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Commentary

The Real Estate Ponzi Scheme Exposed: RBI Warns Banks Funding Builders with Upfront or 80:20 Loans

In a notification, banks have been told to watch all loans under “innovative” financing schemes which involve giving builders the full home loan amount even though the builder hasn’t finished construction.

Such schemes are called 80:20 or 75:25, where a buyer puts up 20% to 25% of the full property value upfront, and the banks fund the rest.

The builder, who most likely hasn’t even started building the property yet, gets all the money. He promises to pay the bank the full EMI until construction is complete, in a tri-partite agreement.

However, these schemes are hugely risky.

The builder has the full amount, without having constructed anything. They get financing in your name, and get to pay a lower interest because YOU are the one taking the loan (individuals get a lower home loan rate than developers, a distinction I totally disagree with – if anything, individual home loans should be charged a higher rate).

If they don’t construct the building, the bank now has no collateral. But since its your loan, you have to repay anyway. This can be a disaster since you don’t have a property now for which you have a loan.

The Realty Ponzi

In reality, such innovative financing promotes ponzi schemes. A real estate developer has to only start advertising, and people are ready to pump money in, in the hope of much higher returns.

Most “investors” plan to flip even before a single slab is complete.

Assume an investor buys a 2,000 sq. ft. flat at Rs. 4,000 per square foot; instead of Rs. 80 lakh, he pays only Rs. 16 lakh with a bank funding the rest and the builder paying the interest during construction. In a few months, if he sells at Rs. 4,200 per square foot, he makes a profit of Rs. 400,000 (200 rupees per sq. ft) on an investment of Rs. 16 lakhs – a cool 25% return on investment.

The ponziness lies in what the developer does with the money. Assume he doesn’t bother to actually build anything. He uses the money received to buy another plot of land, which he then advertises, gets more 80:20 jokers, and does this many times.

How does he pay the interest?

The 20% upfront ensures he can easily pay home loan interest rates of 10% a year. On the 80% of the property that is financed, interest works out to 8% of the property value per year.

You’ve paid 20% upfront. So technically the builder can last 2.5 years – and if he’s gone the ponzi way, he has cash flow from new investors to pay old ones and so on.

What’s left then is a piece of land on which someone has to build something, but won’t because he has no money left (the money was used to buy other land).

Then the blackmailing begins – pay more, or we’ll have to litigate through courts. Banks will harass borrowers because effectively the loan is in the name of the borrower. The borrower, who was either an investor or a homebuyer, has now nothing to show for it.

What To Do?

If you’re an 80:20 borrower, you need to ensure the builder is running to schedule. If he has all the money already, he has no incentive to, and unless you have serious political muscle, you can’t make them. You have to hope they care about their reputation; while some do, others may decide reputation isn’t worth the money they have to pay back.

If a builder doesn’t complete the project, or pay the EMI as he promised, you are on the hock for the money and the interest. If you don’t pay, your CIBIL score will be impacted.

Banks haven’t yet been barred from such loans. RBI’s only said that such loans “should not be made in cases of incomplete/under-construction/green field housing projects.” If banks choose to comply, it might help unwind a large part of the urban real estate bubble.

But I think the RBI will have to come out with a complete ban on such products. I don’t have data for this, but it could be a substantial portion of new loans in the last three years. A ban will kill the ponzi scheme and all such developers, but it will also hurt banks and borrowers – still, it will end up being the better thing to do.

When we lack quick justice by courts, the only solutions are bans. If judges and investigators put fraudulent builders behind bars and seized all their money, within a short time, such a fraud will not happen.

This is negative for real estate developers, of course. I would say it’s negative for banks, but right now EVERYTHING is negative for banks.

  • naman says:

    Wonder what is the role of black money in this. A lot of housing builders compulsorily take part of payment in black. Does that not save the economy from the ponzi scheme?
    talking on these lines http://timesofindia.indiatimes.com/home/opinion/sa-aiyar/swaminomics/Black-money-saves-financial-sector/articleshow/2910592.cms

    • Naman – Black works well for constructed houses in terms of cutting out default. But in the early stages like in 80:20 schemes, the builder might not ask for much in black. Plus, how do you protect your money if the builder doesn’t build anything and defaults on your EMI? Chances are you’ll have to just take your loss or take him to court (where you can’t recover the “black” portion anyhow)

  • fubar says:

    Wow! I didn’t know builder gets full 100% in the 80:20 scheme upfront. How is this even allowed?

    • sandeep says:

      You are right, Banks can’t release full money but only the installments. Thus, the pre-EMI interest is much lower so can be serviced by builders. But this is only in Bangalore.
      I had an experience in Mumbai where my bank release full amount on day one and all the builder had was a plot and sample flat. So not sure if they have started full disbursements in other cities as well. If yes, then this is truly ponzi…

  • fubar says:

    To add to the above, banks have no collateral in these loans then. How can you get unsecured loans at 10%? This is amazing! I smell fraud here.

  • Tarun Dua says:

    The problem is ofcourse that the realty developers are selling ‘financial investment’ products without financial regulation.
    -Tarun

  • RK says:

    Typo alert:
    Under “what to do” the word hook is misspelled in second para. Don’t worry though. For a homeowner what diff. does it make 🙂

  • Nirav says:

    In a Regulatory parlance a “Warning” as good/bad as “Ban”!

  • Yash says:

    Hi Deepak,
    Yes, this has some attributes of a Ponzi scheme simply because everyone expects the ride to go on for ever. However, the banks do get a charge on the land itself, for whatever its worth. A really interesting variant I experienced last year was agents getting in touch with high net worth salaried individuals and offering them a 5-7 lacs cash back if they did the following:
    –Basis their salary slips and form 16, applied for a loan of a minimum value of 1 cr and above.
    –Signed an agreement with the builder to buy the house at a huge discount to operating price, to cover the ‘risk’ of builder default.
    –Sign a separate agreement promising to sell the house back to the builder at the same price after 12-18 months.
    And hey presto, the builder, instead of raising funds at 19%, had access to funds at 13-14, after factoring in payouts.
    The issue of a screwed up credit rating in case the builder defaulted on paying the emi’s stopped me from taking it up, otherwise, I know that a lot of builders in Gurgaon have raised serious monies on this. Employees of a well known and recently discredited MNC bank actually quit and got into this with a start up firm!

  • Px says:

    Didn’t loose monetary policy and predatory loans cause sub prime crises in US ? This is not so different .. The RBI slept, so long as liquidity was being pumping in at 15% pa … now that the pullout of liquidity is on the anvil the RBI is waking up to pitfalls of bad policy !
    In any case the govt policy is made to enrich the Vadras of the world … be it land bill or pushing psus to fund builder lobby ! The way policy was made, the RBI kept real rupee returns negative for over last 5 yrs people had little choice than to shift investment to property or gold !

  • Vj says:

    If the builder defaults, the bank technically cannot come after you as they have lien on the flat which of course is still somewhere in the air.
    Obviously you’ve lost out on the 20% though.

  • Vijay says:

    Many news sites reporting that RBI has “barred” 80:20 schemes. So its not really warning..

  • Inder says:

    Prestige Estates in Blore has a TIME Base payment scheme and not construction based and they have multiple of pre-launches done in the last 2 years. (Could be more than 20) and Ppl are still madly booking them for the BRAND.

  • Px says:

    limited impact says keki mistry
    Hdfc gave loans on installment basis based on actual construction in most cases
    http://www.moneycontrol.com/video/business/tightening-home-loan-disbursals-to-lower-risks-keki-mistry_944425.html

  • Krish says:

    This scheme is not new but very much popularized in today’s time. Nearly 9 year ago, I had used the ADF during launch period and it worked fine. At the time ADF facility was extended by the banks based on builder reputation. At least that was what told to us then.
    Looks like the brand image of realtors has come down lot in recent times with episodes of DLF, Jaypee, Unitech and so on. At the same time builders are also seems becoming innovative. Hats of to them for finding these inventions to lure the customers. I just wish the same zeal is extended to construction execution and sticking to schedule.