Decoding the great Indian real estate ponzi scheme

India-Real-Estate-MarketVivek Kaul
A headline can sometimes tell you the complete story. The May 20, 2013, Hindi edition of the Business Standard had one such headline. “Intehan ho gayi intezar ki, aayi na kuch khabar ghar bar ki (Its been a long time waiting, and there is still no news of the house),” went the headline.
The headline was a play on the hit Amitabh Bachchan-Kishore Kumar song “
Intehan ho gayi intezar ki, aayi na kuch khabar mere yaar ki (Its been a long time waiting, and there is still no news of my love) ,” from the movie Sharabi.
The story which appeared in the English edition of Business Standard as well with a rather drab headline ‘Supply blues persist in realty sector‘, basically made two points:
a) More and more real estate companies were delaying the promised delivery of homes due to various reasons. As the story pointed out “The year 2013 was projected as the year of delivery for residential projects which had been stuck for years. While developers claim they are on course to supply a large number of units this year, sector watchers doubt it.”
b) This delayed delivery had not stopped real estate companies from announcing and launching new projects. As the story pointed out “Notwithstanding the delays in ongoing projects, a number of real estate companies, including DLF, Unitech, SVP and Supertech, are going ahead with launches, to generate cash flow in a tight market situation.” What this means is that people who have paid for homes continue to wait, whereas the real estate companies continue to launch new projects.
These two points basically tell us very clearly that the Indian real estate sector has degenerated into an out an out Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
The important point here to remember is that in a Ponzi scheme the money being brought in by newer investors is used to pay off the older investors whose investment needs to be redeemed. Lets apply this in the context of real estate companies and understand why they have become Ponzi schemes.
The real estate companies have offered various reasons for the delay in delivery of homes. “Builders cite several reasons — not getting requisite approvals, slowdown in the market, land acquisition and farmers issues, among other,” the 
Business Standard points out.
Anyone who is not familiar with the way Indian real estate companies work would be surprised at this. You would expect a company to have sorted issues like land acquisition and getting the requisite approvals before a project is launched. If there is no land where will the homes be built? If there are no permissions how is the real estate company going to get around building the homes? And given this why is a project even being launched?
But typically this is not how things work (at least in large parts of Northern India, and particularly in and around Delhi). The real estate company first launches a project, collects money for it, and then gets around to acquiring the land and getting the permissions in place. And once it has raised some money, only then does it finally getting around to building homes. So when a real estate company says that homes have not been delivered due to these reasons, then they are largely true though not fair on those who have bought homes hoping to live in them.
However, that is just a part of the problem. The real estate companies loaded up on debt during the few years running up to 2008. Money back then was cheap and the possibilities of what you could do with it were endless.
Take the case of DLF, India’s largest listed real estate company. It had a net debt of Rs 21,350 crore as on December 31, 2012. Interest needs to be paid on this debt. At the same time this debt needs to be repaid as and when it matures.
But the slowdown in the real estate market due to the high prices has ensured that these companies are not selling enough to be able to repay these debts. In case of DLF, the sales for the period between April 1, 2012 and December 31, 2012, were down by 9% to Rs 6,777 crore.
What has happened because of this is that companies are using money that has been raised for new projects to pay off interest on debt as well as repay debt. Hence, there is no money left to build homes. In this situation, the only way left for the company to raise more money to build homes, is to launch newer projects. It can also hope to raise money from big private money lenders, where the interest can be as high as 3-4% per month. So launching newer projects is an inherently cheaper way of raising money.
So the money lets say raised for Project A is used to pay off interest on debt and repay debt that is maturing. To build homes that have been already sold under Project A, a Project B is launched. This money is now used to build homes for Project A, assuming its not used to meet debt payments. So, this ensures that Project A is delayed. Now to build homes promised under Project B, a Project C is launched. And so the cycle continues.
So money being brought in by investors into Project B is being used to build homes for Project A. Money being brought in by investors into Project C is being used to build homes for Project B. A perfect Ponzi scheme is one where money brought in by the newer investors is used to pay off older investors. In this case money brought in by newer investors is used to build homes for older investors.
The important part here like any Ponzi scheme is that it will keep running as long as the money keeps coming in. And the money will keep coming in as long as people continue to have faith in real estate as a great investment that has given fabulous returns in the past.
This faith is built on various myths. The biggest myth is that India has a huge population and hence a large amount of land will be required to house this population. And land is scarce. As the great American writer Mark Twain once remarked “Buy land, they’re not making it anymore”.
Given this scarcity of land, real estate prices will only go up. The argument though doesn’t quite hold against some basic number crunching. As economist Ajay Shah 
wrote in a recent piece in The Economic Times “Some claim that India has a large population and there is a shortage of land. A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
But as they say perception is reality. And given this money keeps coming into the Indian real estate sector. What helps in keeping this perception going is the fact that politicians have their black money invested in the real estate sector and it is in their interest to ensure that real estate prices do not fall.
One way of doing this is having some sort of a control on supply of new homes. The best way to do this is having a low FSI, which ensures that real estate companies cannot build enough to meet demand. As Shah points out “The biggest story about the future of real estate prices in India is the FSI. In most of India, the FSI is below 2. This is an abysmally small number by global standards. All over Asia, FSIs are above 5, going up to 20 or to no limit….A higher FSI results in lower rental rates for households and firms, as was seen in Hyderabad which was a pioneer in FSI reform. When FSI goes up, this will unleash supply on a big scale. As an example, if Bombay(the city is now called Mumbai) moves from an FSI of 1 to 2 — which would still make it worse than the FSI seen anywhere else in Asia — this would trigger off a doubling of supply.”
The other way politicians ensure that real estate prices continue to remain high is by nudging the banks to give newer loans to cash starved real estate companies. As Ajit Dayal 
wrote in a column in 2009 “Their act of giving the loan to real estate developers gives them badly needed cash. The real estate developers no longer need to sell their real estate to get “cash flow” to stay alive.”
If at that point of time banks hadn’t bailed out real estate companies, they would have had to sell homes at lower prices, and real estate prices would have thus come down. And that would have meant lower returns for real estate investors. This would have led to the real estate Ponzi scheme that is in operation breaking down because investors would have had some doubts before parking more money in real estate. But that was not to be.
What is interesting is that loans that banks give to what the Reserve Bank of India calls commercial real estate(i.e. to companies and not individuals buying homes) continues to grow at a much faster rate than overall bank lending.
Given these reasons, real estate companies will continue to launch new projects and delivery of homes will continue to be delayed.
The article appeared originally on on May 22, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)