Imagine you deciding on buying a house six months down the line and already have arrested the purchase price thereby slaying the ghosts of cost escalations! Seems a fancy thought, but what if it actually happened?
The insinuation is at incorporating derivatives like future contracts in Real Estate where in a buyer can lock in the future purchase price based on his or her view of the real estate market. The seller by all means will offer a contrarian view of the market for the transaction to take place. Futures would be more apt for the simple reason that unlike forwards they are standardized and in a nascent market it would be more suitable.
The implication of such a price discovery mechanism in an illiquid asset class as real estate is untested and may lead to regulatory intervention. The process of price discovery may become speculative in nature as investment in real estate stokes the basic societal requirement. As our country comprises an aspirational mass, owing a house is looked at as a necessity than an investment. The buyers in all likelihood may not have the knowhow and information to venture into a futures contract. This in turn will offer newer avenues for banks to book futures contracts in addition to extending the usual home loans. The real estate market in India is roughly INR 14000 crores, with a CAGR of 13%. It is being predicted that by 2040 it will grow to a mammoth size of INR 65000 crores. This could be the breakthrough to revive the economy. A lip smacking opportunity for the banks, albeit with a pinch of salt!
Most of the future contracts will be booked by banks with the help of their treasurers, who presumably will have a sound understanding of the market in question. In comparison to the regular futures business volume of banks, the proposed real estate futures will only add to the bank’s portfolio and more importantly to the fee based income. With dwindling credit off take for some time now, banks are gunning for fee based income to spruce up their bottom lines.
Furthermore the narrative of privatizing public sector banks and trimming work force would also mean that banks will have to continually invent and innovate new credit products to sustain themselves, more so in the backdrop of less government support in the foreseeable future. The customer bases, the demographic pattern and the target markets for banks shall witness new changes being ushered in. The scope for traditional and conventional banking will gradually shrink and become redundant or passive. The banking space in India is set for an unprecedented galvanization and the resultant impact of which is yet to be fathomed in its truest sense.
Charting the Unknown Waters- A humbling first!
In India, normally the process of purchasing a house involves signing a pre- sales contract where the buyer and seller agree on a price. In a sense the pre -sales contract can be likened to a future contract, however the differences can be stark. The major issues like cost escalation, delivery dates and exit routes are noteworthy.
In tumultuous times, where a buyer has to wait anxiously because of the delay by the builder, thereby simultaneously paying both contractual payments and rent is a worrisome state to be in. Very often builders cite Force Majeure as a reason for their delay, sending buyers scuttling and scampering for resolution in courts. This furthers the delay in delivery. The much touted RERA has had little success as it hasn’t been rolled out pan India. Only few states like Maharashtra and UP that had embraced RERA in its truest form can boast of the transparency and early resolution management under RERA Act.
Even before the Covid crisis, buyers were wary of the ‘falling back on promises’ attitude of the builders and thus the number of cases filed have been plenty. There have been in excess of 70 percent buyers who have filed cases against errant builders.
Despite insertion of clauses in pre -sales contract of compensating buyers in case of delay, has no real meaning .The builders more often than not throw their weight around causing despair and disgust for the buyers. It is only after the court intervention, that there is some respite for the aggrieved buyer but not before an agonizing wait. This has become customary in almost all disputes related to delayed occupancy. In the following section an attempt is made to propose a derivative product with some added dimensions or amendments to finance housing loans.
Let’s assume a residential apartment costs INR 85 lacs and the share of margin on part of the buyer is INR 10 lacs. Consequently the buyer and builder enter into a futures contract (through the respective banks) of INR 75 lacs for a 3 bedroom apartment by paying margin of INR 10 lacs in phases as and when demanded .Also assume there is a stipulation of a 6 months grace period from the scheduled date of delivery. The futures is essentially to hedge against any cost escalation and performance risks as envisaged by the buyer. The contract can be further rolled over to the extent of the grace period, with the costs of which is to be borne by the builder ultimately. There is an inherent assumption that builders with a certain amount of net worth can only opt for such an arrangement as the final principal will be paid on the agreed date. There will no major intermittent cash flows apart from the margin payments which would form a small portion of the total outlay. Smaller builders may not find it feasible on the liquidity front.
Expanding the premise further, in the event of further delay from the grace period, an embedded letter of credit clause shall be in force where the builders’ bank will have to make good the loss to the buyer. The compensation can be worked out on case to case basis as factors like opportunism and replacement costs will also have to be incorporated. Also, the builder will have to enter into an offsetting deal to cancel /terminate/repudiate the existing futures contract. The length of the futures contract may be set at 2 years excluding grace period or as deemed convenient. The period between 21 to 24 months are normally required to complete a mid-sized project.
The presence of a futures contract will deter the builder to not become complacent and closely monitor the progress of the project. However the idea shouldn’t be solely to paint all the builders with the same brush and penalize them even if the delay is on account of abnormal situations. The builder will largely have 2 broad benefits, less of unsold inventory and the other being arbitrage benefits. The term arbitrage here will mean legitimate profits on account of forming a bearish view on most counts.
Now for long we have addressed the concerns of the buyer but what about the builder’s bank? The excessive payout ratio can render the builder’s bank insolvent in the long run. The situation envisaged could be very similar to what AIG had experienced during the Global Financial Crisis (GFC) during 2007-08. This situation would entail addressing the idiosyncratic risk only but not the systemic risk.
A need to set up a central guarantee house (CGH) for real estate can be mandated where the banks can be a member on paying an annual fee. Basically by paying for the services of the guarantee house, the banks will essentially enter into a credit default swap and the guarantor house can be the protection seller /insurer. The CHG can be likened to an SPV of the NHB or similar entities of the Government. The CHG could be bailed out by the contributions by the members banks much like what happens in the case Central Counterparty. The banks will also have entered into offsetting deals where a loss in one transaction could be mitigated by the profits in another. This will reduce the exposure through netting and the CHG would relatively be protected from a collapse, thereby reducing the chances of hurtling the economy into a tailspin.
A good amount of discussion on the observable benefits though contentious have been listed out but the use of financial derivatives doesn’t come without its fair share of risks.
The focus here is the target group i.e. the home buyers. Investing in real estate involves lot of research, investigation & apprehension on the part of the buyer. In short a buyer undertakes his /her own due diligence. A complex arrangement of a forward contract in Real Estate can have its own share of complications. Some of them are as under:
- Pricing– Real Estate belongs to an illiquid asset class and the pricing of it in the exchange is going to be very difficult. Ideally to price an illiquid asset, one selects proxy on the run assets that are in close proximity to the illiquid assets and the prices are established on the basis of relativity. The factors to be taken into consideration to price them is another challenge. For e.g. – let’s say one has to price a bond & the factor chosen is interest rate. It is an established fact that higher interest rates will bring the bond prices down and hence one can have a short term and a long term view of interest rate (upward sloping, flat, downward sloping term structure) and arrive at the spreads. But for a real estate, the interest rate sensitivity might not be as elastic as for bonds because in most cases a house is a basic necessity rather than a luxury. So the interest rate movement may be nonlinear in certain cases.
- Valuation– The forward contracts are valued as per mark to market phenomenon. As the pricing is apparently difficult to arrive at, so will be the valuation and the margining requirements. This will represent an inaccurate assessment of the off balance sheet exposure of the banks. This is turn might also lead to window dressing by banks to doctor their performance.
- Information Asymmetry– The knowledge of the product may not be uniform across all buyers and sellers. The bank entrusted to enter into or book forward contracts is merely an agent of its client. The acumen and involvement of the banker is limited here. So the onus lies upon the buyer to get to the root of this product before committing to it. A real estate firm will have in depth information about the sectoral trends and may be able to speculate in terms of fixing the forward spreads unbeknownst to the buyer. Also this shall give rise to arbitrage opportunities and soon the purpose of ‘investing for a lifetime’ will convert into speculative trading.
- Moral hazard– With the presence of a forward contract, central guarantee fund, letter of credit etc the due diligence will be diluted on both fronts i.e. buyer and seller. Consider an example where an insurance company is giving away motor insurance policies at attractive rates with all features like comprehensive insurance and unlimited zero depreciation. A motorist may drive recklessly not worrying too much about the costs involved to mend the damaged vehicle because of the insurance coverage.
- Adverse Selection– Let’s assume a bank that wants to capture the credit card market base may offer credit cards to all individuals merely on the basis of some KYC documents without assessing the credit worthiness. This is part of penetrative pricing to increase subscription base. Over a period of time, the delinquencies will affect the expansion plans of the bank and it will have to shut or hive off it credit card arm. A similar thought can be applied to Futures where brokers and banks in order to boost their income might fall into this trap. Very similar to what happened in subprime crisis where banks jumped in to the bandwagon without understanding the consequences.
Indian financial and commodity markets have evolved over the years but may not have been in the same space as advanced markets. A conservative approach by the regulators like RBI and SEBI have held us in good stead. Not to forget the famous decoupling theory during the subprime crisis when the Indian markets and economy were better off than most advanced economies.
One of the most revered investors Mr. Warren Buffet had famously remarked that “derivatives are financial weapons of mass destruction”. The underlying meaning of the statement is that improper assessment of derivatives can cause mayhem beyond one’s control.
In the pre covid situation, our economy was still sluggish and recessionary trends were setting in. The covid outbreak has only accelerated it. With the economy shrinking by the day, the banks wouldn’t want to burn their fingers further as they are already reeling under the burden of rising NPAs. The capital infusion plan of the government Vis a Vis the provisioning that the banks have had to make are not congruent.
To assess the risks of an unfamiliar market would involve thorough investigations by RBI and banks, before coming up with strictures and guidelines. Some of the existing guidelines would also have to be tweaked like large exposure framework, credit value adjustments, IRAC to name a few.
In an emerging market like ours, the in equal distribution of income and thus resultant opportunities may not be conducive to introduce new derivative products or existing ones in new markets. The Global Financial Collapse during 2007-08 has been a testimony to the fact that despite CDO’s, CBO’s and CDS’s being very popular then, Indian markets never got adventurous. The same can also be said about the acceptance of crypto currency in India. Our inherent wisdom of thinking wisely before taking a leap has so far insulated us from major setbacks even in the era of globalization. However to constantly evolve and accept change is a cornerstone for survival in the rapidly changing business environment. The day isn’t far when foreign banks will have their hands untied and then the changing dynamics will be felt. What the credit card and retail liabilities segment have experienced over the years, the entire credit product line soon will. The Indian banks have long been market followers and may be its now time that they came out with offerings that the universal banking fraternity sits up and take notice of! We have already made enormous leaps in fields like pharmacy and space research and may be banking is next in queue. While it may appear premature now, but the conception of ideas and the power of imagination has brought us this far and thus going the next mile is certainly in the offing!