The most common question I hear from my friends is why property prices do not fall in India despite adverse market conditions and almost non-existent demand. Even in the United States, during the sub-prime crisis property prices crashed by over 40% - 60% across counties. The situation was not very different in Europe as well. But why do we not see any property crashes in India?
The real estate industry is facing a terrible slowdown, with sales down drastically and the inventory of unsold flats piling up but prices just do not seem to crash! Let us now understand why developers have little incentive to reduce prices to improve sales:
High land prices
Land accounts for almost 30% - 40% of total project cost. Developers either buy land or they enter a Joint Development Agreement (JDA) with landowners. So if they buy land they need to pay money upfront while in JDA they have to construct area in lieu of land value in the project for landowners at their own cost. Land prices in major cities have skyrocketed and the developers have to pay the ‘market price’ to acquire land.
Funding for land acquisition
Developers usually raise money from private equity investors or private individuals to fund land acquisition. Cost of such borrowing is upwards of 20% and can go as high as 30% per annum. From the day a developer buys the land to the launch day, the lag time could be up to 1-3 years depending upon the city. However, the interest or return meter of investors starts from the day they dole out the cheque to the developer. It would be extremely challenging to pay out these investors over the project tenure from the project cash flows if the prices do not keep going up. So you can see why there is hardly any room to reduce prices as returns to investors are fixed.
Cost of approvals
This is true majorly for a city like Mumbai where you have different types of premiums to be paid to the local authorities, namely; fungible, open space deficit, staircase premium, TDR / premium FSI etc., which developers pass on to the home buyers.
Raw material / input costs
Most developers typically sell about 15% - 20% inventory in the pre-launch to fund the approvals and other costs. However, they have no control over prices of commodities such as steel, cement, labours etc. which form bulk of the total project cost. Typical project tenure is between 3 to 5 years. Imagine if the developer sells bulk of unit at a fixed price on the day of launch he is exposed to cost uncertainty for almost 5 years which he may not be able to pass on to the existing buyers. Any increase in the cost of raw materials has to be passed on to the new buyers to neutralise its loss on previous buyers in the same project. Thus prices have to go up to manage project cost and delivery of the project.
Access to liquidity
India attracted $3 billion Private Equity (PE) investments in real estate in 2015. You would be surprised to know that almost all PE investments in residential sector were debt deals with borrowing cost of funds ranging from 17% to 30%. So, if developers have access to multiple channels of funding, replacing one colour of capital with another, they can hold on to unsold stock without having to reduce prices and sell when the market improves.
Consumer psychology / sentiment
There is no guarantee that even after reducing prices a developer will be able to sell his inventory and may in turn lead to spread of negative sentiment amongst the consumers. Consumers will expect the prices to come down further and even those who have planned to make the purchase are likely to hold back. This will further push down the sales and achieve results contrary to what is being envisaged.
As real estate is about a tenth of the Indian economy, the extent of black money floating around in the sector is huge. When black money quantum soars in the economy, there are only three likely places to park them: real estate, offshore tax havens or gold. The threat to offshore tax havens – from the US tax authorities – has probably pushed some of the Indian loot held abroad into real estate.
Why only real estate, and not gold or shares or other assets? Simple: the markets for gold and shares cannot be rigged for such large sums of money. That leaves only real estate, where politicians, developers and crooks can band together to artificially constrict the supply of land and keep prices high even though nobody is buying.
Developers need cash for bribing officials for approvals or land related matters as well as for paying landowners who need cash to avoid / reduce capital gains tax on land sale. So even if there are poor sales, developers are not cash starved as there is plenty of black money in the system for them to survive. Hence, unlike developers in the western countries, developers in India do not go bust in poor market condition. Why would they reduce prices if they have access to cash?
About the author
Prithijit Chaudhury works with Colliers India as General Manager, Investment Services. He has extensive experience in investment banking, transaction advisory in real estate, infrastructure, power and IT/ITeS sectors. He has a strong exposure to land sales and fund raising for real estate developers.