Nostalgia is a funny thing. It makes you remember the good things you had and the good things you lost along the way (with due apologies to Bob Marley!).
Finance Minister Arun Jaitley recently said: “(The) housing market in India, it had picked up. During Mr Vajpayee’s government, bank rates had come down to such an advantageous level that it was easier to buy an apartment than rent it out. That sort of situation had existed where the EMI has been reasonable. I think that’s the direction in which we have to slowly push our economy.” Jaitley said this at The Economist India Summit 2016 in response to a query on how the government plans to improve the stressed housing market.
What did Jaitley really mean here? First and foremost, he was remembering the good old days of the Vajpayee government (between 1998 and 2004). During those days the rent one had to pay while renting a house was very close to the EMI one would have had to pay by taking on a home loan and buying it instead.
The question is, how did this happen? This is something that Jaitley did not tell us. And one can’t blame him for it, given that there is only so much that one can say in response to a query. The real estate market had seen a boom in the 1990s. By the late 1990s, the market had started to crash and kept unravelling over the next few years. Then the dotcom bubble burst in 2000-2001, the stock market fell after the Ketan Parekh scam came to light and the real estate prices crashed.
Hence, for the period that Vajpayee ruled the country, real estate prices were reasonable. In fact, as late as 2005 (a year after Vajpayee lost the 2004 Lok Sabha elections), property prices, even in Mumbai suburbs were fairly reasonable.
So, the EMI was low because the prices were low and it had nothing to do with lower interest rates.
Also, as I have often said in the past, lower interest rates aren’t going to make any difference to Indian real estate. Let’s understand this through an example. Let’s say the property you are looking to buy costs Rs 80 lakh. The bank gives a home loan of 80 percent against the market price of the home. This amounts to Rs 64 lakh (80 percent of Rs 80 lakh). The down payment that will have to be arranged for is Rs 16 lakh. The home loan is for a period of 20 years and the interest to be paid on it amounts to 10 percent per year. (The prevailing home loan rate is around 9.5 percent. But we will work with 10 percent just for the ease of calculation).
The EMI on this amounts to Rs 61,761. Let’s say the interest rate on home loans falls (the reasonable EMIs that Jaitley was talking about). Let’s say the interest rate falls by a fourth to 7.5 percent per year. The EMI will fall to Rs 51,558. This will mean a saving of around Rs 10,203 per month.
Of course, the home becomes more affordable if such a thing were to happen and home loan interest rates were to fall by a fourth.
Now let’s take a look at a scenario where home prices fall by a fourth or 25 percent. The value of the property falls to Rs 60 lakh. The bank now gives a loan of Rs 48 lakh (80 percent of Rs 60 lakh). This would automatically make more people eligible for the loan than there were when the home loan of Rs 64 lakh had to be taken. The down payment required falls to Rs 12 lakh. This is Rs 4 lakh lower than the Rs 16 lakh down payment required earlier, making things significantly easier.
What about the EMI? At 10 percent per year and for a period of 20 years, it works out to Rs 46,321. This is more than Rs 15,000 per month lower than the earlier EMI of Rs 61,761. Even at 7.5 percent, the difference in the EMIs comes close to Rs 13,000 per month. Also, it requires a lower down payment of Rs 4 lakh. Further, at a lower value of the home, more people would be eligible for the loan, as a lower EMI needs to be paid. A lower EMI can be paid with a lower income.
Also, in this transaction, I haven’t assumed a black component, to keep things simple. But if prices fall, the black component also comes down. Also, I feel a 25 percent fall, as has been assumed here, will not make much of a difference; the prices need to fall more than that.
The point being that if Indian real estate has to get back, prices need to come down. Let’s take the argument forward. Jaitley talks about an era where rents and EMIs were equal. Now, what would it take for the rents to be equal to the EMI, in the time that we live in.
Let’s take the same example again. The value of the home is Rs 80 lakh. The rental yield (rent dividend by the market price of the home) these days is around 2-3 percent. Let’s take the upper end of 3 percent. At 3 percent on a home worth Rs 80 lakh, the rent works out to Rs 2,40,000 per year or Rs 20,000 per month.
If one were to buy this house, the bank would give a home loan of Rs 64 lakh (80 percent of Rs 80 lakh). The EMI on this would work out to Rs 59,656. (Now we assume the real prevailing home loan interest of 9.5 percent per year).
Over and above this, the buyer would also have to pay Rs 16 lakh as a down payment. This means that this money will no longer be available for investment. If the buyer had this money in a fixed deposit which paid around 7 percent per year, this would mean letting go of interest of Rs 1,12,000 per year or around Rs 9,333 per month. Hence, the total opportunity cost of buying a house worth Rs 80 lakh works out to Rs 69,989 per month.
Now compare this to the rent of Rs 20,000 per month. What this tells us very clearly is that renting is a no-brainer as of now as far as numbers are concerned. Of course, there are other problems associated with renting that an owned home does not have.
If the rent has to be equal to the EMI plus the interest lost on the down payment, then is has to go up by nearly three-and-a-half times its current levels. If it has to be equal to the EMI, then the rent has to go up around three times. The other option is that the property prices need to crash big time so that EMIs come down dramatically and are equal to the rent. Both options can be ruled out.
What will happen instead is that rents will rise gradually and property prices will fall gradually, in the years to come, but not dramatically (given that there are too many vested interests at work).
Only that is a given.
What this really tells us is that Finance Minister Jaitley’s dream of a time where rents are close to EMIs will remain a pipe dream at best, unless the real estate prices crash big time. Also, there is a fundamental disconnect here, the cost of owning something has to be greater than the cost of renting it.
This article was originally published in Vivek Kaul’s Diary — a newsletter that cuts through the noise and presents actionable views on socio-economic developments in India and the world. He is the author of a trilogy on the history of money and the financial crisis. The series is titled Easy Money.
Vivek Kaul is the author of the 'Easy Money' trilogy. He tweets @kaul_vivek
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