The recent measure taken by the government of India to demonetize existing currency notes of Rs 500 and Rs 1000 is being seen as a sweeping reform which will have repercussions across various sectors of the economy.
The move aims to bring down corruption by hitting at the widespread use of cash transactions which is the preferred medium of exchange for engaging in illicit activities and evading taxes. By penalizing the hoarders of cash, the government hopes to bring about a change in India’s social behaviour and move towards cashless transactions as the norm, thereby shrinking the shadow economy and integrating it with the formal sector.
Given the disruptive nature of this reform, the process of reorganization is expected to negatively impact the economy in the short term. The sector believed to be hit hardest in the short term by this move is the real estate sector since a number of property transactions were executed with a substantial cash component. Typically such deals are 20%-30% higher than the circle rate. Thus theoretically demonetization is thought to result in an immediate 30% decline in real estate prices.
We think this is an incorrect generalization and a more nuanced understanding will allow investors to make better and more informed decisions.
Why Prices May not Tank
It’s unlikely that there will be an across the board 30% reduction in prices. There is no historical precedence where property prices have fallen by 30% in the near term or as a knee jerk reaction. The nature of real estate markets is such that during slowdowns the prices decline over a period of time. This is because unlike other asset classes (equities, commodities and bonds) which usually trade on an exchange, real estate markets have limited price symmetry, less liquidity and low transaction volumes. Given the large ticket size, asset owners prefer to hold on to their property rather than sell in panic at short notice. For example, even during the global financial crisis (2008-2009) which saw the most severe liquidity and economic contraction in the post war period, Indian real estate prices dropped by roughly 10%-20% and that too gradually. Thus fears of a 30% immediate decline across markets seem pre-mature and overblown.
Secondly, the real estate sector had already seen a correction in the past three years. The crackdown on black money by the NDA government had caused prices to decline by 20%-30% in the secondary market depending on city and location. The more resilient primary market has more or less remained stagnant but given an average annual inflation of ~7.52% since 2012, even this segment has seen a decline in prices (in real terms) by ~20%, thus making prices more affordable. The ensuing pain caused by the slowdown in realty sector has already flushed out speculators and the property market is now largely dominated by end-users.
Add to it the fact that interest rates have been sliding downwards and will provide the force needed to stabilize the market by reducing the cost of purchase. The overall slow economic growth, low inflation and the flood of capital that banks have seen in their CASA deposits post demonetization indicates that interest rates are headed further southwards.
Given the above, we think that rather than a steep price decline, there is likely to be a freeze on property transaction in the near term especially in land dealings and secondary market transactions as customers and investors try to fully gauge the impact of the disruptive move made by the government. The occasional distressed sales at 30%-40% cuts may happen but that’s unlikely to get solidified into longer term price patterns.
The most significant outcome of demonetization will be that it will create a distinct differentiation in the market. It is important to note that the Indian real estate sector is not a homogeneous continuum. It consists of a number of different markets distinguished by geography (city), location (micro-market), type (residential, commercial, retail, hospitality) and category (primary, secondary, land).
Each market has its own characteristics and growth drivers and thus the impact of demonetization on each market will depend on the extent to which it was dependent on cash transactions. Some of the notable trends will be differentiation based on location, category and developer track record.
Differentiation by Location
To understand the short term effect of the move in any market, one may look at the geographical location and the extent to which a micro-market was dependent on demand from investors from the unorganized sector of the economy. Thus areas adjoining centres of parallel economy and colonies marked by residential demand from these players will likely face the most severe slowdown.
Overall we think pain will be more severe in tier II & tier III markets. In terms of cities, the slowdown owing to demonetization is expected to be most severe in Delhi NCR, Mumbai Metropolitan region and certain tier II markets such as Surat and Vadodra. To break down further in terms of micro-markets, taking the example of Delhi, we think commercial centres like Karol Bagh and Chandni Chowk are headed for severe price cuts. In the residential market, up-market luxury locations like Greater Kailash in Delhi, Koregaon Park in Pune and Bandra and Juhu in Mumbai will likely face significant price declines.
On the other hand cities such as Bangalore, Pune, Chennai which are primarily end use driven and development has been driven by corporate and industrial sector growth will likely face minimum impact. Micro-markets catering to clientele from organized sector of the economy and residences closer to corporate commercial hubs are expected to be resilient. Emerging commercial hubs with reasonable pricing like Noida-Greater Noida expressway in Delhi NCR, Whitefield in Bangalore, and Kharadi and Hinjewadi in Pune will see much lower impact.
So, anyone looking at an investment or end-use will be well served to understand the dynamics of each market as the price trends will vary not just from city to city but by micro-markets.
Differentiation by Category
Indian Real Estate assets can be categorized into Land, Secondary Market and Primary Market. Primary real estate is the fresh inventory sold out to buyers directly by the developers. Later when the resale of the property happens it goes into the secondary market.
The degree of adverse impact of demonetization on any real estate category will be a function of the extent to which cash was involved in executing the transaction. This makes it apparent that there will be severe pain in land values in the short to medium term since cash was king in land transactions. Land prices may plunge by 20%-30% or more with tier II, tier III and rural areas likely to bleed the most. In the long term this may have a cascading effect and depending on how the impact of demonetization seeps into the larger economy and land dealings, this may also eventually impact prices of property in all segments- residential, commercial and retail in both primary and secondary market.
The secondary market will be significantly affected too in all major cities as well as tier II & tier III markets. But here again we think that residential areas closer to established corporate hubs (BKC in Mumbai, Hinjewadi/Kharadi in Pune, Noida-Greater Noida expressway etc) will be affected lesser since even secondary market demand in these markets is defined to a large extent by tax paying clients.
On the other hand we think primary real estate will be relatively insulated and face minimum damage from demonetization. This is because black money is a very insignificant part of the payment system for primary market purchases since many builders have their own obligations with financial institutions and thus prefer payments by cheque or other electronic means. Moreover, primary real estate attracts a larger share of end users who take the mortgage route to finance their purchase. Primary real estate is the segment of the market which is catering to the demand emanating from emerging growth centres of Indian economy like IT, BFSI etc most of which are part of the organized sector and hence the clientele for this segment is largely the taxpaying working population.
Though the primary real estate market as a whole is likely to show resilience, we would like to caution buyers to do a thorough due diligence on the developer before pulling the purchase trigger since demonetization will likely impact the delivery capacity of smaller players.
Differentiation by Developer
The Real Estate sector is divided into organized players and smaller developers. Many of the organized players in the sector had moved towards collecting entire amount in cheque. A short-term blip in sales velocity notwithstanding, prices of properties from these builders will most likely be unaffected. Slowdown in real estate in the last three years minimized speculative participation in prime properties and the quality developers had sanitized their business models to rely mainly on end-use demand.
Thus, we believe quality developers with strong balance sheet will not be impacted by the effects of demonetization. The risk for them however will depend on the time frame of the adjustment process that will result from the dislocating effects of demonetization. If the slowdown in transaction velocity lasts very long, then cash flow imperatives may force them to offer discounts and other incentives to lure buyers.
At the same time, the unorganized players who depend on cash for project completions and large developers with over-leveraged balance sheet and a big pile of inventory may face the heat. As the transaction volumes slowdown in the immediate aftermath of demonetization, these players stung with severe liquidity problems may resolve to price cuts to manage their cash flow issues. However, the complexity of their cash flow problems and the compliance challenges resulting from upcoming regulatory changes like RERA may turn liquidity issues of these developers into solvency problems. Thus, there is a significant risk that the under construction inventory of unorganized and over-leveraged players may get stuck in project delays and in some cases may never see the light of day. Moreover, the cash crunch may also result in fewer project launches from all developers. This will reduce the inventory outstanding in the market to those supplied by organized developers with clean track records, thus increasing the integrity premium for their properties.
In the real estate sector, demonetization has shifted the game in favour of organized players. A major re-alignment could be seen as buyers look for quality real estate investments with clear payment structure. Small players with cash exposure will struggle, encouraging investors to look for respected brand names. Overall this is bodes well for the real estate market in India as it is a step in right direction.