Real estate's dystopia

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In literary theory, the opposite of a Utopia is a Dystopia "" a place where everything is nasty and Murphy is proved an optimist. Actually "Utopia" itself was a dystopic novel because Thomas More wrote it as a satire.

Anyhow, without getting into literary tangles, let me tell a dystopic fairy-tale. Somewhere there's a consumer boom driven by high income growth and a big middle-class. Lenders offer easy credit to retail customers.

The retail credit translates into a housing boom driven by EMI financing. That causes a bubble where real estate prices inflate over several years. At some stage, rental yields drop way below the cost of servicing loans on property of equivalent cost.

Nevertheless, credit is cheap and everybody wants to own the roof over their heads; people continue buying on the "never-never". Builders continue building; banks and FIs continue lending. Real estate prices keep rising, people speculate on them rising further.

Inflation jumps due to a huge spike in global energy prices. This hits prospective home-buyers and demand plummets, leaving real-estate developers in a highly-leveraged mess.

Higher rates hit home-owners with floating rate mortgages as they struggle to service EMIs. Real estate prices plummet due to the drop in demand.

There are defaults. Lenders struggle to recover their principal after foreclosing on mortgages because prices have dipped.

The better-capitalised lenders bite the bullet and extend home-loan tenures drastically. An entire generation of middle-class homeowner ends up in the lurch. The financial system takes five years to recover.

Sounds paranoid? It happened across UK and the US between 1983-87. It culminated in what is called the "Savings & Loan crisis of 1987" when most of the smaller US banks went bust.

In the UK, building societies (specialised cooperatives, which lend to homeowners) went bust. It took five years for the financial system to stablise and an entire generation of middle-class home-owners ended up in a mess.

Could it happen here? Sure. The housing boom went into overdrive around 2003 when the banks aggressively entered.

Most housing loans are floating rate and quite often, offered with EMIs at very significant proportions of monthly income. If rates rise, tenures will have to be extended since higher EMIs will be unsustainable.

Real estate prices have risen to levels where rental yields are already substantially out of whack across most major urban areas. The housing boom is continuing and has enough momentum to force prices up 15 per cent over the next year or so.

At the same time, interest rates have started rising. Oil prices are high and likely to stay there.

That is translating into some inflation already. It will mean either more inflation in the future or massive bailouts and subsidies for the oil PSUs. Either way, rates will rise.

Most importantly, nobody believes that it could happen. We've already seen one boom-bust real estate cycle in 1995-2000. But that was confined to very upmarket areas of metros.

Retail real estate loans are considered the safest parts of commercial lenders' portfolios "" there is almost zero default.

If something like this does happen, almost everyone will be caught with their pants down. The contrarian, who prefers to rent rather than buy and refuses to invest in plays with high HF exposure will be the winner.

By mid 2006, banks and housing finance institutions could actually be high-risk investments if this combination of trends continues to develop.