»The Honest Truth by Ajit Dayal

The loan chela
14 FEBRUARY 2009

The real estate market is dead.
People who need homes are not buying property because the buyers feel that the prices are too high.
The developers are not selling any property because the sellers still want the prices they had predicted in their Excel sheets - vetted by the specialist property consultants (the equivalent of the rating agencies who approved junk mortgage bonds as "AAA").

So there is a standstill.
The buyer and the seller are like the two cowboys in a western film each with a gun in a holster. Poised to pull the trigger.

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All things equal, the buyer should be the winner. The sellers - the real estate developers - have debt on their balance sheets. They need to pay an interest on that debt. They are not selling any properties anymore. So how do they service that large debt? The obvious answer is that the developer must slash the prices of the property that he wishes to sell. To a price point where it will actually sell. Then the developer will get the cash to pay the interest on the loan and repay the loan.

But there is nothing obvious about real estate.
And there is nothing obvious about the real estate business in India.
Particularly when this is election season. And real estate has a natural tendency and a perception to be linked to politics and political funding.

Protecting profits
There are probably tens of millions of square feet of property in various stages of readiness lying unsold and available across India.
This is ironic because there are probably buyers for all that unsold property. Unlike the USA where most people already have a home, India is in a situation where people do not have homes - and there are homes lying unsold across the country.

So there are buyers for property. But at a price that makes sense for the buyer. A price at which the buyer can afford the home. That price may be Rs 1,500 per square foot in "middle class areas" of cities like Nagpur or Rs. 2,000 per square foot in Pune, and Rs. 3,000 per square foot in northern Bombay.

But those "willing-to-buy" prices may be pretty far away from the "wishing-to-sell" prices in the Excel sheets of the real estate developers.

Left to the market, the prices would collapse - or the banks would take over the property as the real estate developers default on loans.

Instead, we have a government that is keen on cutting rates of interest for home loans (a good idea for sure) but not forcing the developers to cut their prices! In fact, the actions of the government seem to suggest that they are willing to rescue the developers.

So State Bank of India, a bank controlled by the government of India, announces that they wish to disburse Rs 1,500 crores of home loans at 8% every month for the next 3 months. (Note that, in a convenient coincidence, the elections will be over by then.) In a loan mela, you give away loans to people knowing you will never get the money back. In a loan chela, you follow a government directive even if economic sense tells you that you have the power the turn the terms of trade in favour of the buyer.

With no price cuts and simulating an average price of Rs 3,000 per square foot for a 1,000 square foot apartment on which SBI gives a loan of 70% of the property value, we see that SBI can help the developers clear about 21 million square feet of stock. The buyer, borrowing an average Rs 21 lakhs for a 10 year period at 8%, has an EMI of Rs. 25,478.

But, what if the developer was to blink and drop prices by, say, 30%? SBI’s Rs 1,500 crore per month will then help clear 32 million square feet of property (50% more) and the EMI of the individual will collapse by -33% to Rs 16,985 because the buyer now needs a smaller loan of Rs. 14 lakhs to buy that same 1,000 square foot home.

Table 1: State Bank's loan chela
  No price cut With price cut  
price/sq foot (Rs) 3,000 2,000  
area (sq feet) 1,000 1,000  
total value (Rs) 3,000,000 2,000,000  
loan facility 70% 70%  
loan given (Rs) 2,100,000 1,400,000  
money to spend (Rs) 15,000,000,000 15,000,000,000  
number of flats 7,143 10,714  
total area sold (sq ft) 7,142,857 10,714,286  
over 3 months (sq ft) 21,428,571 32,142,857 50.00%
loan taken 2,100,000 1,400,000  
interest rate 8% 8%  
Tenure 10 years 11 years  
EMI, for 120 months 25,478 16,985 -33.30%

SBI wants to act as a catalyst. They want to help kick start the economy. That is great news. But what are they - or the governments in power - acting as a catalyst for? The protection of the wealth of the developers or the increase in the wealth of the individuals? A decline in property prices would be the way to kick-start the economy. The "saving" in EMI of Rs. 8,500 per month can be used to consume many other products. A decline in interest rates kicks the buyer and protects the developers.

I like SBI and own the stock in client portfolios. But it would have been a better reflection of the times if there was a headline that screamed: SBI takes over projects from defaulted developers and sells them at 30% discount to recover its loans.

Now that would be a more honest reflection of the state of the real estate market.

Note: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt Ltd and Quantum Asset Management Company Pvt Ltd.. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited.