What if the builder disappears? – The biggest risk of investing in real estate

Last week three different people got in touch with me regarding the problems they have been facing with investments they had made in real estate. In each of the three cases the builder had collected money and was now saying that he didn’t have money to complete the project.
The buyers had taken on a home loan to invest in a home. At the same time they had even put in their own hard earned money into it. The question is how did this unfortunate situation come up in the first place? The answer is simple. The money the builder (or actually the builders in this case) raised for the project was used for other things. It could have been used for repaying past debt. Or it could have been used for completing a previous project.
Builders like to launch new properties in order to raise money. It is the cheapest way of raising money for them.
Money from the bank or the informal market, means paying high interest. As I had mentioned in a column last week, builders raise money for a project and use it to pay off debt or the interest on it. To build homes for this project, another project is launched. Money from this is then used to build homes for the first project.
Now, to build homes promised under the second project, a third project is launched and so the story goes on. In the process, all the buyers get screwed and the builder manages to run a perfect Ponzi scheme. 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 the newer buyers is used to build homes for the older buyers.
Th new e Real Estate Bill seeks to stop real estate companies from running such Ponzi schemes. Half the money raised for a particular project needs to be deposited in a monitorable bank account and be spent on the project against which the money has been raised. But until that happens, real estate Ponzi schemes will continue to run.
The thing with Ponzi schemes is that they all eventually collapse when the money being brought in by the new investors is not as much as needs to be paid out to the older investors whose investments are maturing. This is what seems to have happened to a few builders as well (at least in the case of people who approached me).
The prospective buyers seem to have figured out the Ponzi scheme being run by these builders and stayed away from investing in their new projects. Once that happened, these builders did not have money to complete their older projects. This meant that buyers who had bought homes in the older projects were left in a lurch.
The trouble is that the individuals who approached me had also taken on a home loan to invest in these projects. These borrowers continue to pay interest on these loans even though there is no home in sight.
The biggest learning from this example is for those individuals who keep claiming time and again that real estate prices in India do not fall and hence, owning real estate makes for a terrific investment. I will not get into an argument whether this statement is true at all points of time or not. Nevertheless, investing in real estate goes against a basic tenet of investing—don’t put all your eggs in one basket.
The size of the real estate investment is now so large that anyone who invests in a second (or a third) home ends up betting a lot of money on one investment. Given this, diversification which investment experts keep talking about all the time, goes totally out of the window. If the builder disappears (as was the case in the example I am discussing) the losses are simply too large.
Further, given the system is in India, the builder can simply get away with it. He can even avoid meeting the buyers who had bought into his project. The buyers may approach the court, but that is a long drawn process and may not lead to a quick resolution of the situation.
So, yes real estate prices may not fall, but that doesn’t mean that real estate is an excellent investment all the time. If things go wrong, the investment can be totally wiped out. A similar risk is not there with other forms of investing.
Two out of the three individuals who approached me last week with their horrific real estate investment experiences had in the past, lived and worked in the United States. So a question that naturally cropped during the course of our conversation was—what if I default on my home loan, what happens then? Their logic was if we are not getting any home at the end of it, why should we continue repaying the home loan.
Home loans in several states in the United States are non-recourse loans.
This means that in case a borrower decides to default on the home loan by simply walking away from it, the lender cannot go beyond seizing the collateral (i.e., the house) to recover what is due to him. He cannot seize the other assets of the borrower, be it another house, investments, or money lying in a bank account, to recover his losses.
In India, home loans are recourse loans. This means that the banks can come after other assets of the borrower. Hence, walking away from the home loan is a bad idea, even in a situation like this. Further, any default would be reflected on the CIBIL database, leading to the home loan borrowers being deemed unworthy of credit in the years to come.
Once all these factors are taken into account it is very clear that investing in real estate at this point of time is an extremely risky thing to do—the past notwithstanding.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on www.Firstpost.com on Apr 28, 2015

Kingfisher debacle to United Spirits row: Charting out the great fall of Vijay Mallya

vijay-mallya1Vivek Kaul

Vijay Mallya is too much of a stiff upper lip to have ever read the Urdu poet Mirza Ghalib. But if he has, he would know, that one of Ghalib’s most famous couplets, fits the current situation that Mallya is in, very well.
Sometime in the nineteenth century Ghalib wrote:

Nikalna khuld se aadam ka soonte aaye hain lekin
Bahot be-aabru hokar tere kooche se hum nikle

(We have heard about the dismissal of Adam from Heaven,
With more humiliation, I left the street on which you live…

Source of translation: https://medium.com/@herahussain/poetry-in-the-east-a-journey-of-discovery-of-urdu-poetry-6197767f41b4)

The board of United Spirits Ltd, India’s largest liquor company, has asked Mallya to step down as the Chairman of the company. The liquor baron may have been involved in financial irregularities as per an internal probe carried out by the company.
In a press release dated April 25, 2015, the company said: “The inquiry covered various matters, including certain doubtful receivables, advances and deposits. The inquiry revealed that between 2010 and 2013, funds involved in many of these transactions were diverted from the Company and/or its subsidiaries to certain UB Group companies, including in particular, Kingfisher Airlines Limited…The inquiry also suggests that the manner in which certain transactions were conducted, prima facie, indicates various improprieties and legal violations.”
Mallya in true Indian style has refused to bow out. ““All I wish to say is that I intend to continue as chairman of USL in the normal manner. This includes chairing monthly operating review meetings and board meetings,”
he told the Mint newspaper.
Where does this confidence come from? Mallya personally holds 0.01% shares in United Spirits. United Breweries Holdings Ltd (controlled by Mallya) holds 2.90%. Other investment companies controlled by Mallya own around another 1.18%. So Mallya’s holding in United Spirits is down to a little over 4%.
Diageo, the British company to which Mallya sold United Spirits, owns 54.78% of United Spirits. Mallya’s confidence stems from the fact that while selling United Spirits, Mallya and Diageo entered into an agreement, as per which Diageo has to endorse Mallya as the Chairman of United Spirits. This, till Mallya has a stake in United Spirits.
Given this, the stage is set out for a messy legal battle, which will continue for sometime to come. Nevertheless, the question is how did Mallya end up in the mess that he has? One reason was that he took his flamboyant style a little too seriously and ended up starting Kingfisher Airlines in 2005.
Airlines are huge cash guzzlers. As Warren Buffett has said in the past: “
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
Kingfisher Airlines became Mallya’s bottomless pit. Mallya was in a rush to buy planes. He had plans of buying one Airbus A-320 every month until March 2012. All this needed a lot of money. Mallya loaded up on debt from public sector banks. At the same time, Mallya being Mallya could not have run a low cost airline. In a October 2012 article,
Tehalka quotes an aviation sector CEO as saying: “Food served in KFA[Kingfisher Airlines], recalls an aviation sector CEO, was about Rs 700-800 per passenger compared to Rs 300 of Jet’s.”
Other than this Mallya was in a hurry to fly Kingfisher to international destinations. A domestic airline was allowed to do that only once it had completed five years of operation. That meant that Kingfisher would be allowed to fly abroad only by 2010. Mallya did not have the patience to wait for that long. He bought Air Deccan in 2007 to get around the regulation. He ended up overpaying for the low cost airline.
Further, he rebranded Air Deccan as Kingfisher Red. By doing this he diluted the premier positioning that Kingfisher Airlines had acquired in the minds of the consumer. The philosophy required to run a premium brand is totally different in comparison to the philosophy required to run a low cost brand. Hence, Mallya buying Air Deccan was mistake. And then changing its name to Kingfisher Red was an even bigger mistake.
So in the end this did not work and Mallya decided to close down Kingfisher Red. He explained it by saying that “We are doing away with Kingfisher Red, we do not want to compete in the low-cost segment. We cannot continue to fly and make losses, but we have to be judicious to give choice to our customers.”
It is very difficult to run a full-service airline as well as a low cost airline at the same time. The basic philosophy required in running these two kind of careers is completely different from one another. The full service Kingfisher also soon ran into trouble leaving Mallya with a lot of debt. He had got terrible publicity for not paying the salaries of employees of Kingfisher Airlines.
Other than running the liquor and the airline business, Mallya also has interests in real estate. Over and above this, he also indulged in expensive hobbies by buying a formula one and an IPL cricket team. Running an airline is a full time business and can’t be done in a part-time sort of way which Mallya did.
The best Indian companies in the last few decades have made money by concentrating on one line of business. Airtel made money in telecom. It did not make money trying to sell us insurance and mutual funds. The same stands true about DLF. Tata, Birla and Ambani, all lost money in the retail business. Businesses over the years have become more complicated. And just because a promoter has been good at one particular business doesn’t mean it will be good at another totally unrelated business. Mallya did the same with his main liquor business, which he is now losing control of.
Over the last few years, Mallya has been battling the banks which have been going after his assets, for all the debt that is unpaid. To conclude, Mallya has always been too busy living his flamboyant lifestyle and that seems to have caught up with his businesses in the end.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on www.Firstpost.com on Apr 27, 2015

Rahul 2.0 needs some basic lessons in economics

rahul gandhi
Rahul Gandhi recently came back to India from his foreign sojourn of nearly two months. And in his new avatar, Rahul is angry. One of the things he is angry about is the fact that the Narerndra Modi government after coming to power decided to go slow on increasing the minimum support price of wheat and rice. The MSP is the price at which the government buys rice and wheat from the farmers, through the Food Corporation of India(FCI) and other state government agencies.
Rahul told a farmers’ rally in New Delhi on Sunday: “We increased the MSP of wheat from Rs 540 to Rs 1400…The MSP has not changed, no benefit to farmers.”
Between 2005-2006 and 2013-2014, the MSP of wheat was increased at an average rate of 14% per year. The Congress led United Progressive Alliance(UPA) was in power throughout this period. In comparison, between 1999-2000 and 2005-2006, the price had gone up by 4% per year.
The decision to raise MSP did not have any method behind it. It was totally random. A report released by the Comptroller and Auditor General in May 2013 pointed out that “No specific norm was followed for fixing of the Minimum Support Price (MSP) over the cost of production. Resultantly, it was observed the margin of MSP fixed over the cost of production varied between 29 per cent and 66 per cent in case of wheat, and 14 per cent and 50 per cent in case of paddy during the period 2006-2007 to 2011-2012.”
Nevertheless, political decisions do not follow economic logic. But the question is did this decision to constantly keep increasing the MSP benefit the people of India at large. The answer is no. It was the major reason behind the high inflation in general and food inflation in particular, that was seen between 2008 and 2014. As economist Surjit Bhalla put it in 
a November 2013 column in The Indian Express “For each 10 per cent rise in previous years’ procurement prices, there is a predicted 3.3 per cent increase in the current year CPI…When the government raises the MSP, the prices of factors of production involved in the production of MSP products — land and labour — also go up.”
Food inflation hurts the poor the most. Half of the expenditure of an average Indian family is on food. In case of the poor it is 60% (NSSO 2011). What Rahul and the Congress party need to understand is that everyone associated with agriculture does not own land. As per the draft national land reforms policy which was released in July 2013, nearly 31% of all households in India were supposed to be landless. The NSSO defines landlessness as a situation where the area of the land owned is less than 0.002 hectares.
Any price rise, particularly a rise in food prices which is what an increase in MSP leads to, hurts this section of the population the most. Is Rahul not worried about them? They may not be farmers who own land, but they also farm land in this country.
Also, Rahul needs to realize that only a small section of the farmers have a marketable surplus, which they are able to sell to the government. This is primarily because the average holding size of land has come down over the decades. 
The State of the Indian Agricultural Report for 2012-2013 points out that: “As per Agriculture Census 2010-11, small and marginal holdings of less than 2 hectare account for 85 per cent of the total operational holdings and 44 per cent of the total operated area. The average size of holdings for all operational classes (small & marginal, medium and large) have declined over the years and for all classes put together it has come down to 1.16 hectare in 2010-11 from 2.82 hectare in 1970-71.”
This means that only a small section of the farmers make money only from agriculture. Only 17% of farmers survive on income totally from agriculture. The rest do other things as well to make money. And given this they are hurt by the food inflation because of a rapid increase in MSP.
The Congress led UPA government also increased the MSP of rice at a very rapid rate.  In 2005-2006, the MSP for common paddy(rice) was Rs 570 per quintal. By 2013-2014 this had shot up to Rs 1310 per quintal, an increase in price of around 11% per year. In comparison, between 1998-1999 and 2005-2006, the MSP of rice had increased at the rate of 3.8% per year.
This rapid increase in MSP led to a huge amount of food grains landing up with the government. The FCI did not have enough space to store all this grain. “Between 2005 and 2013, close to 1.94 lakh tonnes of food grain were wasted in India, as per FCI’s own admission in the Parliament,” a Crisil Research report points out. Rice formed 84% of the total damage.
While rice and wheat rotting in government godowns, there wasn’t enough of it going around in the open market.  The CAG report referred to earlier points out that in 2006-2007, 63.3 million tonnes of rice landed in the open market. By 2011-2012, this had fallen by a huge 23.6% to 48.3 million tonnes. The same is true about about wheat as well, though the drop is not as pronounced as it is in the case of rice. In 2006-2007, the total amount of wheat in the open market stood at 62.1 million tonnes. By 2011-2012, this had dropped to 61.4 million tonnes.
Also, with MSPs being increased every year at a rapid rate, “the cropping pattern,” the Crisil report points out, was also “biased towards food grains like rice and wheat,” and this led to their “excessive production”.
This is what the Congress led UPA’s policy of constantly increasing MSPs, actually did.
To conclude, as the old English saying goes, “the proof of the pudding is in eating it”. If the policy of the Congress led UPA government of increasing MSPs at a rapid rate was so good, why did the Congress party end up with only 44 seats in the 2014 Lok Sabha elections? Maybe Rahul Gandhi has an answer for that.

The column originally appeared on The Daily Reckoning on Apr 23, 2015

And what will happen to the Chinese real estate bubble?

chinaAt the heart of the financial crisis which started in September 2008 was the real estate bubble in the United States and large parts of Europe. The impact of these multiple bubbles bursting is still being felt in the Western economies, more than six and a half years later.
The impact of these bubbles bursting was felt in other parts of the world as well, including China and India. China has managed to limit the damage of these real estate bubbles bursting by creating a real estate bubble of its own, over the last six and a half years.
China has gone on a huge borrowing binge in the aftermath of the financial crisis. The country has borrowed close to $20.8 trillion between 2007 and mid 2014. This is more than one-third of the money that has been borrowed globally during the period. To give readers a sense of how massive this borrowing is, the Chinese have borrowed more than 11 times India’s most recent gross domestic product of $1.87 trillion.
The McKinsey Global Institute recently released a very interesting report titled 
Debt and (not much) deleveraging. This report points out: “From 2000 to 2007, total debt grew only slightly faster than GDP, reaching 158 percent of GDP, a level in line with that of other developing economies. Since then, debt has risen rapidly.” By mid 2014, China’s total debt had touched 282% of its gross domestic product (GDP). This is greater than the debt to GDP ratio of some of the most developed countries in the world like Australia, the United States, Germany, and Canada.
The biggest driver of this growth in debt was borrowing by non-financial companies, primarily property developers. “At 125 percent of GDP, China now has one of the highest levels of corporate debt in the world,” the McKinsey report points out.
Nearly 45% of the borrowing or around $9 trillion is related to real estate in one way or another. Between 2008 and August 2014, property prices in China rose by 60% as per an index of 40 Chinese cities. Prices rose by 76% in Shenzen and by 86% in Shanghai. In fact, residential property prices at the premier locations in Shanghai are only around 10% lower than similar properties in cities like New York and Paris.
“Property prices have increased as well, as households have bought homes and invested in real estate to find better returns than bank deposits offer,” the McKinsey report points out. Nevertheless, property prices in China have been falling over the last one year.
As often happens in such cases when “easy money” is available the Chinese developers ended up building more homes than there was a demand for and are now finding it difficult to service their debt. In fact, on Monday (April 20, 2015) Kaisa, one of the largest integrated property developers in China, defaulted on interest that it had to pay on its debt.
In a statement to the Hong Kong Stock Exchange the company said that it had not made interest payments on its bonds due to mature in 2017 and 2018.
Business Insider points out that the company “didn’t pay $16.1 million in interest on its 2017 notes, or $35.5 million in interest on its 2018 notes.” Experts who follow the real estate sector in China closely feel that other large Chinese real estate sector companies will also default in the time to come.
Given this, it is not surprising that the activity in the real estate sector is slowing down. As Wei Yao of Societe Generale points out in a recent research note: “The contraction in property starts deepened further, from -17.7% year on year in Jan-Feb to -19.5% year on year in March, making the past quarter (-18.4% yoy) the second worst in history. Land sales, in volume terms, revealed a similar deterioration and were one-third less compared to a year ago in March.”
The Chinese government understands that a major portion of Chinese growth in the aftermath of the financial crisis has come in from the real estate sector. Given this, it has started to step in to ensure that the real estate sector continues to drive growth. “The combination of the policy-easing measures announced in late March, mortgage rules relaxation and bigger tax break, should support a housing sales recovery in the coming months,” writes Yao.
Over and above this, the People’s Bank of China on Sunday (April 19, 2015) cut its reserve ratio by 100 basis points at one go. One basis point is one hundredth of a percentage and reserve ratio is the portion of deposits that banks need to maintain with the central bank. This massive cut will add nearly 1.3 trillion yuan into the Chinese financial system, giving an incentive to banks to cut interest rates particularly to real estate companies as well as on home loans.
The problem is that the Chinese banks are not in a mood to pass on the lower interest rates to borrowers.
As a recent Reuters newsreport points out: “Beijing has tried to revive a flagging housing market as it looks to arrest an economic slowdown, but banks are increasingly worried about bad debts and are not passing on policy steps like interest rate cuts and lower downpayment requirements to home buyers…But the banks’ stance means policy is not feeding through to the real economy. And as the housing market accounts for about 15 percent of China’s economy, it is crucial to stopping the loss of economic momentum.”
To that extent the situation is a tad similar to that in India, where the Reserve Bank of India (RBI) has cut interest rates twice since the beginning of this year, but the banks are in no mood to pass on that cut, given that they are sitting on a huge amount of bad loans.
Getting back to China, one thing that makes the Chinese government different from that of India is that it has much greater control over the economy than the Indian government has. It has recognized this slowdown in the real estate sector and at the National People’s Congress(NPC) in March 2015 (a good time to remember that in China, the party and the government are one and the same) revised the GDP growth target to 7%. As Yao of Societe Generale wrote in a research note released in March 2015: “The Government Work Report, released at the opening session of the NPC meeting, carried few surprises. A number of economic targets have been set lower than last year (see table 1). The much hyped growth target is now “around” 7%, but the urban job creation target was unchanged at “more than” 10m, compared with the actual result of a 13m increase in 2014.”
And if the situation becomes worse than it currently is where more Chinese real estate companies start to default on their debt, the government is in a position to rescue the financial sector, like it has done before. As the McKinsey report points out: “China’s government has the capacity—if it chooses to use it—to bail out the financial sector even if default rates were to reach crisis levels. This would most likely prevent a full-blown financial crisis. Because China’s capital account has not been fully liberalized, spillovers to the global economy would most likely be indirect, via a further slowdown in China’s GDP growth, not through financial contagion.”

The column originally appeared on The Daily Reckoning on Apr 23, 2015

From cutting up a debtor’s body to SARFAESI: Small borrowers have always got a bad deal


Vivek Kaul

In November last year, Raghuram Rajan, the governor of the Reserve Bank of India, made a very important speech, in which he discussed the inequality between the small and the big borrowers, when it came to recovering loans they have defaulted on.
As Rajan said: “
The SARFAESI (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests) Act of 2002 is, by the standards of most countries, very pro-creditor as it is written…But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”
The promoters of big companies on the other hand are able to hire expensive lawyers and get away with it. Though the nation has to bear the cost of their actions. As Rajan had said: “
As just one measure, the total write-offs of loans made by the commercial banks in the last five years is Rs 1,61,018 crore, which is 1.27% of GDP.  Of course, some of this amount will be recovered, but given the size of stressed assets in the system, there will be more write-offs to come. To put these amounts in perspective – thousands of crore often become meaningless to the lay person – 1.27% of GDP would have allowed 1.5 million of the poorest children to get a full university degree from the top private universities in the country, all expenses paid.”
The trouble is that this is how small borrowers have been treated through much of history. In
Coined—The Rich Life of Money and How Its History Has Shaped Us, Kabir Sehgal writes: “Interest bearing loans predated the invention of coins by thousands of years. Around 5000 BC, in what is now known as the Middle East, various types of debt instruments emerged..Interest bearing loans started with agriculture and farming: seeds,nuts, grains, and cows borrowed by destitute farmers who repaid the loan with interest—in the form of the surplus from their harvest.”
And what happened if these farmers did not repay? “Declaring personal bankruptcy wasn’t an option, so there was some creative license in making payments…There were even instances of men giving up their wives or sons to avoid interest payments…A debt contract effectively turned a person into an object or commodity to settle an account, contorting the familial sphere into the commercial one,” writes Sehgal.
In fact, debt prisons were the order of the day through much of human history. It was a common practice even in ancient Rome. As Sehgal points out: “During the Roman Empire, a creditor could arrest the debtor for debt delinquency and haul him into court. If guilty, the debtor could land in a private jail and after sixty days become a slave, a bonded laborer, or even be killed. Though uncommon, creditors were allowed to cut up a debtor’s body into chunks commensurate with the debt owed.” It was that bad. Debtors prisons continued in the Western world through much of the nineteenth century. The United States got around to banning them only in 1869. “In 1830, more than ten thousand people were imprisoned in New York debt prisons. Many times the debts were minimal. In Philadelphia, thirty inmates had debts outstanding of not more than a dollar. There were five people imprisoned for debt delinquency for every one put away for violent offense,” writes Sehgal.
In contrast, some of the biggest borrowers like Kings and governments have gotten away with huge defaults, direct as well as indirect, through the course of history. An indirect default happens when a government creates inflation by printing money and in the process ends up eroding the value of money. This means that when it repays debt, it is actually paying back money which is worth a lot less than it was in the past. And this is nothing but an indirect default.
What this clearly tells us is that the small borrower has always had a tougher time in comparison to the large borrower. And this should not be the case. As Rajan put it in his November speech: “What we need is a more balanced system, one that forces the large borrower to share more pain, while being a little more friendly to the small borrower. The system should shut down businesses that have no hope of creating value, while reviving and preserving those that can add value.”
In fact, research shows that this even has an impact on the amount of innovation that happens in a country. As Rajan put it: “A draconian law does perhaps as much damage as a weak law, not just because it results in a loss of value on default but also because it diminishes the incentive to take risk. For think of a mediaeval businessman who knows he will be imprisoned or even beheaded if he defaults. What incentive will he have to engage in innovative but risky business? Is it any wonder that business was very conservative then?  Indeed, Viral Acharya of NYU and Krishnamurthi Subramanian of ISB show in a compelling study that innovation is lower in countries with much stricter creditor rights. Or put differently, the solution to our current problems is not to make the laws even more draconian but to see how we can get more equitable and efficiency-enhancing sharing of losses on default.”
And this is something worth thinking about.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Apr 22, 2015