Does demand really drive real estate prices?

Thu, 2 May Pre-Open

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Economic logic says that prices are a function of demand and supply. If demand increases prices rise and vice versa. However, it seems that the real estate industry is an exception to this economic logic. For instance, property prices in Mumbai during the last quarter rose to a record high despite slowing sales. Weak sales mean that there is no demand. But yet the prices have refused to correct. In fact, during the quarter ending March 31, prices in Mumbai increased 2.9% as per a leading real estate research agency.

So, why is there such disconnect between prices and demand? Let us try and understand. Basically there are two reasons why prices continue to remain high. The first reason is vested interests of politicians and second is the prevalence of black money which is doing rounds in the system.

Now, it is a known fact that most politicians have vested interests in real estate projects. Thus, they will not take any move that will impact the property prices. For instance, property prices are rising due to scarcity of land. But the government can easily raise the floor space index (FSI) to overcome the scarcity issue. If it is done more vertical structures will come into the market with huge inventory. This will hurt the prices as inventory builds up. However, the government will never take such a decision.

Secondly, most of the black money of major politicians is invested in real estate. Since this money has no other avenue it keeps on moving in the real estate market. The reason it has no other avenue is because if invested elsewhere the source of income will have to be revealed. Thus, it will catch the taxmen's eye. As such, this black money keeps on revolving in the real estate market. And this artificially bids up the prices.

The external support provided by banks (read government) is also noteworthy. Most builders get their loans from banks. Just in case they are unable to repay on time there are various provisions that enable the bank to not classify the asset as non-performing. Instead, these loans get restructured. Now, since the loans don't get classified as NPAs, banks do not incur any additional provisioning. As such, their net profits remain intact. Hence, they will not pressurize builders to repay on time. The end result is prices remain high as builders continue to hold on to their inventory. If these loans are classified NPAs banks will pressurize builders to repay on time and thus there can be some inventory liquidation in the market that can help reduce the prices.

Overall, it seems that property prices are not just a function of demand and supply. In fact, the prices are dictated by the government. And since the government via politicians has vested interest in the sector correction looks like a far distant reality.