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The real crisis in real estate that no one is talking about

Aug 8, 2015

In this issue:
» The stink in Commercial Papers
» China exporting its problems of plenty
» Roundup of global markets
» ..and more!


00:00
 Chart of the day
A million roses. That is how a global fund manager referred to the Indian economy recently. You may wonder what green shoots did he spot. With a parliamentary logjam, reforms are firmly in the backburner. Hopes of GST and Land Acquisition Bills seeing the light of the day soon, stand quashed. And the earnings performance of Indian Inc, in recent quarters, is hardly anything to write home about. But to an outsider looking for safe and high growth investing options, India is the relative safe haven.

Growth has become a misnomer in the developed economies. In the developing world, investments in Brazil, Turkey, Russia, China or Indonesia, are not for the faint hearted. The recent market crash in China was a grim reminder of the inherent risks. In comparison, one can certainly count India amongst the few economies that are most resilient to currency wars and interest rate volatility. The government of India is not over dependant on external debt. And the demographic virtues offer scope for growth for decades ahead. So there is no doubt that there are some lucrative Megatrends in the making.

Therefore apart from disappointment with the slow pace of reforms, you are unlikely to come across any grave risks knocking on our doors. But that is unless you chose to dig a little deeper to get a sense of what is driving asset prices consistently upwards.

Banks are typically the mirror to the economy's health and the first signal of systemic risks. Be it the Asian Financial Crisis or the Dotcom Bubble or the Subprime Crisis, the first signals of things falling apart came from the financial entities. So we dug a little deeper to understand how the credit growth of Indian banks is poised to support growth and asset prices.

It turns out that more than 50% of the incremental credit growth for Indian banks has come from a single segment called home loans. You are not wrong to assume that this in fact is smart move. That is because there can be no better collateral for a loan than the residential property.

Thus the move to retail focused asset growth was an attempt by banks to get risk averse.

While a few banks were the pioneers in retail home loans others latched on to the trend soon. Even the PSUs that were largely corporate credit focused saw themselves aggressively vending retail home loans. Competition got intense as almost all players ranging from NBFCs to truck financers to gold loan companies tried to grab a pie of retail home loans.

Loan to value ratio (LTV), the key yardstick for offering home loans, also gave a good reason to get aggressive on this segment. As housing prices leapfrogged quarter on quarter, banks found their LTV getting smaller, allowing them to offer big ticket loans. So as data from the RBI shows, even as property prices moved up 1.6 times over the past three years, banks' exposure to home loans was up 2.3x.

As property prices almost doubled, banks' exposure to realty grew 2.3x

Banks deny any risk emanating from over exposure to home loans. The fact that the borrowers' income levels and home loan affordability have also gone up is a huge security according to them. But the problem is that as the cream in home loans got skimmed, financial entities got aggressive in scraping the asset class. Some got more innovative in their pursuit of capturing the upside in lending against real estate. NBFCs started specializing in loan against property, commonly called LAP. While the home loans have the security of the income of the borrower, the LAP largely relied on the value of the property. Moreover, thousands of SMEs that failed to fetch bank loans by virtue of the business assets have relied on LAP.

So you can now imagine the kind of cascading effect that any meaningful correction in realty prices in India is likely to have. It will not just impact over leveraged home loan borrowers or real estate speculators. But several financial entities that have taken their optimism about realty prices too far will see themselves writing off billions in non recoverable loans against property. Plus small businesses that have been shopping for loans based on sky rocketing realty prices will find themselves in dire consequences.

Thus the biggest risk that could shake India's status of being a relatively stable economy is an imminent correction in realty prices. The RBI and other financial regulators are doing little to stem the mess. So as an investor you are better off being watchful and price in the risk in your portfolio.

Do you see real estate prices being one of the biggest risks to India's economic stability in the years ahead? Let us know your comments or share your views in the Equitymaster Club.

P.S. Have you had a chance to take a look at our Advanced Charts? In case you haven't, I would strongly recommend that you do so right away And in case you need some handholding and tutorial on how to use the charts, my colleague Apurva Sheth has put in place this video for you.

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02:44
The risk of instability in the financial sector, however, is not restricted to home loans alone. Corporate borrowings too are raising a stink! Companies in India have raised around Rs 3 trillion or US$ 47 bn from banks in the past 12 months. Surprisingly, this huge amount was not funded through direct bank borrowings. Instead most of them were through commercial paper or CPs.

The demand in CPs zoomed up by 64% in last one year and has been outstripping the bank credit growth since some time now. One of the key reasons for the borrowers opting for this instrument for short term funds, is that the cost of the funds are currently at 5-year.

Now, as the rising NPAs are becoming a major concern for the banks in India, many have been reluctant to lend to the companies that are reeling under financial pressures. These factors have led to slow credit growth for the banks. In fact, bank lending has grown at the slowest pace in last 20 years. So, on one hand banks have become increasingly cautious in lending to weak companies, but on the other hand they continue to fund such companies through CPs. Higher exposure to such CPs of financially weak companies is a major risk to the banking sector. In case such papers become stressed assets, banks will have to sell the papers at huge losses in the secondary market.

03:35
If a story in The Wall Street Journal is to be believed, China is facing problems of plenty. It has so much capital lying in its vaults that it does not know what to do with it. Of course, the first right of use of this huge stash lies with its own domestic industries and companies. However, this strategy seems to have run its course. Nearly every industry in the dragon nation is suffering from overcapacity. And therefore pushing more money towards them would be akin to simply watching it go down the drain. Consequently, it has now turned its attention outwards. It has started funding big infrastructure projects in other countries and has started giving out loans to companies outside its borders.

This is not to say that it wasn't doing this before. But the recent push has come in the wake of what can be called its slowest pace of growth in many years. What is more, even Indian companies like Bharti Airtel have been the beneficiaries of this largesse. However, the cheap money is not without its set of riders. The main one being that the borrowers need to buy Chinese products and employ Chinese people. And while this will certainly help the world's second largest economy on the growth front, it also brings with it a whole set of new challenges in the form of credit risks and other such things.

04:32
The performance of global markets this week was a mixed bag. Among the key global markets, US stock market witnessed losses (down 1.8%), as jobs report matched economists' estimates and suggested that US gained over two lac jobs in July. This boosts the chances of a rate hike in September by US Fed.

The European stock markets recovered a little from the last week. The stock markets in Germany and France were trading higher by 1.6% and 1.4% respectively. However, major European stock markets witnessed losses towards the end of the current week on the back of lackluster German Industrial output reports. Further even US jobs data and disappointing earnings report had negative impact on the markets.

Among the major Asian stock markets, stock market in China posted gains (up 2.2%) over the week as the Government put in efforts to arrest the slide in stock prices. The stock market in Japan gained 0.7% over the week. The gains were mainly on account of Bank of Japan keeping its stimulus programme unchanged.

Back home, the Indian stock markets posted marginal gains (up 0.4%) over the week. After a healthy rally in past couple of days, the markets ended the week on a lackluster note amid weak global cues and stalemate in Parliament.

The major sectoral indices witnessed gains over the week with stocks in the realty and auto sector leading the gainers.  Smallcap and midcap stocks continued to remain in demand during the week gone by.

Performance during the week ended 7 August, 2015
Data source: Yahoo Finance

04:55
 Weekend investing mantra
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets." - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst).

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5 Responses to "The real crisis in real estate that no one is talking about"

KD

Aug 17, 2015

This website is about equities. Why talk about real estate.

In one of my emails 1.5 years ago, I told Modi effect is hype. Now I predict that economy will bottom out in this financial year. Whether there is Modi or not, it does not matter. Its just a business cycle.

Like (1)

Sanjay

Aug 10, 2015

After ambit report it has become fashionable to predict price correction. Based on present cost structure they will have to wind up their business if price correct that much. In my view price may remain subdued for a few years till present oversupply is absorbed. Don't see much price correction though time correction will be their.

Like (1)

dhruveshwar Nath

Aug 9, 2015

At present level of real estate prices hardly any viable manufacturing activity be started. Neither can retail shop make any profit. Hotels which have bought land at present prices are in crises. We have to let real estate prices to sink or economic activity to come to grinding halt. There is no reason for government to prop up real estate prices.

Like (1)

Gunesh Apte

Aug 8, 2015

This is indeed a good article about the Real Estate scenario in India. While the real estate prices have gone up multi fold in past ten years, due to various reasons, such as, shortage of land, black money transactions, people perception of real estate as safe asset class, no one has thought seriously whether such price rise is real and sustainable in long term.

If there is some major problem in economy, and people would loose their capabilities to repay such high amount of home loans, it would trigger another long cycle of NPAs in Banking sector.

Even private sector banks would be in trouble if such scenario occurs. We have hardly seen any concrete steps taken by government or RBI to curb the unrealistic prices of homes in India. If you just look around, you can realize that, such high prices do not stay for a long time and sooner or later, there would be corrections. Real Estate prices have not seen any major correction since 2003 and it is high time that, things can turn around very soon than one can image.

All home buyers should be very cautious while buying homes at the current prices, and taking large amount of loans which would eat into their long term savings. Let us hope that, things would change for the better and prices would correct to realistic prices in years to come.

Like (1)

Rupaal Singh

Aug 8, 2015

Absolutely maám could not agree any more. The simple fact as observed on the ground till a few years ago, where immediately post launch to within six months of project launches, prices were shooting up exorbitantly, while not having backing of any credible fundamentals that could explain the price rise, apart from the fact that in the low growth economic environment, alternative investments aka Real Estate was the face saver. Banks piled up home loans and at times I wondered was our real estate market looking up to be like that of the UK (London region) with no southward trend. I am glad that reading articles by Mr. Vivek some semblance seems to be coming through, but that none of the large-medium real estate players will be dealt with in a decisive matter is an entirely different matter.

Like (1)
  
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