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Financing your dreams - Outside View by Nitin Gregory

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Financing your dreams
Aug 1, 2016

Lending is an ancient profession. Many business families have their roots in the business of lending. The key to not losing money in the lending business is to assess credit worthiness, which can be broadly classified into two categories:

  • Cash generating capability (a business with free cash flows)
  • Value of assets held as collateral (real estate, inventory)

Both can change dramatically. For example, a business could go through a downturn and real estate values could drop suddenly. The best lending institutions are able to ride out these variations without substantial losses.

The Indian Scenario

According to World Bank data, the domestic credit available to the private sector in India is around 52% of GDP. This is a modest number compared to developed countries like the UK and the US, where it is greater than 100% of GDP. The number in India is set to grow if regulations are introduced and business uncertainty reduces.

Some of the key areas of concern are public sector bank non-performing assets (NPAs). This problem stems from misjudging the 'cash-generating' capabilities of the businesses. Not recognising the bad assets means doubling down on your bet. The companies will increase their leverage until there is no way they can service their debts.

Industry (and government) is looking for lower interest rates. Interest rates are nothing but the hurdle rate for creating value. They do not have any bearing on the 'cash-generating' capabilities of the business. In other words, the businesses that are currently stressed will likely remain bad targets for financing.

Housing Finance - An Opportunity?

The next big financing area is housing finance. Housing finance loans are only about 10% of total bank credit, a relatively small number compared China, the US or the UK. Recently, there has been a lot of interest in this sector, which has been growing at 18% YoY and gives exposure to the financial services as well as the Indian real estate market.

This business is primarily 'asset-based' lending. RBI regulations stipulate the loan-to-value ratio to be 80% for loans above INR 30 lakh. There are also regulations about the risk-weighting of the loans. Higher LTV means higher risk and higher capital provisioning.

In other words, there is a margin for error in the asset value and you are insulated from aggressive practices by other lenders.

Rising affordability will also help this sector. A rise in income levels coupled with widespread aspirations of home ownership is a powerful trend. Simplifying the regulatory procedures will reduce the time and cost of construction. In time, these benefits will be passed on to the consumer.

Government schemes are providing tailwinds. The 'PM Awas Yojana' aims to boost home ownership. Central assistance will be provided for sections of society based on economic criteria. This will be implemented in partnership with the private sector. For example, primary lenders like housing finance companies will disburse loans eligible for an interest rate subsidy. The investment in smart cities across the nation will also result in incremental housing demand. The effectiveness of these schemes is debatable, but they are possible catalysts.

Indicators of Great Targets

The potential investment drive in India could result in growth for this industry. Given this is a long-term trend, how can we identify great targets within the housing finance sector?

Free cash is not a good indicator (what a surprise!): In this fast-growing sector, all the free cash is ploughed back into the lending operations. In other words, the disbursements will consume the free cash and more...

Net Interest Margin: This is the difference between the cost of funds and the actual yield on loans. This is a great indicator of the business economics. It is like pricing power. In general, the industry suffers from poor pricing; the NIM is in the range of 3%. This translates into poor return on capital (average 10%). The 'NPA' ratio and the 'operating expense' ratio provide clues to the riskiness and efficiency of the firm.

The housing finance industry has very little differentiation (e.g. the customer is not swayed by brands). This results in poor pricing power. However, in a scenario of fast growth, it is easy to post good results. The real test is when the tide goes out. If you are looking to benefit from this long-term trend, companies that have seen a few cycles are the best bet.

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

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The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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