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Indian Real Estate Sector - Will the phoenix rise again

Indian real estate industry has witnessed a huge swing in its fortune in recent time. Till December last year it was a darling of both domestic and foreign investors. It received around $10 Billion in funding through FDI, Private Equity and JVs. Everything was looking rosy and developers were busy acquiring lands at exorbitant rates and launching new projects. Economy was growing at 9.5% and corporate were looking for new real estate space to either expand or begin new businesses. However, with the bust of real estate sector in the US, things turned from good to worst. Investment Banks in the US crumbled and created a mess called "Sub-prime crisis".

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. At the core of this crisis lies "sub-prime housing loan market."

How sub-prime crisis started?

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 FIIs 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, resulting in this big “Sub-prime” mess.

Why did India market fall?

Once investments by the FIIs 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 FIIs.

Since most of FIIs who invest in India are based in the US, the stock market in India generally closely follows the sentiments in the US economy compared to that of Japan or European economy.

Stock market and real estate

Let’s explore how stock market affects real estate industry. Most of the real estate developers are publicly listed companies and trade on these stock exchanges. This is because real estate development is capital intensive and developers need cash to develop properties which is then sold or rented to customers. Firms need to buy land, which is extremely expensive these days, raw materials such as cement and steel, and hire manpower for the construction activities. All of these require huge amount of money. Developers generally raise capital either by borrowing from banks or issuing stocks. RBI has made extremely difficult for the firms to raise debt in domestic market and through external commercial borrowing (ECB) in order to check the incessant rise in property prices. Hence, the best way for them is to issue stocks. The investors in the stock market provide these developers cash for their projects by taking some stake in the company or projects. Hence, the market to a large extent decides the fortune of these companies.

A large number of financial institutions (Banks, Mutual Funds and Hedge Funds) buy or sell these companies’ securities on the exchange. For the last few years these FIs were extremely optimistic about Indian economy and real estate sector. They made huge investments in these companies and got great returns. Hence, their stocks went up through the roof due to heavy demand. If these FIs start selling their investments heavily for one reason or other, it will negatively affect companies’ stock price. The stock is an attractive currency for the firms in the bull market. Firms may sell (issue) these stocks in the market to raise capital to fund their expansion plan without the headache of interest payments that accompany debt. So any downward movement in the stock market might decrease the stock price of these firms and hence reduce their ability to raise sufficient capital; thus, affecting their future plans.

Unfortunately, the global financial crisis has taken a heavy toll on the Indian stock market. In less than a year Sensex has gone down from 21,000 to 9,500 levels. Most of the real estate stocks are down by over 70% w.r.t to their 52-weeks high. This is because of higher interest rates, global slowdown and heavy selling by financial institutions, seriously cutting down these companies expansion plans. They are stuck with their existing projects while investors have pulled out. Lehman had around $1.3Billion of investments in Indian real estate market. Several developers such as Unitech had planned to raise money through Special Purpose Vehicle (SPV) to fund their projects. Now, after the bust of Lehman, firms may seek PEs help to raise capital.

Some macroeconomic factors such as inflation and economic growth also affect companies and their stock prices. As we know inflation in India was around 11.5% (October 2008) which was quite high compared to last year’s figure of 3-4%. Banks had to increase interest rates to counter high inflation. For real estate companies higher interest rates environment is not suitable because customers avoid taking home loans (due to higher EMI) which decreases the demand for properties. A bad prospect of growth in the earnings of the firms gets reflected in their stock prices.

Company Current Price* 52-weeks high % drop
DLF 304.65 1225 75
UNITECH 86.8 546.8 84
PURAVANKARA 123.95 535 77
SOBHA 132 1060 88

Mega deals - are their days over?

Indian real estate sector was a hot cake for foreign investors a year ago. Everyone wanted a pie of it. Did you ever hear about mega real estate deals that happened in Mumbai in 2008? If not here they are: London-based banking major Barclays Bank created history in May when it took space at Cee Jay House, a landmark office complex in Worli, for Rs. 725 a square foot (sq ft) per month. Yesteryear movie star Vinod Khanna and his wife set a reality record in Mumbai by buying an apartment in Malabar Hills for Rs. 30 crore after paying a mindboggling Rs. 1,20,000 per square foot. But those days are over now. The sub-prime crisis and negative economy outlook have taken their heavy toll on the sector.

Outlook just after sub-prime crisis

From the Table 1 we can see the outlook for these companies was not so good. Over 70% of their market value was wiped out in less than a year; thus, putting brakes on their expansion plans. They were looking for alternative sources of capital or delaying their projects. The global financial crisis and recession in the US severely affected a large number of industries such as IT/ITES and Financial Services. Both these industries were creating huge demand for A-grade commercial properties in Metros and Tier-1 cities. Now, that demand has reduced by over 50% which might decrease further if the US goes into deep and prolonged recession. So the next one year would not bring good news for the firms in the realty sector.

However, the consumers having cash have great opportunities in this bear market and high interest rate environment. With the decrease in demand for both commercial and residential properties, prices/rentals have come down. We have already seen a correction in the range of 5-10% across the properties and believe prices may go down further by another 3-5% in the next 2 to 3 months. Also, the prices in the secondary market have fallen more compared to that in the primary market. We believe inflation might cool off by June 2009 which might push the demand for residential properties. Though the long term outlook looks good, the short-term outlook is bad for the industry. So if you plan to buy a house, either buy now (only cash) or wait for couple of months but definitely before inflation falls below double digit and banks gradually start rolling off hike in rates.

What does 2009 holds for the sector?

Good news for both industry and buyers! Inflation has come down from its October high of 13% to 8%. RBI since then has announced a series of rates cut- Repo rate has been reduced by over 200bp, while Reverse repo rate saw a 100bp decrease. CRR too was reduced by 150bp to inject liquidity in the market.

Today, which is December 15th 2008, as I write this article, public sector banks hold a press conference to announce major rates cut and other measures to boost real estate sector. The highlights of today’s meeting were :

  • Rate for home loans up to Rs 5 lakhs will not be more than 8.5%
  • Five-year fixed rate terms on up to Rs 5 lakhs home loans
  • Banks to take 10% margin on home loan of up to Rs 5 lakhs
  • No process, prepayment fees for home loans
  • Home loan rate under package can fall if rates fall more, which is likely to happen
  • Home loan of Rs 5-20 lakhs for maximum 20 years at 9.25%
  • India banks’ margin for Rs 5-20 lakhs loan will be 15%
  • India state-run banks will offer free life insurance cover for home loans

These new home loan rates will be effective Monday, December 15, 2008 and expire on June 30, 2009. This has come as good news to some developers while rest felt disappointed. DLF and Unitech have good presence in sub-20 Lakhs housing segment, which is also called “Affordable Housing”. Those operating in “affordable housing” hailed these rates cuts. Sanjay Chandra, MD of Unitech, said “It is a big benefit — the rates coming down, no processing fees as well as the fixed nature of it because a lot of people didn’t like the uncertainty with the way interest rates were moving. So I think the fixed rate and also the only option possibility of downward revision is a good thing for the sector and for us in general.” This might force and encourage other developers to focus on affordable housing. But the existing home loan borrowers felt dejected because these rates are applicable to new loans only.

However, these measures may not revive the flagging sector conditions because a majority of residential projects cost above Rs. 40 Lakhs i.e. where loans are above Rs. 25-30 lakhs. Industry insiders say that unsold property to the tune of Rs 20,000–25,000 Crores remains stuck in the country. Unless these properties are sold first, developers may not launch new projects or finish the under construction ones. To give a boost to this, developers are demanding an interest rates in the range of 7-8% i.e. back to the days of 2005.

With falling crude prices and global recession, Inflation should come down to the level of 5-6% by June 2009 end. So expect RBI to cut rates further by 100-150bp which we will bring the interest rates in single digit. This will give the much needed boost to the industry. Buyers, who are right now playing wait and watch game, will go for cheaper home loans. Expect another cut in prices in the month of January or February by developers who desperately want to flush out their inventories. More so costs of construction have come down by 10-15% due to decrease in prices of cement and steel. This cost should be passed on the customers as well. I will surely bet my money on real estate companies, especially bigger ones like DLF, Brigade and Unitech.