Another 'brick' in the wall

By the time this article goes to print, I am sure every second person in the urban world would have read at least one article covering the looming US economic recession, the mortgage market meltdown or the historic fall of a few supposedly ‘infallible’ financial institutions. So, why post another brick on a wall already plastered with articles, analysis and forecasts? My corporate finance professor at the Indian School of Business, Hyderabad used to say – “In the big scheme of things nothing really matters”. But then does it really matter to us that the US economy is nearing a recession that is turning out to be as big if not bigger than the Great Depression in the 1930′s? Does it matter that scores of layoffs have taken in firms across different sectors in developed nations? Does it matter to us that house builders in the developed nations are facing acute pressures from severely depressed home valuations and an increasing inventory of unsold homes? Does it matter that the sub prime crisis in US is likely to cause about 2.2 million foreclosures and leave about 10 million households with negative equity on their home investments in US?

How will these ‘catastrophic’ events affect us as individuals in the Indian real estate market? Two pages surely cannot do justice to a topic as vast as this. However, it will be my humble attempt to explain in simple terms what happened or what is happening in the US, why did it happen, what are reasonable impacts of the same in India and most importantly how we as real estate consumers, producers or service providers can brave stormy seas looming ahead.

What is happening? The US economy is currently undergoing what is being termed as its worst financial crisis in this century. What started off in 2007 as a housing sector financial crisis in the US has now spread across to credit and financial sectors with tremors felt in markets across the globe. Home prices in US are expected to fall by 20% to 30% and in some places by 50% of their values in 2006. This fall in house price makes it uneconomical for many in the US to keep servicing their loans and more sensible to just hand over the house to the bank!

The housing sector sub-prime crisis started with lenders (mortgage originators) granting loans to sub-prime borrowers (borrowers without a good credit history and poor FICO score) by charging higher interest rates and taking little or false documentation as proof of income. As a result of this, sub-prime borrowers got access to credit and provided lenders an opportunity to charge fees and earn interest. Lenders in turn passed on their risk to hedge funds and securities dealers who made money in turn by selling securities to investors and charged commissions on underwriting. Investors loved this structure since it gave them greater liquidity and an opportunity to diversify their portfolio irrespective and unmindful of the last mile sub-prime borrower. This castle however started falling apart in mid 2007 with many borrowers failing to service their debt. Lenders soon started facing the heat and stopped approving home loans as well as sub-prime mortgage loans. Global hedge funds that had borrowed lot of money to invest in sub-prime mortgages were forced to sell their mortgages at extremely low prices to pay off lenders and investors who wanted out and dumped their stock resulting in plunging stock prices worldwide.

Increasingly, the financial industry and the US federal government awoke to the realization that the banking system had a fairly large exposure to this underlying real estate bubble and the housing crisis could lead to a more systemic financial crisis. There were other factors playing mayhem as well. Subprime defaults were slowly spreading to near

prime and prime mortgages. Private consumption, considered to be over 70% of aggregate US demand, was slowing down and the US consumer already burdened with rising debts was also witnessing a slowdown in income and labor markets. This in turn led to a slowdown in commercial real estate markets and a rising default rate in hitherto healthy corporate default rates. With recent bail out of AIG, bankruptcy of Lehman Brothers and the last minute sell out of Merrill Lynch to Bank of America, recession is now no longer ‘news’.

Why is it happening? The genesis of the crisis can be seen to be built around 3 fundamental human attitudes – greed, risk-aversion and herd-mentality. Lenders and brokers in order to earn higher commissions went overboard in giving loans to sub-prime borrowers bypassing basic fundamentals of banking. Home appraisers supplied inflated housing values to satisfy banks. Wall Street investors backed loans without adequate verification of underlying risks and competed against each other in financial innovations. Borrowers, who eventually have the maximum to lose were responsible in that they entered into loan agreements, trusting their brokers, which they could not really afford. Last but not the least, the US government underestimated the housing crisis and have only from early 2008 started to take drastic measures to tackle this crisis.

Impact on Indian real estate and how you can protect yourself: The US real estate industry witnessed a boom between 2001 and 2005, with property prices soaring to historic highs due to low interest rates and other factors. Does that sound familiar? Till about a year back, industry reports in India too were highly optimistic about the growth of the industry and we have all seen a tremendous growth in real estate construction across different asset classes across the country. Fortunately for us, we had much lesser exposure to mortgage market and an even lesser exposure to inflated realty assets, as a percentage of GDP compared to US or other developed markets. Also the Indian market did not witness the development and application of complex financial structured products on the lines of instruments developed over mortgage in the US.

This along with highly cautious and prudent regulations have averted the crisis to spread its arms into the Indian banking system. However, liquidity crunch is a reality and a global phenomenon that the Indian industry

cannot avoid. Real estate developers are now increasingly finding it difficult to get access to funds. Even private equity fund houses are overtly cautious on their investments and are getting thorough professional due

diligence done on their proposed and current investments.

Real estate markets are inherently correlated and cyclical and impacts on the economy have cascading effects on real estate markets. A slowdown in global economy means a curb on expansion and expenditure which translates to a reduction in growth of IT/ITES and banking sectors. Slowdown in banking sector itself impacts the IT/ITES sector acutely. Such slowdowns over a period of time start affecting demand for a host of professional services from advertising to consulting, to research & development and ancillary back office services besides bringing rate of consumption down. When this continues on an unending spiral, demand for commercial and residential space plummets amidst an over supply of space and prices fall. Falling prices further erode home owner equity and foreclosures and defaults start taking place. Residential markets are already seeing a slowdown with some markets showing clear evidence of corrections. So, if you are in the process of buying a house, negotiate, negotiate and then negotiate even more. The US markets actually have a term for this – ‘Gazundering’ whereby homebuyers take advantage of the housing slump to cut the price of properties at the very last minute to secure a deal.

So, what strategies can one adopt in the immediate term that can reduce vulnerability to market forces and reduce risk. As a developer, I think it is vital today to adopt best practices and create affordable properties that are fundamentally good. When prices take a plunge, competition will intensify and properties that are built on a good location following sound design and construction principles and providing adequate amenities and facilities will stand a better chance of retaining value. It is vital therefore to adopt proper construction project management techniques and adopt rigorous execution risk management to save cost. If you are hunting for funds, it is time to really look hard at your project documentation and if necessary seek professional help.

As a home-buyer whether it is for staying or for investing you need to assess your requirement to buy property at this stage closely. Do you really want to buy that house now or can you afford to wait a while longer? Some words of advice. 1) The real estate market is and will remain local in nature: Inspite of developments around the world, you may actually beat the market even in a downturn by making an investment in an area where local demand supply warrants buying a house now. Variations around the mean value will be much lesser for a sound property in a good location than an average property in an average location 2) Invest before it becomes a buzz: If everyone is talking about a new locality in some faraway region as the next best investment, think twice and check out fundamental demand in that region. 3) Develop your own perspective: Real estate professionals are by nature optimistic people and will sell you the world. How can you not be optimistic when you are in the business of making buildings from mere dreams? 4) Treat forecasts with caution: If you don’t believe me just read forecasts of the market in years 2005 / 2006 and compare with present realities. You see, there are only two directions for value of a property – up or down and in a mature market they keep going up and down cyclically so it is really hard for anybody to give an accurate prediction! 5) Get your personal sensitivity quotient prepared: Everyone loves your money be it the banking, retail, entertainment, healthcare, hospitality, insurance, automobile or just any sector. Before you sign up that next holiday package with an attractive EMI scheme, do analyze your personal balance sheet, especially on the debt side and check out scenarios for increase in debt and expenditures. Do the Maths before you increase your debt. Before I close for this issue, I must bring your attention to this rather beautiful ‘financial’ graph shown above, that I found the other day on the web on a blog by Mike Shedlock, which I am replicating here. My take is that we in India are in between anxiety & denial – what do you think?

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The author is an urban planner from School of Planning and Architecture and a recent graduate of the Indian School of Business, Hyderabad. He is currently working as AVP – Development Advisory at Jones Lang LaSalle Meghraj,

Gurgaon. The ideas expressed on this site are solely the

opinions of the author and do not necessarily represent

the opinions of sponsors or firms affiliated with the

author. The author would love to hear your views at Saumyajit.Roy@gmail.com