Demonetization Effect: If You Plan to Invest in Real Estate, Please Read This First!

Last week, PM Narendra Modi announced his plans to demonetize Rs. 500 and Rs. 1,000 notes, a move that most Indians (in principle) agree with. Everyone in the country is affected by the move and are all theorizing how the economy will get affected by it. Indian economy is unique — most businesses here run on cash, irrespective of their scale. While the effects on many industries is expected to be short term, Indian Real Estate is one which is going to have long term consequence — both good and bad.

Over the past few days, I’ve read many irresponsible (and ignorant) articles by industry leaders on this topic, all of whom have tried to sound casual in their evaluation of the consequence. Most have voiced a ‘Real estate will have short term drawbacks, but long term gains’ tone without divulging too many details. The repercussions of this move will affect the industry heavily, negatively and will last for a long time. Below, I’ve taken a stab at explaining how this is likely to play out over the next few months and years, and how it’ll affect the different players in the eco-system.

Impact on the Primary Sales Market and Real Estate Builders

It’s no surprise that real estate builders will be most affected by this move. Many CEOs and MDs of Tier A builders have come out over the past few days and said the move won’t affect their sales. They claim the big players don’t take ‘black money’ from buyers and all the money in their system is accounted.

This is a lie. EVERY Real estate builder in the country takes at least some money in cash–even publicly traded real-estate companies, even those with huge market capital and even those who’ve been on the BSE and NSE for decades. It’s part and parcel of how the industry has evolved — clever CFOs and questionable auditing practices have allowed cash transactions to very much be a part of every real estate business in this country. Even those builders who start off legit are forced to turn this way, as they can’t compete with others who operate with cash and offer similar products and projects at lesser prices to customers.

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Its important to understand why the industry has evolved this way. Builders should not be given all the blame — it’s an ecosystem which has been built over many decades. Real estate is a HUGE value chain. Starting from landlords who own the land, to the developers who purchase and construct on the same, the engineering companies who design and manage the construction, the contractors who source labourers, the suppliers who provide the raw material, the brokers who sell to the end customers — everyone prefers to take cash payments over payment channels. It makes their lives a lot easier, and this way they can provide their service a lot cheaper.

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The cash stock which builders have is generally used to purchase land required for new projects, so we can expect that no new projects will be launched in the next few quarters (but that’s happening any way, due to slowdown in the real estate market). It will be interesting to see what real estate builders do with their existing cash stockpile. Declaring it to the IT Dept and paying the 200% tax penalty will cause too much harm, so most will try convert the money through alternate sources. Time will tell how they manage this tricky situation.

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Over the past couple of years, when the real estate market slowed down, banks and PE firms have walked away from funding real estate projects, especially from smaller builders. In their absence, many of these businesses have turned to private money lenders who give cash at higher interest rates (against properties in the project as collateral) to fund their ongoing and new projects. With this crackdown on black money, these private money lenders are stuck in a fix as well. They’re contemplating how/if they can get their cash back from builders they’ve lent to already. Given that these builders have already spent the cash in their projects, this seems to be a tough ask. Though this area appears to be murky at this point, what is clear is that if you’ve recently purchased property from any real estate developer and the project isn’t complete yet, you can expect a significant delay in handover of the property.

Effect on Secondary Sales and End Customers

Secondary sale or Resale is when a customer, who has purchased a real estate property for investment or possession, decides to sell the property to another entity. This market is very difficult to analyze as all transactions are between end individuals and invariably facilitated by unorganized brokers and middlemen. Upon the completion of sale, the seller may have to pay up to 30% tax on the effective capital gain, which they always hope to avoid. This is where the cash transactions help. The property is sold to a potential buyer and registered at a price below the sale value, thereby enabling the seller to save on capital gains tax. The buyer is also benefited as —

i) The registration fees levied by the State Govt. is 5–6% of transaction, so they save money by lowering the registration value.

ii) They can get rid of any cash they might have accumulated through the course of time, which can become bulky and difficult to store.

With cash transactions becoming more difficult to carry out, and successful implementation of the demonetization efforts by the Government, sellers of real estate property will have to come to terms with the fact that they’ll have to pay their share of capital gains tax. Sellers will attempt to build this into the sale price of the property, which only make it more difficult to sell the unit, as buyers will have plenty of options to choose from in the market. Eventually, sellers who’re desperate will lower the price, and prices will fall drastically till they attain fair market value.

Buyers will also start re-looking at whether a real estate purchase is warranted if they don’t have/can’t transact through cash. Younger generation of buyers are already rethinking whether the concept of home ownership is as relevant in present day scenario as it was even a decade back. Renting homes is growing in popularity, and the average age of the home renter is increasing (Data from our learning at Cozee Homes — www.cozee.in)

The resale market is headed for a greater slump and price correction than the primary market segment. There will be difficulty in finding accurate data points which will back this statement over the next few years, but this is bound to happen. If you’re a home owner who’s looking to sell your home, you will have to price the property significantly lower than present market rates or wait for a long period of time for the prices to go up.

Home Rental Market

One of the biggest winners of this move will be players in the home rental market. As the market turns sluggish, and buyers and sellers try to figure out what to do, the default option for people for accommodation will be home rentals. Even people belonging to an older demographic (30+ years) who can afford to purchase property will choose to rent during this period over buying. This new demand coming into the market might not really increase the rental values as the rates in most cities are high, in terms of absolute value. Another reason why the rental rates might not increase is that there’s adequate supply in the market for rental homes, which are currently unoccupied, which might start getting rented soon.

The rental yield (which is the ratio of rent received from a property to the property value, expressed as a percentage) in India is one of the lowest in the world. This is primarily due to inflated property prices in most cities. With the possibility of a property price correction looming large, the rental yield of units will see a 30–40% spike. This can eventually lead to more organized players and property management companies making the most of a currently unstructured rental market, that has almost no regulations.

In most developed countries, rental inventory is owned and operated by PE funds or property management companies, who invest capital and enjoy the rental yield received as the primary return on capital deployed. Currently, there’re no financial instruments for such a phenomenon in the Indian market, and REITs are not allowed for residential real estate. If the Govt implements the right policies and extends REITs to the residential sector as well, we can expect to see great movement in the organized home rental space*.

Existing landlords who rent out their property to tenants, and collect rent and deposit as cash, will have a tough time adapting to the new rules of the land. They will no longer be able to collect the rental amounts in cash and will have to pay tax on the amount they collect. It is expected that they will increase the rent to cover the losses in taxes they’re likely to incur, but this is expected to have a highly localized effect and won’t affect the market at large.

*Disclaimer —Author is the Co-Founder of Cozee Homes, A Managed Home Rental Platform (www.cozee.in) which is an active player in the home rental space.

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Impact in Other Market Segments

Agricultural Land

Another major setback will be seen with owners of agricultural land in Tier 2 and 3 cities. These land parcels, often bought for investment, are dealt heavily in cash. Many landowners who’ve benefited from such investments have made their money when they converted the land from Agricultural to Industrial and sold the same to book their profits. A long period of sluggishness and a sharp correction in land prices is expected as demonetization plays out.

Commercial Real Estate

Commercial Real Estate will escape unscathed in this phase. Though there is cash involvement during development of commercial property, a bulk of the leasing is done through white money by registered companies. Most developers have commercial real estate assets which they’ve rented out, and this source of revenue will crucial to them for sustenance over the next few months.

Retail real estate might take a hit in the short term owing to cash shortage, but it’ll get back to normal level soon.

Tier 2/3 Cities

The growth of real estate in Tier 2 and Tier 3 cities has been restricted. Urbanization and rapid expansion of the top 10 cities in the country has ensured that real estate markets in smaller cities have grown relatively slowly. Over the past 2 decades, cities like Coimbatore, Mysore, Nagpur, Bhopal, Salem, and a host of others have failed to grow as quickly as some of their counterparts like Jaipur, Pune and Patna, which have sometimes grown faster than even metros.

That being said, real estate in these markets has largely gone unnoticed, with most big developers choosing to stick to Tier 1 cities. A bigger percentage of transactions happen in cash compared to metros and these will get affected now. Most buyers in these markets are local businessmen or people in the agriculture business, who are used to dealing in cash and seldom have the banking and digital infrastructure to transact in white money. We can expect these markets to be most affected over the next 2 years.

State Governments need to increase their spending on infrastructure (including internet) in Tier 2 cities, else we’ll continue seeing a big disparity in growth between Tier 1 and Tier 2 cities.

Concluding Thoughts

Demonetization was a bold move by the Government and it is forcing the real estate industry to transform itself, at a time when there was blatant refusal from the industry to take the initiative to do so. With a 10+ year vision, this is probably the best thing which could’ve happened to the industry. Private Equity Funds and other foreign institutional investors who’ve stayed away from backing real estate companies will now be willing to look at a more transparent and clean sector. Real estate will no longer be viewed with cynicism and skepticism by Indians — it’ll become a legit investment instrument with reasonable and organic returns.

In all likelihood, there will be a period of stagnation in the market (3 months-9 months) with both buyers and sellers preferring to ‘wait-and-watch’. This will be followed by period of market correction when prices will drop, and we’ll eventually reach a state where the prices attain market value, transactions happen in white money, everyone pays their fair share of taxes, and real estate market can grown organically from there on in. We’re probably 2–2.5 years away from such a situation.

The views stated above is on the assumption that the Government will strongly follow the move to demonetize with strict execution. Real estate builders and investors are shrewd and are always looking for loopholes in the existing framework to exploit to their benefit. The Government has to implement Real Estate Regulation and Development Act to the word and keep checks to ensure black money doesn’t creep back into the system. Real estate in India has been abused for over 50 years now, and the path to revival of the sector is just beginning.

The views expressed here are those of the author and do not necessarily represent or reflect the views of Channel 42. If you need to contact the author you may write to [email protected]

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