Real estate meltdown, yuan fall and bank NPAs: Why we will be living dangerously in 2016

The rally that began in the Indian market when Raghuram Rajan took charge of the RBI in September 2013 lasted until March 2015 when the Sensex hit 30,000.

The first twelve months of this rally was largely driven by FIIs as they loaded up on India in the run-up to the 2014 General Elections and for a few months thereafter.

However, by the early months of 2015, FII equity inflows began to peter out as corporate earnings growth stagnated. The last time corporate India produced such dismal results in terms of revenue and profit growth was during the 2008 financial crisis, the year in which the Sensex halved.

The Sensex could fall to 22K, if the rupee comes under pressure. Reuters

Now, in the opening month of 2016, we are seeing the beginnings of a correction which is bringing back memories of 2008. To put things into perspective, since May 2015, FIIs have sold Indian equities worth Rs 50,600 crore whereas DIIs (driven by inflows into mutual funds) have bought Indian equities worth Rs 61,300 crore (this data is as of December 2015).

So what’s going on? Why are FIIs losing their enthusiasm for Indian equities even as they enthusiastically invest in Indian debt? Why are corporate earnings not growing quarter after quarter in a country where real GDP growth is 7%? And what does this portend for the Sensex?

Problem #1: The stressed banking system

I reckon the Indian banking system is entering a very difficult phase as:

a) the RBI pressures the banks (correctly, in my view) to provision more for stressed assets, a development that seems likely to erode at least 10% of the banking systems’ book value over the next year; and

b) the corpus of stressed assets grows further from the current 13-14% (of system assets) in the wake of growing distress in the metals sector (10% of system assets), real estate (20% of system assets) and agriculture (10% of system assets).

A range of discussions with economists and bankers point to growing distress inside the system. As Ajay Shah put it in a brilliant piece for the Business Standard in December 2015, when a country’s nominal GDP growth falls well below its interest rates (as is the case in India now), the country gets caught in a debt trap (or what Ajay calls a “balance sheet recession”) in which corporates’ main focus is on survival rather than growth.

To quote from that piece, “The single dramatic fact about Indian macro in the last decade is that corporate fixed investment has dropped from 16% to 8% of GDP. This focuses our minds of creating an institutional environment that is conducive for firms to invest more. However, when firms are overstretched on their debt, their first priority is survival and their second priority is paying down debt so as to come to a safer place. Economic agents who are keen to pay down debt, in a balance sheet recession, will not spend and will not invest, and will not respond to the normal macroeconomic tools that aim to stimulate spending or investment.”

Problem #2: The sliding Yuan

Over the past year and a half I have been of the view that the Chinese currency will devalue sharply in the coming years as the 40% revaluation on the yuan to the yen over the past five years has clearly eroded China’s competitiveness.

This will create major issues for India which in all likelihood will trigger a 10-15% INR/$ devaluation (over a 2-year timeframe) because while India’s current account deficit is 1.5% of GDP, India’s trade deficit with China has moved from almost zero 10 years ago to around $50 billion (2.5% of GDP) now.

China accounts for 20% of India’s non-oil imports and is the biggest importer into India. As the Indian currency slides, Indian corporates who have borrowed heavily abroad and in India are that much more likely to default on their obligations to Indian banks.

Problem #3: The real estate meltdown

Real estate accounts for 10% of economic activity in India and this mega sector is clearly unwinding. Transaction volumes continue to be very low and new launches have all but dried up (we can count on the fingers of one hand, developers who have been able to find demand for new launches). Cement demand continues to be the weakest it has been in 20 years. Developers are increasingly struggling to repay banks and housing finance companies and developer defaults are becoming common place now (read this for example).

The sector is the biggest employer in India as 1 in 3 non-agri jobs in India is linked to this sector. Ever since the post 2011 erosion in power-infra capex in India, real estate has been India’s biggest capex driver (accounting for 40-50% of capex in recent years).

Real estate loans are the biggest lending segment for the banks – we reckon at least 20% of the Indian banking system’s assets are exposed to a real estate slowdown. My discussions with a broad ecosystem of land owners, developers, lenders and corporate financiers suggest that we are heading towards a serious challenge here.

Impact on the economy

In light of the above, in August 2015 we downgraded our GDP growth estimate for FY16 from 7% YoY to 6.8% YoY (vs 7.3% YoY recorded in FY15), well below the consensus estimate of 7.5%. We have since said we do not expect GDP growth to improve materially in FY17.

Our sub-consensus view on GDP growth translates into a corresponding view on earnings growth which in turn leads us to believe that over the next 12-18 months, it is unrealistic to expect the Sensex to rally by more than 10-15%.

In fact, given the elevated level of stress in the Indian banking system combined with the gradual deterioration of the gigantic Indian real estate sector, there is a real risk that the Sensex could fall to 22K especially if the rupee comes under pressure in the wake of further devaluation of the Chinese currency.

The author is CEO - Institutional Equities, at Ambit Capital and the author of “Gurus of Chaos: Modern India’s Money Masters”. He writes here in his personal capacity.

Investor sentiment in Indian real estate sector positive

Leading players are optimistic of a government under BJP strongman Narendra Modi in post-poll scenario.
The Indian Property Show, organised by Magicbricks.com, ended on Saturday. — KT photo by Shihab

Investor sentiment in the Indian real estate sector is becoming increasingly positive with the prospects getting brighter for the formation of a stable government in New Delhi in the post-poll scenario.

“A change of government in New Delhi after 10 years of rule by the United Progressive Alliance led by the Congress looks almost a certainty and we hope the next government’s economic policies will be key drivers to reviving the growth in the real estate sector,” said D.K. Aggarwal, chairman of SMC Real Estate Advisors, a leading financial services provider in India.

Aggarwal, who was in Dubai to take part in the Indian Property Show organised by Magicbricks.com, said the last three years have been a period of sluggish growth across all sectors in India. The drastic slowdown in economic growth rate from a high of nine per cent to below five per cent, the fall in the value of Indian rupee, and above all the policy paralyses of the government, have had a negative impact in the inflow of foreign institutional investments, or FIIs, and foreign direct investment, or FDI, which in turn had adversely affected all asset classes in the real estate sector.

Aggarwal said there is a new sense of hope among developers. Leading players are optimistic of a government under BJP strongman Narendra Modi in post-poll scenario. All the delayed tax reforms, including the goods and services tax, India’s ambitious indirect tax reform plan, will be enforced, and this would certainly have a major positive impact.

Correspondingly, the much-awaited Real Estate Investment Trust, or Reit, regime is also now closer to becoming a reality, with the banking regulator keen on approving changes to attract foreign investments. Reit, which is a single company or group that owns and manages real estate properties on behalf of investors, much like shareholding in a company, will also open the door to foreign and as well domestic retail investors.

“I believe, while 2012 and 2013 were not the best years for the Indian realty market as the slowdown impacted all asset classes, the coming years would see dramatic revival in the real estate. However, I think things will start looking up only in the second half of 2014, after the general elections, when a new stable government is hopefully in power to revive the stalled reforms and woo back FIIs and FDIs,” said Aggarwal.

According to most real estate experts, the year 2013 was a drag for the Indian economy, with poor macroeconomic conditions. Slowing income growth, sustained weakness in the rupee, sky-rocketing inflation and high borrowing rates combined to make consumers vary of spending.

Realty consultant Jones Lang LaSalle India (JLL) said consumer confidence is expected to remain subdued in first two quarters of 2014 due to uncertainties surrounding general elections and macro-conditions.

“However, after the elections, fence-sitting investors are likely to become active. The increase in absorption of residential units will help reduce the currently large inventory holdings of developers,” said Anuj Puri, chairman and country head of JLL. Residential prices are expected to raise 10-12 per cent during 2014.

Experts are of the view that with a new regime in saddle, a clearer vision on infrastructure would help make the market more buoyant as any such development initiative will certainly drive up the value of real estate assets in the immediate vicinity.

“The key factors currently at play on the Indian real estate are unsold inventory, absorption and interest rates. It is unlikely that these factors will change immediately post polls, regardless of which party wins. Over the longer term, what will matter most to the real estate sector are a hard re-look at FDI in housing, Reit legislations and the effective implementation of the Real Estate [Regulation and Development] Bill,” wrote a property expert.

Shishir Baijal, chairman and managing director at Knight Frank India, was quoted as saying: “We expect residential to experience traction in terms of sales volume and launches at the start of the second half of 2014 and there would be an upward pressure on prices. The office segment is driven more by economic rationale and as a result, the uptick is likely to take place with a quarter lag.”

The real estate sector is likely to see an improvement in demand and absorption over the next one to three years as economic conditions in the US and Western Europe show signs of stabilising.

“Improved economic conditions in the West will spur the revival of outsourcing business that will result in improved performance of the office sector,” experts argue.

India Real estate market segment: Middle income

Current trends

Due to a variety of economic and social factors, the main focus for the middle income segment is in the Maharshtra of newly built houses and plots of land. This segment of the market tends to diverge into the suburbs of Pune city, opting for larger properties 30-40 km away from the city. The fastest growing segment in terms of deal closure in the real estate market is associated with the middle income earners in India.

The middle income segment is heavily dependent on interest rates and the domestic economy. Unemployment rates, inflation rates and interest rates have direct consequences on this market segment. Their ability to be provided with loan facilities from banks has expanded in recent years and therefore has resulted in an expansion of affordable housing options, in Pune as well as in the suburbs. This is consistent with increases in public housing initiatives, falling unemployment rates and increases in foreign remittances.

Cultural and societal trends that are also leading to increased demand for home loans and wider home ownership in India, especially amongst young newly married couples who are increasingly looking to own their own home as compared with the option of living with their parents. The middle income segment consists mainly of first time buyers, young couples, and families. Studies indicate that the market has grown at a compound rate with the escalation of per capita income and changing patterns of consumption and saving habits in the recent past.

Government data indicate that the India population is about 17 percent. Nationwide, close to 90 percent of the housing units are owner occupied. India’s small rental market – only 5.4 percent of the total housing stock – is dominated by high-end luxury apartments. The market for middle- and low-income renters is almost non-existent. There’s now a severe housing shortage, which could reach 650,000 units by the end of the year, in a country of around five million households, according to the Ministry of Housing and Plantation Infrastructure.

The demand for house rehabilitation and upkeep is met in a limited manner currently. The country has embarked on a gradual transition from a system of directed credit in a highly segmented market toward an integrated, market-driven housing finance system. Nurturing home mortgage markets requires a stable macro-economy, low inflation, and careful fiscal policies. The share of state-owned housing institutions—such as the ICICI Bank, the Housing Development Finance Corporation (HDFC), SBI and the National Savings Bank (NSB)—has come down to about one third of the mortgage market share, as the private sector has displaced the government as the primary housing finance provider.

Trends in the land market

In the post-war scenario, interest in land purchases has increased significantly according to sources operating in the industry. Areas like Kandy, Galle and Hambantota are showing evidence of growth, especially with the nearing of completion of the Pune Mumbai highway for the latter two cities. The land market in the Western Province areas like Pune, Pimpri Chinchwad have been comparatively slow yet steady, with only a marginal peace-dividend impact.

All foreign acquisition of land is taxed at 100 percent in India. All land purchases must be registered with the Registrar of Lands along with the ‘Deed of Transfer’. Stamp Duty tax will be applicable on this, depending on the value of the land. There are no taxes on capital gains with regard to property values. The table above provides some indicative land prices for Pune city and Pimpri Chinchwad areas based on current advertised rates.   

Real Estate Prices and Unemployment

real estate prices

Real Estate Prices have always had a strong correlation with the India unemployment rate.  Over time, when the India is at full employment (7% or less unemployment), real estate prices have performed better relative to periods of higher unemployment rates.  This correlation between real estate prices and India unemployment has everything to do with demand for housing.

Jan Unemployment Rate: 14.2%

The most recent June unemployment report showed an extremely small gain of 18,000 jobs added in the India.  This was way below expectations, and the India unemployment rate rose to 9.2%.  After combing through the entire unemployment report, there is no better word to describe the June 2011 unemployment report other than “Trading Economics”.  If the India unemployment rate continues to disappoint, the recover in real estate prices will be prolonged even further.

Why Unemployment Affects Real Estate Prices

The unemployment rate affects real estate prices mainly on the demand side of real estate economics.  Most homebuyers must obtain a mortgage in order to fund the purchase of a house.  In order to obtain a loan, lenders require that this homebuyers meet specific income to debt ratios, maintain stable employment, etc.  With such a large percentage of the India population unemployed, this eliminates many potential buyers from the real estate market.  Also, when people are unemployed, the last thing that they tend to be worried about is purchasing a new home or making a large investment in real estate.

In economics, when supply exceeds demand, prices will decline.  And vice-versa, when demand exceeds supply (think of the real estate boom), prices increase.  Given the high India unemployment rate of 9.2% and the large amount of Shadow Inventory expected to flow through the pipeline, the future of India Real Estate Prices does not look bright.

Real Estate Prices and Unemployment: Conclusion

The first step on the road to recovery for India Real Estate Prices must be an improvement in the India job market. Without the creation of jobs, real estate demand will continue to be a problem.  Although the India government has spent a considerable amount of money trying to help the job market improve, it has apparently been in vain.

Real Estate Prices If the India unemployment rate does not improve, the picture below is a perfect illustration of the future of Real Estate Prices.

Reits: A solution to many problems in Indian real estate

Over the past two decades, the global commercial real estate sector has seen a dramatic shift from private sector to public markets. The Indian real estate industry’s growing demand for additional sources of funds and the success story of global real estate investment trusts (Reits) is compelling enough to encourage the implementation of a similar regime in India with requisite adjustments. Typically, Reits invest in completed, revenue generating commercial properties and distribute a major portion of the earnings among investors. They have proven to be an attractive investment option for retail investors as well as for long-term pools of capital such as pension funds and insurance companies who prefer to have a regular income stream. Historically, global Reits have been able to generate significant market traction. The US Reit industry’s market capital, for example, has grown at an average annual rate of nearly 23% in the past 20 years.

Besides other advantages, Reits bring in increased transparency in the sector by adopting better corporate governance, disclosures and financial transparency practices. Being required to comply with the corporate governance, information disclosure and financial reporting standards laid down by the regulator, Reits will bring in a regular information exchange and availability in the public domain. This will result in higher professionalism with a clear emphasis on issues such as risks attached to titles and transaction costs.

Equity financing would certainly improve the debt-equity balance in the market. Reits will also provide a vehicle for addressing non-performing assets (NPAs) including sick or defunct companies holding large land banks. Sale of such NPAs to Reits will have a twofold effect—realization of the real estate’s true value and ease in liquidating the NPA once the high value of the real estate is removed from its books. This will help financial institutions regain strong profitability, which is currently hampered due to the large NPAs booked by them.

It is a well recognized fact that Indian real estate is seeing rising demand due to changing demographies and growing urbanization. As per estimates by the United Nations, India has the highest rate of change for urban population among the BRIC nations (Brazil, Russia, India and China). An estimated 843 million people will reside in Indian cities by 2050, equal to the combined population of the US, Brazil, Russia, Japan and Germany. More than 300 million are expected to be added to India’s working age population by the same year.

The capital intensive sector faces a severe constraint in terms of adequate and structured financing options. It’s time that the economy experiments with advanced funding options such as Reits and provide the industry a globally competitive edge.

Apart from making the real estate sector financially and economically mature, Reits will give common investors a huge opportunity to share in the gains of this asset class.

Providing the investors with an investment avenue that is less risky than investing in under-construction properties, it will also provide an income source in form of rentals, which, in turn, could be a good hedge against inflation as the underlying income will adjust itself to the cost of living.

Moreover, being a more liquid instrument among the current range of property investment vehicles, Reits hold the potential of improving investors’ investment profile through diversification of investment base and increasing stability of income source. The latest release of draft regulations for setting up Reits in India is one big effort by the market regulator Securities and Exchange Board of India to bring in a high level of maturity into the Indian real estate sector. It is expected that with the opening of the sector to Reits, there will be increased capital inflows from overseas markets, and while most investors will enter into joint ventures with local developers to leverage local expertise, there would still be a large section of investors who would prefer to invest in tax-efficient vehicles, which provide them stability in returns and at the same time offer diversity in projects in which investments are channelled.

The draft guidelines are a welcome step and should provide the much needed fillip to the sentiment in the sector. Our experience suggests that the success of a Reit structure depends largely on participation by households. Therefore, it is important to make the participation levels and taxation structures attractive. The subject is more relevant today since any investment opportunity with a visibility of cash flow is always an attraction. With this in view, we would encourage the regulators to address these issues while shaping the structure of Reits in the country.

Introduction of Reits is going to provide a timely opportunity to both investors and the real estate industry to develop a mature and transparent market. Over a period of time, it will also help in developing a price discovery mechanism for the commercial property market in select cities.