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Saturday, December 24, 2011

Uncomfortable times in real estate in store?

Patrick Chovanec has a fascinating article in Foreign Affairs, titled China's Real Estate Bubble May Have Just Popped. This is interesting and important from two points of view.

First, bad news for China is bad news for the world economy. We are already in a bleak environment, with difficulties in Europe, Japan, the US, and India. It will not be pretty if China runs into trouble as well. I am reminded of the feeling of carefully watching real estate in the United States in 2006, with a sense that the future of the world economy was going to turn on how it turned out.

Second, it made me think about real estate in India. As with China, one often sees buyers of real estate in India have the notion that this is a safe financial asset. This is a questionable proposition. Real estate is perhaps not an asset class with a positive expected return in the first place; and it is certainly not a convenient asset class with features like liquidity, transparency, diversification and easy formation of low-volatility diversified portfolios. I find it hard to explain the prominence of real estate in the portfolios of even educated people in India.

In the article, Chovanec says:

For more than a decade, they have bet on longer-term demand trends by buying up multiple units -- often dozens at a time -- which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast `ghost' districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.

This has not happened in India. So in this sense, the situation in India is not as dire. But his second key message seems uncomfortably close:

As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.

Part of this looks familiar. There is a lot of leverage in Indian real estate development and speculation. Real estate speculators and developers are finding themselves in a bit of a scramble hunting for credit. One hears about very high interest rates being paid by developers. Other sources of financing are also weak. This reminds me of the dark days before the global crisis, when borrowing by real estate companies was the canary in the coal mine.

If business cycle conditions and financial conditions worsen, the problems of borrowing by real estate developers and speculators will get worse. How might this turn out? Perhaps the borrowers will merely get uncomfortable. Or, a few firms could really get into trouble, and start liquidating inventory. That would have substantial repercussions.

Suppose there is a situation where there are many people who have speculative positions in real estate, but significant selling of inventory has not yet begun. The longs would then be nervously looking at each other, wondering who would be the first one to sell, to take a better price and exit his position. The ones who sell late would get an inferior price. In such a situation, conditions could change sharply in a short time.

On a longer horizon, I would, of course, be delighted if real estate prices are lower. This would help shift the supply function of labour, reduce the cost of setting up new businesses, etc. But that's more about the long-term policy changes, which would remove barriers for converting land into built-up housing, while rising vertically into the sky with FSI in Indian cities ranging from 5 to 25.


  1. Curiously, a couple of the disadvantages of real estate (illiquidity and high leverage) are also its biggest advantages.

    Since its illiquid, people tend to do a lot of homework and then commit for years if not decades. So, they then sit tight whereas lots of reports on equity investments shows that investors panic and time the markets badly and they would have done well if they could only commit for long periods.

    And, one can employ leverage. It is just ok to buy a house on mortgage but one doesn't go about buying shares using a loan.

    In India, the stock market outperformed real estate from 2001 to 2007 but real estate has outperformed since.
    See RESIDEX from 2001-2009
    RESIDEX from 2007 onwards

    If one were to believe that real estate and stocks are part of the same asset boom story in India, either the stock market is going to rally or the real estate prices are going to come down. Either way, real estate should be a bad choice for an asset class in India today (relative to stocks/bonds).

  2. Very interesting point of view Sir. Patrick Chovanec's authoritative comments on China are unquestionable and offer a ground view of the real estate market in China. Have always enjoyed hearing and reading your views on different aspects of the financial world. Happened to bump into you at the Salt water Grill a couple of weeks back. Wanted to introduce myself and appreciate your work. Won't miss the opportunity the next time. Best wishes for 2012. Kush Katakia.

  3. As far as i can see, there is too much demand even right now for residential flats in delhi NCR. You should also shed some light on the transition from the practice of living with parents to a westernized way of moving out and buying your own apartment, considering the number of youth graduating, dont think there will be any reduction in demand

  4. The China doom-mongers have mostly been wrong. Some have been predicting doom since 2001. Another claimed that the US will be the first one out of the recession of 2008. All wrong but they continue to sell their doom. I think it would be nice if these academics showed some humility and went over their past analyses. I remember when not even a single mainstream academic (except for Roubini) would speculate about a possible collapse in the US housing market. They are all wrong.

    When I look at the demand in India and China, it is enormous. There are people who are desirous of living in their own houses/apartments. The Delhi metro is so much more crowded than NYC subways. It's crazy. You build it and it gets filled up. It's no wonder that China engages in grand projects because it makes more sense of build maximum capacity in one go rather than going in for haphazard expansion later.

    Now, the question is that of price and I do believe that Indian real estate is overpriced and has to do with hot money inflow and perhaps black money being round-tripped from abroad, not to speak of the need to hide black money through transactions that are entirely domestic. These are definitely unproductive investments and reflect a different sort of demand from criminal elements that are almost ubiquitous in our society.

    Both India and China need these infrastructure investments. The question is that of price. So an investment in railways and roads makes more sense than purely private sector investments in apartments. Hence, I am more worried about India.

  5. I am a bit surprised as to how popular real estate is as an asset class. Im sure ratios such as rental value as a % of price, will show up signs of concern. As far as leverage is concerned that would depend on the developer, RE companies at least in Tier-2 and 3 cities have very little leverage. They start taking bookings just by getting the plans approved. So in a sense they first 50% of buyers have already financed the operations. Inventory carrying costs for unleveraged players will be really low (no interest rates). You also need to factor in black money/corruption money. A huge amount of it is invested in RE and land.

  6. I fail to see systemic risks fromt eh housing sector as India is still "housing short."

    Firstly, it will continue to have a rising working age population, albeit with stabilizing/shrinking household size.

    Secondly, I doubt if the excess/unsold inventory (in months of bldg activity) of homes anywhere in India is remotely as large as in China (or U.S. back in 2006).

    Third, inflation and the rate cycle has probably peaked.

    These reasons are key conditions for limiting systemic risks in Indian housing.

  7. It surely seems tough times both for the buyers and the developers in the coming year and also the rates are going up from the banks' side.

  8. I apologize that this comment is quite off topic. But I need somewhere to vent my amazement that I can find no reference in either the Economic Times or the Times of India about the recent OECD Pisa educational rankings that find India virtually last out of 74 countries. Foreign bloggers like Tyler Cowen are conducting thoughtful discussions about these results, which finger huge present and future problems in the country's human development, long run growth and distributional strategies. ( Yet our terminally smug elites ignore it altogether!

  9. Real estete prices tend to be location specific. In the event of forced liquidation by developers, prices in the suburbs may go down by 20% plus but in the core city where other factors like proximity to schools, busineess district and hospitals drive valuations, the prices may contract very little or may stay flat.

  10. Anonymous,

    You are right about PISA. Do you have suggestions for the right person who should be requested to write a blog post on this? Thanks for the headsup. I am trying.

  11. With consistent money supply inflation far in excess of nominal growth, price inflation is bound to show up in goods/services or capital gains in real/financial assets.

    Behaviour with respect to real estate in India may be considered "rational" in an irrational market in my opinion, given the persistent inflation we see in India.

    A few things in favour are:
    1. Tremendous amount of black money, domestic and round-tripped. Tough to prove but any person who has any exposure to real estate dealings would vouch for this.

    2. Possible misuse of FDI route?

    Considering that FDI in real estate is only possible in "townships" which have min reqt. of 50,000 sq. mt of built area (approx. 0.5 mn sq. ft). 422 projects were sanctioned in Mumbai as per the article above. It begs the question as to where these land parcels indeed are in Mumbai? Any Mumbai resident knows how crowded this place is. It seems like a fantastic no. to me at least.

    3. A populace that is looking to protect real wealth and which has hardly any worthwhile options. Fixed income is -ve yielding at real levels given high inflation. Equity markets are still not considered very seriously by people (entrenched behaviour passed on from generation to generation). And anyway, the notion that equity investing does great over the long term is being increasingly questioned.

    4. A rigged market which is perceived to be protected on the downside

  12. Mint carried an article on this.

    Manish Sabharwal had some comments on the issue in that article. Perhaps, he may have more to say. Or, the Azim Premji foundation guy, if he writes a blog, which he should.

    There was also a recent report that only 1 Indian university ranks in the top 400 Times Education rankings.

    And, today there is an article that 100s of students got admission into a medical college by fraud. Its very depressing. There is no place for merit in this country.

    The elite do not care because they will get their degrees from abroad anyway. They will also get healthcare outside India.

  13. Wow is the HRD ministry sleeping? Will this be on national TV?

  14. First of all, the real estate in India is region specific. India's urbanization is mostly in big metros till now. It's started moving towards tier II cities now. In tier III cities and big towns, it's not even started. I'm sure big metros will see stagnation in asset prices but the same may not be applicable in rest of of the India. For example, the asset at nariman point may not return the same percentage as an asset in Erode in the coming months. It's just me. I have a assents in big towns and tier III cities and I see them increasing in value in the next few years.

    Last but not least, you can't use all the land that are available for building homes. The growth will be in urbanized areas (Tier III and big towns).

  15. Hi Ajay, I may be a little late in reading and reacting to your post. Would apprecaite your view on the fact that our geneartion in metros have 2-3 properties and in all likelihood to have a single child. Will the Gen Y invest in properties with so much in inheritance ? Secondly i am witnessing Tier 3 cities like Bhagalpur & Jabalpur where prices have gone up 100% in last 2 years where there is no significant drivers of ecomy present .Sixth pay commissison has been the probable culprit in these cases. Your insight on this aspect would be interesting. Amit (NSDL)

  16. I need somewhere to vent my amazement that I can find no reference in either the Economic Times or the Times of India about the recent OECD Pisa educational rankings that find India virtually last out of 74 countries.


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