The conundrum of residential real estate prices

The residential segment of the real estate market, defies the price determining demand-supply mechanism. The Fitch group’s research arm, India Ratings and Research Pvt. Ltd. recently came up with a report titled “2014 Outlook: Real Estate Sector”. It has been said in the report that the prices of residential units have risen continuously since financial year (FY) 2009, even though, the end-user affordability is on the decline. Shedding further light on the paradox, the report further added that the continuous rise in prices and persistent negative sentiments have hit the residential demand badly. The first half of FY14 has seen a decline in the sale of the total area in sq. ft terms. The trend is expected to continue in the first half of FY15 as well.

The asset classes such as equity or gold witness cycles of price appreciation and depreciation in tandem with various domestic and global economic, political and socioeconomic events. The real estate prices, on the other hand, tends to be “sticky”—after attaining a certain level, they tend to remain there or increase ultimately. However, pockets are seen across the country where slight correction may be observed. Mr. Lalit Kant, head-real estate, Arthveda Fund Management Pvt. Ltd is of the view that the real estate sector witness a common thread across segments. The project off-take has slowed down and though, there is enough inventory, the prices have not come down. He further added that if there is a slowdown in the projects, prices should fall to bring in more liquidity. However, since this is not being witnessed, it means that either developers are able to sustain themselves without sales increasing or there is liquidity coming in from other sources—both from on-shore and off-shore financing.

Let us discuss some of the reasons that are contributing to this phenomenon in greater detail.

Market dynamics

Real estate has always been a preferred choice for investment in the most parts of the world. Mr. Sanjay Dutt, executive managing director-South Asia, Cushman & Wakefield India Pvt. Ltd. is of the view that even with the advent of various softwares, training and codes, nobody across the world has been able to crack equity. He further added that real estate is a local and tangible asset and the benefit is that the principal does not get eroded. The certainty of returns, also, makes the sector behave differently. Another reason is that, in India, there is an emotional connect of having one’s “own home”.

Sunil Agarwal, adjunct professor at RICS School of Built Environment and managing director, Black Olive Ventures Pvt. Ltd is of the view that most of the retail customers hold real estate for the long term. This maybe held with an eye on the future.

Other investment instruments either give negative or low inflation-adjusted returns. Though, Gold is volatile and risky but it is the only other asset class which retail customers are comfortable with. Many social factors can be attributed to this too.

In addition to those who buy a house to live in it, there is another set of people in the residential space segment— the investors. “The investors” typically look at the real estate as just another asset class and look to get returns as they would with other asset classes. The report by India Ratings said that the Builders are perhaps expecting a greater participation from this segment rather than from end-users. Thus, they prefer to gradually increase prices to satisfy the return expectation of investors.

Parallel economy

Dutt says that though, it is difficult to explain and establish the rationale, but on a global level there is a parallel economy that finds its way into real estate. As the sector lacks transparency, it is largely a destination for black money investments.

Agarwal seconds this view. He says that the sector mostly attracts the high net worth individuals. The cash is generally used by the parallel economy to park its money in the sector. Since there is a high tax and stamp duty on the capital gains, some investors use the cash as a medium of investment to save on these.

Dutt further adds that In fact, the developers give huge discounts to the HNIs but the retail customers are not given any such discounts. Typically, the big investors such as HNIs are reluctant to withdraw their investment as real estate is considered a safe haven.

Kant says that the developers do not play with their own money and the deep-pocketed financiers will not force a repayment schedule on them. This is another factor that keeps prices of residential projects from reducing.

Developers’ cost matrix

Before a real estate project reached the execution stage, it has to cross various barriers. Aggarwal says that a developer goes through a harrowing time at various stages of development. Some of them are: buying land that has no litigations, adequate manpower and getting various clearances.

A project is typically sold at a margin of 20-25%. Developers incur 30-40% as land cost and another 30-40% as construction cost depending upon the location of the project. Agarwal adds that since 60% of the cost is received by the developer, there is no rush to reduce prices in case of low sales.

The money coming through the parallel economy generally takes care of the “land and construction” part of the cos. Dutt says that since the money from the parallel economy meets the short-term need of the developer, it can go ahead with construction and debt finance. As the developers already make some profit by this stage of the project, or reach break-even, they tend to keep the prices high.

Banks, too, keenly look for safe avenues with good developers. If banks stop lending in construction, there are very few other opportunities to invest in. Dutt says that the other sectors such as telecom and auto have limited scope. This keeps project financing on track for developers. Though the banks are under pressure due to the rising non-performing assets and from the Reserve Bank of India to lighten books, “if banks move in Sarfaesi, other loans may go under as well,” said Kant. (Through the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, or Sarfaesi, financial institutions can auction residential and commercial properties if borrowers have not made repayments.)

The theory says that once prices are pulled down, there could be a condition of a freefall. And, of course, no developer or investor will want that to happen.

Is it sustainable?

Agarwal, however, believes that one can soon see corrections in projects where the margins are more than 25-30%. He says that these would typically be luxury projects (that cost Rs.8,000 per sq. ft or above). Some pockets, such as south Delhi, have already seen a correction. He also adds that the projects in the mid-segment, Rs.4,000 per sq. ft level, however, may not see a fall as margins here are lower.

Dutt is sure that the prices may change but the modification will not be radical at all. He says that he prices are also inflated from the market and political sentiment angles. If one sees a change in these, then the prices will change accordingly.

The prices may remain stable in case some of the investors will not pull out their money for another 5-10 years. However, considering inflation of, say, 6-8% in the long run, the real cost will reduce if not the per sq. ft rate.

Source: Livemint