Potential Real Estate Crisis In India Economics Essay

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In this report we are examining whether India is heading towards a real estate crisis? With the increasing prices of real estate in recent two three years it seems that investors are highly optimistic even on real assets that have low revenue. There is huge concern in Indian market that this will form a bubble which will burst sometime or later making all other related financial activities go down with it.

A bubble is defined as the difference between the market price and the market fundamental. Bubbles lower productive savings and thus increase the marginal productivity of capital and the interest rate. When the bubble less and rent less economy is efficient, the interest rate in the same economy with bubbles and rents a fortiori must in the long run exceed the rate of population growth.

Large capital inflows can also have less desirable macroeconomic effects, including rapid monetary expansion, inflationary pressures, real exchange rate appreciation and widening current account deficits. Lower interest rates in the developed nations attracted investors to the high-investment yields and improving economic prospects of economies in Asia and Latin America.

Real estate in India deals in three areas: agriculture, commercial and residential. We should know what different players in this sector are and what the types of products in which they transact are. We should analyse the demand side and the supply side of this sector. Considering various industry specific changes in the market we should also examine various macroeconomic factors affecting the real estate sector. The various factors include GDP growth in recent years, high rise in inflation as well as high paying jobs, the growing workforce of India and increasing level of consumption, speculation of various market players like banks and changing in interest rates of home loans.

From various market trends there was high cash inflow in real estate market in past few years. The rise in inflation has also led to high volatility in the market which means that speculators are heavily investing in this sector. There is cyclical trend observed in the real estate market but Indian real estate market is growing without bounds. With high demand and low supply there will be mismatch of assets and hence mispricing which will lead to bubble.

Real estate in India

The rising disposable income and increasing number of nuclear families is driving the demand for residential properties. In the commercial space, because of the increase in Indian as well as foreign retail giants, there is proliferation of malls and related activities centres. Real estate market is different from other financial markets because of the difficulty in valuing the assets properly. High volatility in returns and perceptions has made this task difficult. Some of the unique features of this market are:

Land or Building is has long life time

Unequal and Unmatched terms in the market

High transaction cost

Long time and high costs for transaction and

Land: investment as well as consumption good

Land and buildings are not mobile, only rights are transferrable

High confidence in Indian economy in current period is easily seen in the increase in the flow of FIIs. Optimism in investors with the BSE going above 20306, along with this there are many reasons why investors invest in Indian realty market:

India is a developing economy with 8.3% rate of growth.

Gain from the human capital because of the ever increasing working population of India.

With the development in service and IT sector there is high development in other sectors like healthcare, chemical, jewellery and manufacturing.

There is high dividend payout ratio in real estate investments in India. 70 percent of foreign investors in India are making profits

Components of Real Estate Business

With the coming of many private players in India's reality sector there is innovation in this sector. Many new businesses are emerging in this industry with specialisation in particular areas. Some of them are:

Appraisal : Services for valuing an asset

Brokerage: Act as mediator in transaction of buyers and sellers

Real Estate Marketing - Manage the sale of property

Relocation Services - Relocating people or business to difficult country

Development: Developing an existing real estate property for further new use.

Property Management - Manage property of someone else

Some of the demand side and supply side people present in this market are:

Demand Side

Owner/User: This implies that a person is owner of house and it also uses the property. They consider property as investment and keep tenants and also live in them

Owner: These people simply give on rent the property they own. They don't utilise it in any other manner.

Renter: These are the tenants or basically the consumers of real property.

Supply Side

Developers: These people work on new land or structure which will be considered as an new property in the market.

Renovators: They are people who help in developing an existing real estate property for further new use.

Facilitators: They are somewhat like brokers which facilitate the buying and selling of real estate. These include real estate grocers, lawyers, banks etc.

The increase in the number of business is because of the varied interests of consumers in this sector, this implies that there exists heterogeneity in the ownership interest in real estate, which includes Freehold, Life estate, Estate for years, Leasehold, Reversion, Concurrent or co-tenancy etc.

Real estate basically operates into three important sectors which are commercial, agriculture and residential. Some of the factors that have great influence on the property prices are: the physical characteristics, the property rights in the area, time for the holding of the property, the area in which property is held, rate of developing the property etc.

Fundamental factors for real estate valuation

There are many factors that determine the path of real estate prices in a given area; this includes various macroeconomic as well as microeconomic factors. Analysing demand and corresponding supply of the real estate:

Demand

Demand includes demand by current owners and renters. The demand of real estate can be increased with the increase in employment, jobs, standard of living and the need of office space.

GDP growth has increased from 6.7% in 2008 because of global meltdown to current 8.8%. Over the 10 years India has shown around 7.7% growth rate. This was because of the high agricultural output along with high output in industrial and mining industry. Industrial output rose more than 12%, while mining and quarrying jumped nearly 9%. India currently has 11th highest GDP in the world and 4th largest in developing countries.

Supply

There is high increase in rentals of office spaces in tier I and tier II cities because construction opportunities are not much. Rise is seen in Grade A projects in districts, Kolkata has highest rise (10%), Delhi, Mumbai, Bangalore and Pune have shown rise of 4%, 3%, 3% and 4% respectively. With the development of private property ownership, real estate has become a major area of business. The construction and development of new commercial and residential complexes can be proxied by cement industry and construction industry.

Cement Industry: India is currently second largest producer of cement in world. Cement production increased by 10.8% in 2009-10. Domestic demand for cement is mainly from the housing activities and infrastructure development. While domestic consumption for 2008-09 stood for 178 million tonnes, it was 100 million tonnes for period from Apr- Nov 2009 showing CAGR of 12.5%.

Construction Industry

In India, construction is the second largest economic activity after agriculture. Construction accounts for nearly 65 per cent of the total investment in infrastructure. Many banks are lending in infrastructure sector because of sure growth prospects in it. In Delhi there is recent surge of construction activity because of the Commonwealth Games Village project worth US$ 40 million. A study conducted by IHS global insight predicts that construction spending in India will grow from $200 billion to $400 billion from 2010 to 2013. This will cause supply pressure in real estate market.

Factors for Boom

FDI and FIIs

FDI inflow in India has registered a significant growth in recent years. Earlier, restrictive norms were imposed on foreign investments with their presence permitted only in the integrated townships. The government of India allows foreign direct investment up to 100% for the development of real estate sector. In the April to December, fiscal year of 2009, foreign investments in India inflows peaked at an impressive US$26.5 billion.

Source: Department of Industrial Policy & Promotion, Ministry of Commerce and Industry

As can be seen in the graph the FDI inflows in India increased from 2005-06 and maintained steady growth in spite of global meltdown and peaked in 2009-10. There is again slowing down of the FDI inflows. There was considerable increase in FDI inflows in 2008-09 year which increased slightly in 2009-10.

Source: Department of Industrial Policy & Promotion, Ministry of Commerce and Industry

Housing and real estate was the third highest sector attracting FDI worth US$ 2.8 billion during April-March 2009-10, according to data released by DIPP.

According to SEBI an increase was seen in the FII inflows in the current year. During January to June 2010 FII invested US$ 6878.50 million in equity and US$ 6083.90 million in debt. In FIIs, infrastructure projects attracted much of the funds. From January 2010 to May 2010 there have been 19 deals in this sector; this meant an investment of around US$ 1.07 billion. In the corresponding time period in year 2009 there were 14 deals with value of US$ 257.5 million.

Banks' interest in real estate

RBI guidelines that banks should maintain low level of exposure to real estate. As real estate market is showing up trend banks are lending more money in this sector. RBI also increased the provisioning requirement of advances in this sector which are classified as standard assets from 0.4% to 1%. Advances to real estate from Public sector Banks rose by 15% to Rs 3.01 lakh crore from Rs 2.62 lakh crore, whereas there was a decrease in private banks of 0.4%.

Four banks (Bank Of Baroda, Syndicate Bank, State Bank of India (SBI) and Punjab & Sind Bank) among 22 PSB have shown more than 30% increase in their advances to real estate during 2009-10.

In %

Advances to real estate

Real estate total advances

Banks

2009-10

2008-09

2009-10

2008-09

Bank of Baroda

42.8

15.2

12.9

11.04

HDFC

36.9

81.9

20.1

18.68

SBI

35.9

10.8

13.79

11.82

Axis Bank

28.4

26.2

23.61

23.53

Bank of India

-2.7

18.5

11.38

13.79

ICICI

-16.8

-5.5

35.25

35.18

Source: Financial Express Nov-Jun 24 2010

FICCI asked banks about the promising sectors in 2010. All respondents were confident in the infrastructure sector leading the profitability for the industry, followed by retail loans (73.33%) and others. Real estate sector was ranked lowest at 20% only.

Source: Federation of Indian Chambers of Commerce & Industry (Feb 2010)

Land allotted to Special Economic Zone (SEZ)

There is allocation of land to SEZ this makes it impossible to match the demand of real estate. The situation is quite grim with no land available even for fulfilling SEZ requirements. Most Real Estate Developers In India are interested in setting up a SEZ to cash in the India real estate bubble by acquiring SEZ land at cheap rates and creating a land bank for themselves.

Per Capita Income

Per capita of Indian individual is increasing. Multinational companies have access to skilled and cheap labour easily. Specialisation in service and telecom industry has led to outsourcing of services from foreign companies to Indian companies.

Source: World Bank

The average income of Indians has grown by 10.5% to Rs 44,345 in 2009-10 as against Rs 40,141 in 2008-09, at the current price. This implies there is high disposable income present for current population some of which will surely be diverted to real estate for housing needs. Per capita income at fixed price grew by 5.6% in 2009-10.

Inflation

There is high increase in inflation in current years. In 2009 inflation crossed the double digit barrier, leading to too many people invest in real commodities rather than money instruments. India's 2009-10 Economic Survey Report suggests a high double-digit increase in food inflation, with signs of inflation spreading to various other sectors as well. In 2009, Indian inflation stood at 11.49%. If the government promises to decrease inflation to manageable levels then there is possibility of increased real estate investments in India. This trend of inflation is making Indian markets quite unstable.

Source: World Bank

In New Delhi, Mumbai, Kolkata or Bangalore are expected to explode because here residents are ready to pay high premium to get hold of the properties. High inflow of capital into real estate and housing has triggered sudden increase in price of related land and inputs.

 

2004

2005

2006

2007

2008

2010

Delhi

 

 

 

 

 

 

Shanti Niketan

11500

15000

18000

22500

27000

35,000

Vasant Vihar

11000

14500

17000

21000

26500

30,000

Friends Colony

6000

8000

10000

13500

18000

25,000

Gurgaon

2000

2500

3700

4850

6100

7,600

Nodia

2000

2800

3700

4900

6850

6,000

 

2004

2005

2006

2007

2008

2010

Mumbai

 

 

 

 

 

 

Cuffe Parade

11500

18000

25000

35000

42000

50,000

Worli

8500

12000

18000

26000

32500

30,000

Bandra (W)

8500

10000

13500

21500

26500

20,000

Navi Mumbai

1800

2300

2800

3500

5500

7,000

source: http://in.diarealestate.com/

Interest Rates on Housing Loans

Real estate purchase is greatly affected by the interest rate that banks charge for home loans. The weighted average call money rate can be taken as a proxy. The movement of interest rates on housing loan has remained synchronous with short term money market rate. It is shown that error in variance of house pricing increases with increase in call rates. As can be seen from the graph below the call money rate were lower in 2009 but are again gaining in 2010 and has now reached to 6% level.

Source: RBI: From Jan 2010 to Nov 2010

Source: RBI (for November)

Conclusion

Real estate prices are seen to increase with the increase in GDP and per capita income. Right now Indian market is showing mixed reactions: GDP has shown growth rate of 8.5%, inflation has reached to high levels and the disposable income is also increasing. Though banks have shown low confidence in getting returns from real estate, banks continue to invest in real estate projects. RBI to manage inflation increased the policy rates, but this move will only increase the volatility in real estate market and hence speculators will try to invest in this. With increasing demand of real estate and low supply there is inefficient market hence people will misprice properties which may lead to bubble. There is slowdown in real estate market in present financial year which is giving some hope of getting correction done. The need for today's realty estate market is reduction in transaction cost and giving an efficient way to deal in the market.

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