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Realty: Interest rates woes

Aug 30, 2008

The real estate sector is currently going through a tough phase as it is caught between the sluggish housing demand and the rising cost of capital. The demand for real estate significantly depends on the prevailing interest rates offered by the banks. As such, due to poor cash flows, the developers have to resort to higher cost borrowings. Since most of the banks have increased their lending rates by 0.5% to 1% in the months of July and August, the scenario for companies from the real estate sector looks grim for the medium term. With inflation (as measured by the wholesale price index, WPI) hovering above the 12% level, curbing the same has been the main priority of the government. As such the Reserve Bank of India (RBI) has resorted to interest rates hikes thrice during the current fiscal. This in turn has led the major banks to increase their lending rates as a move to protect their net interest margins (NIMs).

Interest rate despair Firm interest rates have had an adverse impact on real estate firms, as the residential segment is highly sensitive to the same. The lower the interest cost, the lower will be the EMI and vice-versa. If we observe the adjacent chart, the housing loans have increased in absolute numbers, while the actual year on year growth has considerably slowed down. The compounded annual growth (CAGR) over the last two years was 19%. Now, on the other hand, if we look at the year on year growth, the same has drastically fallen over the same period. During FY06, the housing loans had increased by 34% YoY as compared to its previous year, however, in FY08, the growth has slowed down to 12% YoY.

Rising cost of capital The recent US sub prime crisis and the liquidity tightening measure by central banks across the globe has had a significant impact on the real estate developers. Banks have lowered their exposure towards the real estate sector due to the higher risk weightage attached to the same, the impact of which can be viewed from the adjacent chart. In FY06, the banking sector lent nearly Rs 238 bn to the real estate sector. This lending grew by 79% YoY the year after. As on February 2008, the total outstanding amount lent to the real estate sector stood at Rs 529 bn. Again, while the amount of exposure did grow on an absolute basis, if one were to view the year on year change in FY08 it was comparatively lower at 27% YoY.

The high interest rates have thus had a double impact on the real estate sector. The future of the sector in the short to medium term is expected to remain bleak. However, the larger players are expected to survive this phase because of being relatively well capitalised. A quote from the economic research agency, CMIE describes this aptly - "Many small and medium sized realty companies are currently facing severe liquidity crunch on the back of lackluster sales and rising costs. With external funds hard to come by, smaller companies could face execution risk on planned projects. However, we believe that larger and well capitalised companies would be better positioned to manage this risk as they have access to banks/financial institutions and private equity companies."

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