How Wrong RBI Policies And Irrational Income Tax Laws Keep Housing Prices Abnormally High
Liberal housing loans, largess of public sector banks, wrong RBI policies, and the strange income tax laws are the reasons why real estate remains almost out of reach for majority of low and middle income families.
According to a latest Reserve Bank of Indian (RBI) report, housing inflation is moderating – prices grew by 5.2 percent in the first quarter of 2016 compared to 9.8 percent in the earlier quarter.
Housing prices, which started to rise 2002 onwards, have defied every logic and have seen only rise and rise without any sign of cooling off or price correction. Even the massive financial crisis of 2008-2009 saw no price correction in the Indian real estate market, except some minor slowdown where rather than prices going down, deals stopped happening - an attribute which demonstrated massive staying power of investors/builders.
Who deserves the blame for high real estate prices
There is a naive belief among the experts that it is black money, which is providing the liquidity, and hence, not allowing prices to correct. But black money is a very small component. Liberal housing loans, largess of public sector banks, wrong RBI policies, and the strange income tax laws in the country deserve the majority of the blame.
These three arms of government are the reason why real estate remains almost out of reach for majority of low and middle income families.
Why the prices remain abnormally high
During the housing boom, the rise in housing prices was behind lower interest rates. People forget that there is very little relationship between “cost of building a house” and “sales price of house”.
It sounds counter-intuitive. So, let’s take the price movement of a housing project.
A builder launches a project at Rs 3,000 per sq/ft and takes around three years to complete it. However, by the time the house is ready to move in, the price moves up to Rs 7,000-8,000 sq/ft. Hence, one can easily see that there is hardly any relationship between price of housing vs cost of housing (remember that the builder project was viable with 30 percent internal rate of return even at Rs 3,000 per sq/ft). So one wonders what changed in three years for the price to double or triple?
The answer is not the cost inflation but “risk premium”. Given the fact that almost 95 percent of housing projects are delayed beyond two years and some never finish, there is a huge risk premium for a ready-to-move-in-house compared to a newly-announced project as there is no liability/pressure on builder to deliver the project on time in latter case. Though present government has passed a real estate regulatory law, but given the state of judiciary in India, one wonders what change this bill will bring in reality.
Putting the Interest Of Investors above those of home buyers
This risk premium brings huge returns to investors and other players, and hence, creates huge incentive for prices to remain high. In the 2008 financial crisis, while the whole world was collapsing under massive liquidity pressure, there was no movement or pressure on Indian builders to cut the price, as public sector banks were happily restructuring the loans to accommodate India’s real estate. Now before you jump to conclusion and blame public sector banks-politician-bureaucrat nexus, it’s high time we look at RBI policies that encouraged or rather nudged banks to disburse loans to builders in a most liberal way.
Effects of the wrong RBI policy
One must understand that the price of an asset is not just the function of supply and demand but also a function of liquidity, and unfortunately, liquidity in real estate has been maintained due to RBI policy of lower-risk weightage.
According to RBI policy, housing loan is given a risk weightage of 35 percent, while small and medium enterprises (SME) loan gets 100 percent risk weightage. On top of it, for SME loan, one has to provide collateral or fixed deposits to avail a loan at 12 percent. While in case of housing loan, no such collateral is needed (it is another matter that a significant amount of those flats are never build).
Hence, by keeping favourable risk weightage, liberal guarantee/mortgage policy, RBI has created a scenario of crowding out where banks focus on disbursing loans to housing sector rather than SME sector, which is the real driver of the economy.
Experts argue that real estate is far less risky than SME. However, they forget the fact that more than one lakh houses are delayed beyond two years (Jaypee Group loan on account of its housing is close to Rs 90,000 crore). If one takes retail housing loan on these delayed and abandoned projects, the amount of loan being carried by all individual house owners will easily cross Rs 50,000 crore.
In a way, one can say that close to Rs 50,000 crore of consumption at household level is forever locked in unproductive assets and is creating big difficulty for those families.
However, risk weightage is not the only tool driving liquidity to real estate sector, there are other very sub-prime kind of lending scenarios to which RBI keeps a blind eye.
RBI, which closely monitors functioning of banks, has curiously ignored their participation in a highly-risky financial product called “subvention scheme”, offered by real estate players. In subvention schemes, a builder asks the home-buyer to take loan in his/her name while proposing to pay equated monthly installment (EMI) on behalf of home buyer until possession is done. This scheme is akin to a derivative scheme where the risk is held by bank/borrower, while money is taken by builder without any risk. There have been many cases where builders disappeared after promising all kinds of guarantees, thus putting capital at risk for bank and borrowers.
Adverse effect of the income tax policy
Income tax laws in our country are structured to give more benefits to investors/speculators than to first-time buyers. So if you are a first-time buyer of house, rebate in income tax is capped at Rs 1.5 lakh for the interest paid on housing loan, but is unlimited if you are buying house for investments. So if your EMI is Rs 30,000 a month (yearly Rs 3.6 lakhs where interest amount is Rs three lakhs), you will get benefit of Rs 1.5 lakh only if you are a first-time house buyer (self-use) but will get full Rs three lakhs benefit if you are investor and there is no limit. So practically, as a high-net-worth individual, you can use this provision to minimise your tax outgo by investing in real estate and keeping the liquidity high!
The proponents of real estate tout the benefits accrued to nation on account of contribution to the gross domestic product, job creation, and stress upon fulfilling the basic needs of citizens, which is housing. Citing this need, every year demands are made to reduce interest rates and give more benefits to loans at a certain rate.
Interestingly, they never demand reduction of liquidity, reduction of lowering risk premium, or reducing costs of houses. Despite news of so many houses remaining unsold, we always hear a friendly request to the builders from the Finance Minister or RBI Governor of that time to reduce house prices.
Dr Raghuram Rajan, who is known to be quite aware of the risks created by housing, remained oblivious to the risks created by wrong policies of RBI/banks, as far as real estate is concerned. Interestingly, despite deep insight into the workings of the banking system, RBI never restrained banks from providing additional liquidity to real estate, or stopped fancy derivative schemes, like interest subvention, etc. This continued liquidity given to housing sector in the form of lower interest rates (through lower risk weightage and subvention schemes) has created massive build-up of risk in Indian banking system in the form of housing. Strangely, Dr Rajan didn’t take any action in terms of normalising exposure to housing sector.
Such anomalies - i.e., low-risk weightage, low-interest costs, convoluted income tax laws - have created serious danger to the Indian economy, as it is at one end creating loan bubble in the books of the banks, while on other hand, is reducing consumption at ground level, since majority of free cash flow at a household level is going towards servicing loan/rent.
Hence, the hope that implementation of the Seventh Pay Commission, or Make in India, will revive the Indian economy without any serious policy shift, is a mirage. It’s just a pie in the sky. The policy making shouldn’t be a prisoner of wishful thinking.
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