The paradox of residential real estate prices
Sales have been low for a while, but this has not brought down prices. Here’s why
The Indian real estate sector, especially the residential segment, defies the normal demand-supply mechanism that determines prices. A report titled 2014 Outlook: Real Estate Sector by India Ratings and Research Pvt. Ltd, the Fitch group’s research arm, said that prices of residential units have risen continuously since financial year (FY) 2009 and considering that the end-user affordability is on the decline, this is a paradox. The report further added that “residential demand has been hit by the continuous rise in prices and persistent negative sentiments”. The total area sold in sq. ft terms decreased in the first half of FY14 and this is expected to continue in the first half of FY15 as well.
Let’s examine some of the reasons that are contributing to this phenomenon.
Real estate is a preferred choice for investment in many parts of the world. “Despite various software, training and codes, nobody has been able to crack equity across the world,” said Sanjay Dutt, executive managing director-South Asia, Cushman & Wakefield India Pvt. Ltd. According to him, real estate is a local and tangible asset, and the principal does not get eroded. Also, the certainty of returns makes the sector behave differently. Apart from that, in India there is an emotional connect of having your “own home”.
Apart from those who buy a house to live in it, there is another set of participants in the residential space—investors. They typically look at real estate as another asset class and look to get returns as they would with other asset classes. The India Ratings report said: “Builders, perhaps expecting a greater participation from this segment rather than from end-users, prefer to gradually increase prices, satisfying the return expectation of investors.”
Though it is difficult to explain and establish the rationale, said Dutt, but globally there is a parallel economy that finds its way into real estate. As the sector is not transparent, it is a destination for black money investments.
“In fact, developers give discount to HNIs but not to retail customers. This does not come to the notice of retail investors,” said Dutt. Typically, such big investors are reluctant to withdraw their investment as real estate is considered a safe haven.
Developers’ cost matrix
A real estate project has to cross various barriers before it reaches the execution stage. “A developer goes through a harrowing time at various stages of development—buying land that has no litigations, adequate manpower and various clearances are some of these,” said Agarwal.
Typically, a project is 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. “Since 60% of the cost is received by the developer, there is no rush to reduce prices in case of low sales,” added Agarwal.
This portion of the cost—land and construction—is often taken care of by the money coming through the parallel economy. “Since the short-term need of the developer is met, it can go ahead with construction and debt finance,” said Dutt. Since developers already make some profit by this stage of the project, or reach break-even, they tend to keep the prices high.
Banks, too, look for safe avenues with good developers. If banks stop construction lending, there are very few other opportunities to invest in. “Other sectors such as telecom and auto are limited,” said Dutt. This keeps project financing on track for developers. Though there are rising non-performing assets with banks and there is pressure 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 is that once prices are pulled down, there could be a freefall. And, of course, no developer or investor will want that to happen.
Is it sustainable?
Agarwal, however, believes that projects where the margins are more than 25-30% will see a correction soon. “These would typically be luxury projects (that cost Rs.8,000 per sq. ft or above). Some pockets, such as south Delhi, have seen a correction,” he added. However, projects in the mid-segment,Rs.4,000 per sq. ft level, may not see a fall as margins here are lower.
“Prices are also inflated from the market and political sentiment angles. If these change, prices will change accordingly,” said Dutt, but added that the changes won’t be radical.