Since the sub-prime collapse of 2008, there have been recurrent questions about India's real estate sector. In the past three years, listed Indian real estate companies had very poor returns. The real estate business has seen a cash crunch, in part because the RBI raised prudential norms. Projects have stalled. Mortgage offtake has slowed. There is commercial space to spare. However, real estate prices have not fallen much. Nor has there been a very large number of mortgage defaults.
Nobody seems to believe Indian real estate could collapse. There have actually been multiple real estate bubbles in India and property prices have declined substantially in several periods - during 1996-2002 for instance. But the psychological belief that "property is safe" is strong despite evidence to the contrary.
There are also concrete reasons why Indian real estate is unusual. One is that legal hurdles and long processes restrict supply. New real estate takes a long time to be developed because multiple clearances from multiple authorities, changes in land use, FSI norms, and so on, are difficult to negotiate.
A more ticklish issue is the prevalence of black money in Indian real estate transactions. The white component of a real estate deal is the official price declared in the registration. This is generally close to official valuations. The black component is cash paid under the table. The black component may range from nominal, to a third or half of total price. On average, the black component can be estimated as 25-35 per cent of price by comparing prevailing rates with official rates.
Rampant tax evasion aside, there are other interesting consequences. These are not necessarily bad. The black component adds an extra layer of buyer commitment. Consider the following situation. An individual buys a property, taking out a mortgage for say, 80 per cent of value. The buyer puts down 20 percent. There is a crash. Let's say, within six months of the deal, the property's value falls by say, 25 per cent. The buyer may then decide to cut losses and default.
This scenario played out during the US sub-prime collapse. Many mortgages were for 95-99 per cent of property value. The cascading effect led to steeper falls in real estate prices and triggered more defaults. Similar scenarios played out in Spain and Ireland.
Defaults are less likely when the buyer has put down 35-40 per cent of original value. The sunk cost, and hence, the commitment, is higher. Indian mortgages are calculated only on the white component and not usually sanctioned for above 75 per cent of the white value. Hence, a mortgage is usually for 55-65 per cent of total price. Indian buyers always commit a large proportion of their own funds. Hence, multiple mortgage defaults with a cascading effect are less likely in India.
A large black component also means that the usual valuation matrices do not hold. For example, one may compare rental yield (rent as a percentage of property value) with a risk-free return from a fixed deposit. Put simply, can a property owner sell, park sales proceeds in an FD, rent the sold property back and have a surplus? If so, the rental yield is too low and the property is over-valued.
This calculation needs adjustment in India because the black component earns little or no interest. The black:white ratio must be estimated to calculate fair valuations. For example, suppose the rental yield on the total price of a property is 5 per cent, while the fixed deposit interest rate is 7 per cent. The black component is 30 per cent of the total price. Despite the 200 basis point spread between the rental yield and FD yield, the property is near fair-value. If the property was sold, only 70 per cent of the realised price could be parked in FDs.
In combination, these distortions jack up Indian real estate prices abnormally. It is ridiculous, but true, that India with a nominal per capita of $1490 has real estate prices comparable to the US (per capita of $49,900) and Japan ($46,700).
The premium valuations of Indian real estate is likely to continue unless and until there are massive, far-reaching reforms across tax structures, land acquisition laws, conversion laws, ceilings, and so on. That's certainly not happening any time soon.
In the short term, falling interest rates should be beneficial for the real estate sector. It helps developers borrow relatively cheaply, and it creates demand. The retail customer is tempted to take out mortgages if they think rates will fall. Hence, battered real estate shares could bounce much more sharply than most people anticipate through the next year.
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