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Sub-prime Crisis and Indian Real Estate

Mr. Rahul Singh | Posted On Thursday, October 16,2008, 12:58 PM

Sub-prime Crisis and Indian Real Estate



Sub-prime crisis is the current financial crisis (considered as the worst ever since World War II) characterized by acute credit crunch in the global capital markets. At the core of this crisis lies “sub-prime housing loan market.”

How sub-prime crisis started?
The crisis began with the bursting of the United States housing bubble. A slowing US economy, high interest rates, unrealistic real estate prices, high inflation and rising oil tags together led to a fall in stock markets, growth stagnation, job losses, lack of consumer spending, a virtual halt to new jobs, and foreclosures and defaults. The sub-prime loans were given by FIs at floating rates. With rising interest rates in the US, EMIs for these individuals also started increasing (what we see today in Indian market) and sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping out their net worth. Their mortgage-backed securities were almost worthless as real estate prices crashed.

The moment it was found out that these institutions had failed to manage the risk, panic spread. Investors realized that they could hardly put any value on the securities that these institutions were selling. This caused many a Wall Street pillar to crumble. As defaults kept rising, these institutions could not service their loans that they had taken from banks. So they turned to other financial firms to help them out, but after a while these firms too stopped extending credit realizing that the collateral backing this credit would soon lose value in the falling real estate market, resulting in this big “Sub-prime” mess.

Why did India market fall?
Once investments by the FIs in the US turned bad, more money had to be invested back, to maintain that fixed proportion i.e. to match assets and liabilities on their books. In order to invest more money in the US, money had to come in from somewhere. To make up their losses in the sub-prime market in the US, they went out to sell their investments in emerging markets like India where their investments have been doing well.

So they started selling their investments in India and other markets around the world to maintain enough liquidity in the US economy and for their own operation. Since the amount of selling in the market was much higher than the amount of buying, the Sensex began to tumble. Additionally, crude prices were in the range of $120-150 which caused inflation to rise in double digit forcing banks to raise their interest rates. Thus, higher rates seriously affected real estate, automobile and banking firms’ operations and their stock crashed. Moreover, there were some rumors that even Indians banks had some exposure to these risky MBS and hence, banking stocks were among the worst hits. The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar. The stock market will continue to tumble as long as there is huge selling pressure from these FIs.

Since most of FIs who invest in India are based in the US, the stock market in India generally closely follows the sentiments in the US economy compared to that of Japan or European economy.

Stock market and real estate
Most of the real estate developers are publicly listed companies and trade on these stock exchanges. This is because real estate development is capital intensive business and developers need cash to develop properties which is then sold or rented to customers. The investors in the stock market provide these developers cash for their projects. Hence, if the market is going down, these companies may get affected as well.

A large number of financial institutions (Banks, Mutual Funds and Hedge Funds) buy or sell these companies’ securities on the exchange. If these FIs start heavily selling their investments for one reason or other, it will negatively affect companies’ stock price. The stock is an attractive currency for the firms in the bull market. Firms may sell (issue) these stocks in the market to raise capital to fund their expansion plan without the headache of interest payments that accompany debt. So any downward movement in the stock market might decrease the stock price of these firms and hence reduce their ability to raise sufficient capital.

Some macroeconomic factors such as inflation and recession also affect these companies and their stock prices. As we know inflation in India is around 11.5% which is quite high compared to last year’s figure of 3-4%. Banks had to increase interest rates to counter high inflation. For real estate companies higher interest rates environment is not suitable because customers avoid taking home loans (higher EMI) which decreases the demand for properties. A bad prospect of growth in the earnings of the firms gets reflected in their stock prices.

Indian Real Estate Sector
Indian real estate sector was darling of foreign investors a year ago. Did you ever hear about mega real estate deals that happened in Mumbai in 2008? If not here they are: London-based banking major Barclays Bank created history in May when it took space at Cee Jay House, a landmark office complex in Worli, for Rs. 725 a square foot (sq ft) per month. Yesteryear movie star Vinod Khanna and his wife set a reality record in Mumbai by buying an apartment in Malabar Hills for Rs. 30 crore after paying a mindboggling Rs. 1,20,000 per square foot. But those days are over now. The sub-prime crisis has taken its heavy toll on the sector.

Real estate is a capital intensive industry. Firms need to buy land, which is extremely expensive these days, raw materials such as cement and steel, and hire manpower for the construction activities. All of these require huge amount of money. Developers generally raise capital either by borrowing or issuing stocks. RBI has made extremely difficult for the firms to raise debt in domestic market and through external commercial borrowing (ECB). Hence, the best way for them is to issue stocks. Unfortunately, the global financial crisis has taken a heavy toll on the Indian stock market. In less than a year Sensex has gone down from 21,000 to 10,000 levels. Most of the real estate stocks are down by over 70% w.r.t to their 52-weeks high. This is because of higher interest rates, global slowdown and heavy selling by financial institutions, seriously cutting down these companies expansion plans. They are stuck with their existing projects while investors have pulled out. Lehman had around $1.3Billion of investments in Indian real estate market. Several developers such as Unitech had planned to raise money through Special Purpose Vehicle (SPV) to fund their projects. Now, after the bust of Lehman, firms may seek PEs help to raise capital.



Current Price*

52-weeks high

% drop

















* As of October 16th 2008

From the above table we can derive the outlook for these companies is not so good. Over 70% of their market value has been wiped out in less than a year; thus, putting brakes on their expansion plans. They might have to look for alternative source of capital or delay their projects. The global financial crisis and impending US recession have severely affected a large of industries such as IT/ITES and Financial Services. Both these industries were creating huge demand for A-grade commercial properties in Metros and Tier-1 cities. Now, that demand has been reduced by over 50% and it may decrease further if the US goes into deep recession. So the next one year would not bring good news for the firms in the realty sector.

However, the consumers have great opportunities even in this bear market and higher interest rate environment. With the decrease in demand for both commercial and residential properties, prices/rentals have come down. We have already seen a correction in the range of 5-10% across the properties and believe prices may go down further by another 3-5% in the next 2 to 3 months. Also, the prices in the secondary market have fallen more compared to that in the primary market. We believe inflation might cool off by June 2009 which might push the demand for residential properties. Though the long term outlook looks good, the short-term outlook is very bad for the industry. So if you plan to buy a house, either buy now or wait for couple of months but definitely before inflation falls below double digit and banks gradually start rolling off hike in rates.


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