Will lowering interest rate boost realty demand?

At a recent media interaction, Finance Minister Arun Jaitley urged the Reserve Bank of India to cut interest rate to help fuel growth in India’s realty sector which is suffering from demand slowdown. He wasn’t wrong. Over 75 per cent of the home sales are credit financed, and there are 7,50,000 unsold apartments in just seven cities including Mumbai, NCR/Delhi and Bengaluru. RBI governor Raghuram Rajan obliged the finance minister with a 50 basis point rate cut on September 29. Will that be enough to revive realty demand?

With an estimated shortage of over 25 million residential units, why are there so many unsold apartments? Most of the demand for homes in India are in the affordable segment. However, developers are generally coming out with high-priced premium and luxury apartments that may give them better margins, but most buyers can’t afford them. Some 69 per cent of the unsold homes in Mumbai are priced above Rs. 1 crore in a country that has only 42,800 people with an income of Re. 1 crore or more.

Inventory pile-up

The result is ever-growing unsold inventories. The inventory pile-up is so huge that it would take at least five years in Delhi/NCR and three years in Mumbai to sell them off, says a report by Knight Frank India. Bengaluru will take 32 months to clear off inventories says another report by JLL. Rajan is right when he says builders should cut prices so that more people would want to buy homes. Most salaried class people can’t afford to buy flats in Indian cities. Obviously, builders will face a shortage of buyers.

No surprise, India’s home market is driven by investors. If home prices continue to remain flat for long, investors will start losing interest, irrespective of whether their money is black or white. Return from investment in property comes in two ways: capital gains from appreciation in apartment prices and rental income.

When it comes to rental income, a typical 2 BHK 1000 sq foot apartment in the Mumbai suburbs of Andheri East or Malad with a quoted price of anything between Rs.1.5 crore to 2.5 crore will generate a rental income of Rs. 25,000-50,000 a month, that is, Rs. 3-6 lakh a year which is 2-2.4 per cent of the price of apartment against the global average of 10 per cent or so.

Home-owners also have to incur expenditure on property tax, maintenance, and normal wear and tear that devour anything between 20-30 per cent of the rental income depending upon the age and location of apartment building. Then comes capital gains tax.

Obviously, a realty investor would expect capital appreciation to compensate for low net rental. The problem is that at present, apartment prices are either stagnant or slowly going down in most parts of India if one goes by prices in resale markets.

Manipulation by builders

If rental is insignificant compared to property price, and capital appreciation is not really happening, how long can the artificially high home prices hold ground?

Yet, builders are using all kinds of tactics for keeping apartment prices artificially high. To manage demand from buyers, builders are relying on the introduction of compact homes to celebrity endorsements and schemes such as pay 20 per cent now and the balance 80 per cent on possession. With rupee depreciation, NRIs are wooed to invest in properties.

To keep effective supply of homes in check, builders are delaying completion of under-construction housing projects and going slow on launching new projects. There are clever inclusions of minimum lock-in period before the buyers can resell their properties. The imposition of transfer charges on re-sale neutralises any capital gains that individual sellers of under-construction properties may hope to make, thereby discouraging them to drop the idea of re-selling before possession. By that time, the builders try to offload all the inventories they have. However, given the artificially high prices and near universal delay in completion of housing projects in most locations, such tactics do not seem to be working.

There are penalty provisions for delayed delivery of apartments but builders smartly insert clauses in thick apartment buyers’ contracts (which most buyers don’t read) that makes paying penalty beneficial rather than painful for them.

One-sided apartment buyers’ contracts mean builders can extract as much as 18 per cent a year if buyers delay payment. Interestingly, for apartments priced below Re. 1 crore, in case of delay in giving possession, builders themselves don’t pay more than Rs. 5-20 per square foot per month.

Thus, Rs. 10 per sq foot per month for a 1,000 sq foot apartment means late delivery payment of 10×10,000×12= Rs. 1.20 lakh/annum irrespective of the apartment price. Builders manipulate payment schedule in such a way that long before actual delivery of the apartment, they have already collected 90 per cent of the cost of apartment. Assuming, the apartment is priced at Rs. 5000/sq foot, 90 per cent means  Rs. 45 lakh. Even if one invests Rs.45 lakh at 10 per cent per annum (say in corporate bonds), it would mean an interest income of Rs. 4.5 lakh/annum.

Thus, for every year of delay, the builder is making Rs. 3.3 lakh (4.5 -1.2). A three-year delay (quite common, especially in Noida) in giving possession means a net gain of Rs. 10 lakh to the builder (4.5 – 1.2 multiplied by 3), and 25 per cent extra cost to the home-buyer.

Housing regulator needed

Thus, most buyers of under-construction properties are actually subsidising builders by lending them money at below 3 per cent (1.2/45 multiplied by 100) and by borrowing at 10 per cent from banks. Buyers also pay for rented accommodation. This is the reason why end-users have lost interest in India’s realty sector. And that is why a 50 or 100 basis point rate-cut will not revive realty demand. Well, you don’t buy something worth Rs. 50 lakh or 1 crore just because borrowing is now cheaper by 50 basis points. A 50 basis point rate cut on a Rs. 50 lakh loan @10 per cent for 20 years means that EMI goes down from Rs. 48,251 to Rs. 46,607, that is, Rs. 1644/month assuming the rate cut is fully passed on.

Instead, the rate cut will embolden the builders-developers to hold prices at the current high levels that are not sustainable by any standard. Given the nexus between builders-bureaucrats-politicians in maintaining the status quo, a housing regulator is not coming anytime soon. Luckily, home-buyers have a choice: to postpone purchases till prices become realistic and housing regulator a reality. It doesn’t make sense to buy a 2-BHK apartment for Rs. 2 crore when the rent is Rs. 50,000 a month.

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