Even a sharp short-term correction could trigger bank defaults. And it is making investors nervous.
Liberalisation started in 1991. But the financial sector was freed up gradually. One major shift - the introduction of floating interest rates came in the early 2000s. Floating rates led to more enthusiasm about mortgages. The liquidity boost for housing loans sparked off a real estate boom.
The equated monthly instalment (EMI) magic helped millions of middle-class Indians buy their own homes. By the mid-2000s, the bigger real estate developers had started listing at unreal valuations. Between 2006-2008, land values in many urban clusters doubled but the share prices of real estate firms multiplied, often by 10x. One “common-sense” investment idea in that period was to shop around for housing bargains and housing loans and to invest in the shares of the entities that made the best offers.
By 2008, the RBI was making cautionary noises about over-exposure to real estate and it took a series of measures to curb excessive lending. Housing loan off-take continued to grow but at slower rates. Share price valuations of real estate developers dropped sharply. It became apparent that many were cash-strapped. Promoters were pledging shares and projects were stalling.
Even though the stock market recovered from 2009 onwards, the listed real estate segment didn’t return to the peak values attained earlier. That was understandable since 2007 and 2008 had seen massive bubbles.
On the surface, land values have remained fairly stable. Mortgage lending continues to show steady growth. But the commercial real estate market has suffered from over-supply. Developers were hit hard by rising interest rates and by the inability to get enough in the way of cheap loans or bookings to fund operations.
The rate cycle still seems to be heading up and it’s started pinching on the home-loan front. People with mortgages have already seen their loan tenures extended, as interest rates have risen. Now, some are being asked to pay higher EMIs as well.
A comparison with the so-called subprime bubble in the US is interesting. The US bubble involved several factors that won’t be replicated in India. Due diligence on US mortgages was very poor. The US financial sector used exotic derivatives such as credit default swaps, and subprime bundled loans and so on, to hyper-inflate the bubble.
But some flawed assumptions made most US institutions and rating agencies complacent and those beliefs are shared in India. There was absolute faith that real estate values would never fall in the long run. Another belief was that the rate of default on real estate loans would always stay low. A third belief was that, even in default, mortgages secured against fixed assets were safe because real estate values would never fall and repossession would lead to lenders recovering their cash.
In practice, there was a dramatic collapse in US land values. As the crisis got worse, home-owners saw property values decline to a point where it no longer made sense to service mortgages. They defaulted in droves.
Houses were repossessed. When sold at auction, they either found no takers, or the realisations weren’t enough to cover the loans.
There is no intrinsic reason why land values could not fall in India. It happened between 1995-1998 in several upmarket areas in Mumbai and Delhi. There’s a bigger cushion against default than in the US. The official price of most Indian real estate is less than the actual price. People often pay black cash components and that means greater commitment to mortgages.
However, consider the case of recent mortgages. In these, the borrower has incurred less sunk costs and the lender has correspondingly larger exposures. Somebody who bought a house in early 2011 has since seen a hike in interest rates. If the value of the house falls sharply in the next 6-12 months, it may make sense to default. That would mean huge write offs for lenders. In this scenario, one sharp short-term correction in real estate values could trigger higher default rates. In turn, higher defaults could create a crisis for over-leveraged and cash-strapped players in the financial, construction and developer sectors.
It’s still a low probability scenario. But the chances of it are rising. If it does happen, it would hurt more than an equity bear market. Diagnosing it early would also be very difficult, given a lack of reliable sector data and the opacity of balance-sheets of operators across this value chain.
While most analysts publicly ignore this possibility, nervousness about it could be one reason why the real estate sector has continued to lose ground. It’s been beaten down but it could take a further beating. It’s not yet time to buy into the sector.
