lot about snob factor – housing in desired localities will always fetch higher then less-desired ones – so they will always find people who will pay a premium to acquire. Moreover – Indians generally are far richer today then any time in the past – as soon as RE comes down even a bit – you will see thousands of Indians starting to buy again. It’s a self-propelled machine – there will be a correction – but don’t expect or dream a crash.

  • Deepak Shenoy says:

    >I love the comments on this and the alternate theories do make one think.

    anon1: I don’t know if wage costs are just 15%. If you see infy’s latest results they’re a lot higher than that – Infy made 16,600 cr. this year of which 7,500 was salaries only. If you add staff welfare, FBT and all other wage related expenses, you will end up with nearly 50% costs as wage linked.

    Anon2: Interesting theory about the marriageable age funda. But I think rates are way too high for this population to buy houses, relative to their salaries. And considering their jobs may not quite be steady and the phenomenal oversupply of luxury apartments, we are bound down on prices.

    Diwakar: I think you’re the one in denial – no one got “rich” in this real estate game other than the developers. Everyone who has just one house is sitting on a huge liability thinking it’s an asset. You probably are one of those that doesn’t like to see anything bad about real estate written – even though facts are pummeling us all right now. To me the first house is a liability – at whatever price – and I’ll buy a house only because I get sick of renting and shifting. There’s no timing a liability like that.

    Now construction cost wise – base construction costs have doubled in the last four years and will likely drop 40% in the next four, because these are cyclicals. Even vitrified tiles, bathroom fittings and lights have cycles and tend downwards when demand slows down

    RE and snob factor. I hear this argument everytime there is a downturn. In the 80s they thought downtown mumbai has snob value – well prices dropped like crazy in the late 80s. In 94-96, prices in central bangalore were down 40%, and teh same case happened in Mumbai (nearly 50% in the heartland). The snob value doesn’t go away but it loses it’s equation with Mahatma Gandhi enscribed notes.

    There is a crash of huge proportions happening already. But it’s slow and steady, and eventually we will only look back and realise it was a crash – right now it looks like a minor correction and in a year, it will probably start to show in its decline.

  • madhavan says:

    >have you noticed that anytime you speak about real estate prices in a room or picnic or party or wherever, two debating parties automatically spring up: those who have bought houses a couple of years back (‘will never go down’) and those who cannot afford to buy it right now (‘crash is imminent’).
    In fact, I know someone who bought his flat in 2003 and used to argue that prices would never come down. He sold it early last year for thrice what he paid, and now heads the group which says there will be a crash.
    My own view is that real estate usually does not witness a stock-marketish crash, instead prices just stagnate with neither buyers nor sellers until after an extended period of time, the stagnated price becomes a reasonable market price, which is when the next bubble takes off. But the model will probably not hold this time, because the scale of the game has changed. So, I am with the doomsdayers in the room.

  • Diwakar says:

    >I agree with Madhavan — whenever anyone makes an opinion about RE market – it’s mostly driven by his vested interests – it really sucks to acknowledge that your beloved investment is actually going down.. if it does happen… most of the investors stay invested… they don’t sell at lower prices… so prices don’t ‘actually’ come down as Sellers don’t sell… there sure are some panic sellings and ‘deals’ etc… but not a norm. This time – there is a dangerous twist — lot of investors have borrowed at 10% or more to buy homes – their ability to hold on to their investments in a market downturn is limited – so the scale of ‘panic’ sellings this time would be much higher – add to it stagnated economy and incomes – and it could really lead to a crash. It depends on how much ‘risk’ an investor took to buy his property. Borrowing to invest for a common middle class person is a bad idea – and he will suffer the consequences… to how much extent… time will tell… or may be not. But those who invested and can stand by it… will benefit… may be in a longer timeframe.

  • Deepak Shenoy says:

    >madhavan: You’re partially right, though it’s dangerous to classify people only in those two categories. I’ve benefited from real estate though I personally don’t own any, for different reasons than price – I’ve had horrendous experiences owning land, and I’ve no desire right now to create a long term liability when I have better uses for the money.

    So even if there is a crash of epic proportions I could still choose to rent instead of buy if rents go down proportionately. But there is a point when rents are close to EMIs, and if that happens it is more economical to buy, which then starts to make sense.

    I think anecdotal evidence is out there – I know people who think there is a crash and still will not sell their properties because they dont’ believe their property prices will come down 🙂

    Stock markets are much more transparent. Housing markets are not. So you don’t realize there is a crash until you are in the middle of it. Believe me, prices can come down DRAMATICALLY. I have seen this first hand in Bangalore and Mumbai in the 90s, and I think we will all see it in the near future as well. But in RE terms life moves slowly – and crashes happen over months, not days. Scale this time looks huge, but there was just as much speculation in the 90s.

    Diwakar: You may be partially right, but my strong feeling is that in 5-8 years, the price change in apartments will not even beat inflation. Prices go down, sales happen in back rooms, only the visibility is much much later. In fact at those times you only feel bad for the guy who paid the high prices – and think the then current prices are more “reasonable”.

    Real estate makes sense if you invested in the right locations in the outskirts. That stuff takes a lot of time and sheer luck. In Bangalore I know folks whose property was acquired for roads or such, or who invested in those parts that still haven’t appreciated much – and then I know those that invested near Devanahalli and doubled money in a year.

  • techntrek says:

    >i agree deepak
    most super premium real estate has already stagnated and stuff like a worli property close to the tv tower developed on land of a pharma company has not sold an apartment for last 3 mths and most super duper rate sales have been internal or fixed
    the prices will crash – like in 1985 to 90 period but this time i suspect it will be a lot bigger as prices have sharply increased over the last three yrs

  • Anonymous says:

    >You are saying “First house is a liability”. Well, interesting and I can partly understand it is, but I am not able to convince myself that it is a liability. Can u elaborate here or probably a separate post because I belive many people will find it hard to accept that its a liability. – Rajiv

  • Manickkam says:

    >Asset is something that grows and it makes sense to say stock/business as an asset.

    But in our first house, we sit and use it, and it grows in value. But do you sell it to reap the profits. NOPE. So, it is a liability.

    Deepak can explain in more detail.

  • Deepak Shenoy says:

    >Rajiv: If you didn’t own the house, you’d have to pay rent because you still need to stay. Your primary residence is always a liability that way – and you have regular outgoing anyhow (property taxes, house painting, maintenance work etc.).

    I will elaborate on this separately.

  • Diwakar says:

    >Home – 1st or nth – is an Asset – it appreciates/depreciates – you can sell it to get cash for it – you can rent it to get income from it. It has maintenance cost (taxes, repairs etc) – By definition an Asset is your liability on it plus your equity on it – so if you have a 100% loan on it and it has not appreciated at all – you can define it as a Liability – otherwise you have some positive Equity in it which you can cash out. Its a common practise to sell your ancestral so called 1st home in centre of the city and buy a modern condo in outskirts and stash away the change in bank 🙂

  • Deepak Shenoy says:

    >Diwakar: I disagree. The place you reside in – your primary residence – will always remain a liability because you don’t get income from it., and because if you should sell it you will then have a liability.

    The question really is – will your equity in the house (market value minus costs of selling minus loan amount minus capital gains taxes) earn enough for you to pay rent? So you are “net-even” if you live in a house whose rent otherwise would be 20K per month, ONLY if your equity in the house is 30 lakhs (assuming 8% post tax return on this money).

    Most homes bought in the boom simply don’t qualify.

    But if you have a fully paid for house, it is a liability to the extent that you have payments to make on it. It may be looked at as an asset if you can take a reverse mortgage out (but to be honest, reverse mortgages are simply debt and not income). But remember that if you can’t afford to live exactly in the same lifestyle AFTER you sell the house, you are kidding yourself if you think the house is an asset.

  • Ideasmoney says:

    >Fabulous!! Let every one get enlightened by this article

  • Diwakar says:

    >I am not sure if you are defining ‘Asset’ as per prevailing commerce terminology or your own ‘business’ sense – generally – property/home where you have some equity is considered an Asset !

  • Deepak Shenoy says:

    >Diwakar: This *is* commerce terminology. Do a study on “replacement value” and do the debt-equity analysis on the home. If you sell the house you live in, and pay off the debt, the remaining money should be able to generate cash flow that pays off a rental of an equivalent house. Your first house does not qualify in most cases. In fact I go on to say it never does until you own a second home that you can alternatively live in.

    There’s nothing wrong with liabilities, because they can provide great satisfaction. You just shouldn’t lie to yourself that you have an asset, when it’s actually a liability.

  • Diwakar says:

    >Relax dude… you are not the only 1 who is extra cautious in calling a spade… well a spade ! Read thru this –
    http://www.lazymanandmoney.com/your-home-asset-or-liability/

    And read back what I said earlier – if you have +ve equity in it – it’s an asset – otherwise not. An asset may or may not generate income – that’s an after effect – not a pre-condition.

  • Deepak Shenoy says:

    >diwakar: No offense meant. “Some”equity in a house is not equal to “positive” equity – where positive I presume means that you have more equity than debt? Or does it mean that if you should sell your house today you will have something left over? the latter definition is scary because that is exactly what is screwed up in the US.

    In the US HELOCs cashed in on the equity part – the part where the current value of the house was greater than the debt and the downpayment. As house prices crashed, the market price wasn’t even good enough to hold the original debt, let alone the HELOC.

    I liked the article you mention – in fact I don’t like Kiyosaki much but this is one place where I agree with him.

    Now cash flow is not the only reason, there is also replacement need and value. Assets may not generate cash flow but are not “necessary” – like stocks, or bonds. You don’t need them to survive.

    But you need a place to live, and the house you live in serves that need. If you took it away you wuold have NEGATIVE cash flow because now you need to pay rent. That means the house is actually a liability because the replacement is necessary and causes outgoing cash flow.

    However I am warming up to the argument that if your net equity (current value minus debt minus costs minus taxes) can generate post-tax income enough to pay rent you have a break even asset. Any more and then it’s a real asset.

    SO for houses that have equiv. rent of Rs. 20K per month, you need to have a net equity of Rs. 30 lakhs (assuming 8% post tax risk free return) As you might notice, not many houses have that kind of equity. I must agree they START to look like an asset if the equity is greater than, for example, 30 lakhs.

    But otherwise it’s a liability. Most houses that people live in, are so.

  • Rajiv says:

    >Deepak, Thanks for elaborating. I get the point and I guess its a big time liability if someone had bought the house in this boom. But then its debatable whether its an asset or liability depending on various conditions in which one has purchased the home. What if I had bought my house/flat by making 100% downpayment from my own pocket and the value of it has started appreciating from the time I purchased it.

  • Deepak Shenoy says:

    >rajiv: PRoblem here is – how much really is the equity? If you sold the house, the money you get back may not be all usable (a good portion of it would be used to pay rent!)

    For example: if the house is sold and another is taken for say 20K a month. Consider 5% raise in rent a year, and you end up paying, over say 10 years, an amount of Rs. 30 lakhs in rent alone.

    Taken another way, if you had to keep money in a safe deposit (no chance of loss) with post tax returns of say 8% and use it to pay rent, you need 30 lakhs to cover rent every year (forget the raise every year, that needs even more)

    Either way, 30 lakhs of your money is a liability. Your “equity” or what is really your asset, is the amount above Rs. 30 lakhs. This is for a house whose equivalent rent is Rs. 20,000 per month. If higher, the same calculations may yield a higher value.

    Now you see why I don’t think first houses are assets? They have an inbuilt liability that you must consider. Most houses that I know of are under water sicne they have debt, but some others are so even if there is equity.

    Of course there is another issue. If you can get an equivalent house elsewhere for a much lower cost (say sell in Mumbai and buy in Lonavla) then you can consider your house an asset. That way even my car is an asset because a second hand bike leaves me money in hand. My phone is an asset because I can buy a much cheaper one.

    So changing your lifestyle may yield assets you don’t know about.

    But if you really want to get to the wire, assume the same lifestyle. Then assets and liabilities will be more comparable.

  • Rakesh says:

    >A very heated debate and some well discussed points. I tend to agree with Deepak’s viewpoint that your first house is your liability. Its definitely not easy to digest it for most peoples, since we are brought up to think that our house is an asset.

    As Deepak mentioned earlier, your first house is a liability because if you sell the house where you live, you will either have to rent or buy another house to live.

    From my perspective just because the house you live in is considered a liability doesnt mean that it is something wrong. I would like to think that just like we buy TV, car etc, the house we live in is an expense. It without doubt has many non-monetary benefits , though shouldn’t be mistaken to be an economic asset.

    Anyway this is a very lively debate