Why I disagree with Deepak Parekh

By Morningstar | Jun 16, 2020

Two months ago, Deepak Parekh, chairman of HDFC, said that “real estate prices have to come down, and will come down”. He pegged the drop at 20% and noted that the real estate market was already battling prolonged pain due to high leverage, tight liquidity and rising non-performing assets (NPAs) in construction finance.

This month, Union minister of commerce and industry Piyush Goyal urged builders to construct and sell projects at reduced and realistic prices, without waiting for the market to improve.

Most recently, Uday Kotak, executive vice-chairman of Kotak Mahindra Bank, echoed the identical sentiment. He recommended builders to clear inventory explaining that a drop of prices will bring buyers into the market.

AKHIL SARAF, the chief executive officer at Loyalie, has a contrarian view. Here he presents his perspective on why a price cut would be detrimental.

THE IMPACT: As one of the largest sectors in the country, real estate has a far-reaching impact on the economy’s revival.

After agriculture, real estate employs the largest workforce in the country - directly and indirectly. The real estate sector supports about 250 ancillary industries – steel, cement, interiors, elevators, tiles, pipes, paint, sanitaryware, and so on. Hence real estate has the fourth highest GDP multiplier effect on India’s economy.

The multiplier effect is one where an increase in spending produces an increase in national income and consumption, greater than the initial amount spent. In effect, it means that each rupee spent, produces an increase in income and consumption greater than the original rupee.

Richard Davies explains it brilliantly in Extreme Economies, when he looks at the devastation of the tsunami on Ache. Offsetting the enormous economic loss was the fact that rebuilding a village or town meant lots of fresh activity.

In the four years following the disaster, 140,000 new homes were built in Aceh. Each one meant builders needed to spend on materials such as bricks, wood and electrical wire, and they had to pay the wages of the workmen who use them. All this generates incomes for companies – the builders’ merchant, the concrete supplier and the haulier – and for the tradesmen such as the bricklayer, joiner and electrician. Once the job is finished, new house has been produced. Construction means a rush of the three types of activity – producing, earning, spending – that contribute to GDP.

The $180 billion real estate sector contributes 6% to India’s GDP. If you find that impressive, let me give you some context. Bear in mind that we have the 5th largest economy in the world, the 2nd largest population, and one of the highest population densities in urban areas. Now contrast the 6% with the global average of 13% of GDP.

It really is not too hard to imagine what a transformative impact the growth of real estate could have.

THE PROBLEM: A price cut will delay demand and hamper revival.

The real estate developer is stranded in the slugfest between the economic mandate (protection of the financier) and the political mandate (protection of popularism). The collateral damage can be huge.

The past 5 years have not seen any price appreciation. Investors have kept away and the market has been dominated by end users. Necessary policy changes such as GST and RERA have had an impact too.

Consolidation has taken place and the number of developers has shrunk by 50% between 2011 and 2017, and a significantly higher number since the implementation of RERA.

On implementing such price cuts, builders will lose a significant amount of their capital base which would hamper the growth of the sector for years ahead. With no money, there will be no new project launches. With no new launches, there will be no jobs. Can the country afford it? The expected rise in the cost of raw materials will make it even harder for developers to bear the burden of price cuts.

Price cuts also have far more serious cascading effects. Typically, a customer pays 5-10% of the property value during the project and the rest is funded by banks. With price cuts, you narrow down the LTV (Loan-to-Value of property). In such an uncertain environment, what really happens when the LTV exceeds 100%? Do Indian customers care more about their credit score or in uncertain times, would they rather default on home loans if the underlying home is valued lesser than the outstanding loan?

There has been a complete stagnation for around 3 months during the pandemic lockdown and property site visits were close to zero. If the market can take its form, then there might have been a surge in demand owing to the necessity of owning a home in a COVID world and the fear of subsequent lockdowns. Additionally, RBI’s home loan rate cuts would have supplemented actionable purchases from customers (as claimed by the government itself).

THE SOLUTION: To help revive the economy, real estate developers, bankers and the government must work together.

  • Circle Rate

Circle rate is the minimum price at which a property has to be registered in case of its transfer. The rates are determined by state governments. The circle rates differ within cities in the same state, and among various localities of a city. These rates are an indicator of likely prices of properties in various areas.

With circle rates (ready reckoner rates) being close to the market value in several micro markets in the country, it is legally impossible for companies to sell below those rates. These rates should be reduced to protect real estate companies from tax burdens created under section 43C and 50C of the Income-tax Act, 1961.

Moving to a dynamic circle rate concept is the only way forward to prevent black money from coming back into the ecosystem and ensuring that market forces determine the price.

  • Stamp Duty

Stamp duty is a tax levied by the state government on property transaction and varies for different areas and states. Stamp duties put an additional burden on real estate buyers. The governments should explore means to reduce stamp duties without causing a significant impact on state finances.

  • Home loans

Banks should focus a lot more on home loans, considering the low NPA.

The value of all outstanding home loans is around $250 billion (2019) or 10% of the nominal GDP. Mortgage loans at 10% represents significant under-penetration when compared with China (18%), Malaysia (34%), and developed economies (50+%).

Banks should focus on what is their most secured asset class when corporate debts are going under. Home loan NPAs stand at around 1-2% for banks compared to 9.5% average for India.

  • Real estate developers can throw in freebies and ensure delivery lifecycle price guarantees to encourage sales.
  • A renewed focus on Smart Cities and urban infrastructure augmentation should be of utmost priority. In this context, the pandemic revealed how crumbled our urban infrastructure is.

Add a Comment
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Jul 6 2020 03:04 PM
I believe that, both things need to happen:
1. Real estate prices should be realistic.
2. Circle rate & stamp duty need to be adjusted accordingly.

In reality, chances of both these points happening look low.
1. Builders may not like to reduce prices more than 5-8%, as they can wait for some more time for sentiments to improve. In the past, such corrections have not lasted for few months. Same is likely to happen this time as well.
2. Government may not reduce Circle rate and stamp duty both, as they also need funds since tax collections are low post April 2020. At the most they may fine tune these by 1-2%.

Recently, Governments have continuously increased excise duty, petrol/diesel prices, to raise some funds through higher taxes, so this shows that, they may not do much.

Also, Stamp duty has been applied to all MF(s)/Equity transactions, so reducing stamp duty in real estate will hamper the collections. There is no logic in increasing/applying stamp duty in one asset class and reducing in other, unless it is done with the intention or by design.

So, overall, situation may remain same with some minor tweaks, nothing beyond that.

This is just personal opinion based on observations in all these asset classes since year 2000, and there may be completely different approach by Government this time, and then scenario could be completely different.
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