Liquidity

A Real Estate Story That Everybody Should Read

250px-Underconstruction_Building

I am in Delhi these days.

And Delhi and the National Capital Region around it, as you would know, dear reader, have their share of real estate stories.

There are stories of builders who have taken the money from prospective buyers and not delivered.

There are stories about builders who have taken the money from prospective buyers and simply disappeared.

There are stories about builders who have taken the money from prospective buyers and abandoned construction midway.

There are stories about prospective buyers continuing to pay their EMIs with no idea of when their dream home will be delivered. Meanwhile, they also continue to pay rent.

There are stories about builders now demanding a bailout from the government.

All in all, the overall real estate story in Delhi and the National Capital Region, is a mess.
Nevertheless, recently I came across a slightly different sort of story, which tells us the different kind of problems that people face with real estate and why sometimes there are really no solutions to a problem.

One of my relatives, who are now very old, have lived a good part of their lives in a DDA colony in South Delhi. The flat was bought in the early 1980s at around Rs 2.5-3 lakh and is now worth close to Rs 3 crore. Of course, South Delhi is a great place to live.

All the everyday amenities from banks to vegetable vendors to milk booths to medicine shops etc., everything is within walking distance and almost everything you can think of is home-delivered.

But the relatives I am talking about here are now old and want to move to a different part of Delhi, to be close to their immediate family, which stays there. That part of Delhi is much cheaper than South Delhi. A similar sort of flat can easily be bought at around 40-50 per cent of the price in South Delhi.

If things work as smoothly, as they are supposed to in theory, this would mean selling the flat in South Delhi for around Rs 3 crore, buying a new one for around Rs 1.5 crore and paying a capital gains tax on the remaining Rs 1.5 crore. And then, they can live happily ever after.

Now only if things were as smooth as that.

As I well known, no real estate transaction can happen in Delhi-National Capital Region in full white money i.e. the full payment is made through a cheque, demand draft, bank transfer etc. A part of the transaction will always have to be carried out in black, which means a payment needs to be made in cash.

How would a Rs 3 crore sale go? Around Rs 1-1.3 crore would be paid in black. The remaining would be in white. Typically, when this happens, the black money is then used to buy more flats, and this is how the vicious cycle of black money continues.

In this case, the flat in the new locality costs around Rs 1.5 crore. Of this around Rs 50 lakh will have to be paid in black. And the remaining in white. This means that of the Rs 1-1.3 crore of the original black money received, around Rs 50-80 lakh will remain.

This is a lot of black money for someone who has never really dealt with black money. What does he do with this black money? At his age, there is no point in investing in more flats (given that the real estate sector is down in the dumps and also the fact that more money would be needed to do the same) or buying gold for that matter.

Given this conundrum, the sale is stuck. At his age, there is no possibility of a home loan as well.

In fact, this is an excellent example of a situation where an individual is asset heavy and liquidity light. Of course, in this case, he didn’t arrive at this situation because of the choices he made. Over the years, that is exactly how the situation turned out to be.

A part of Delhi, which no one really wanted to go and live in, turned out to be its most posh part, over a period of three decades and more. And given, this real estate prices sky-rocketed. A flat which cost Rs 3 lakh, was worth 100 times or Rs 3 crore, nearly 35 years later. This means a whopping return of 14 per cent per year (without taking any maintenance cost into account). In fact, at its peak price nearly five years back, the flat would have gone for anywhere between Rs 3.5-4 crore.

Of course, from the investment point of view, it has been a superb investment. But 35 years later, the situation is such that the flat cannot be sold. And this is a lesson for everyone who believes that real estate is the best way to invest.

The biggest problem with real estate is that it lacks the liquidity of other forms of investment, even though the returns might be superb. While, in this case my relatives can continue to live in this flat, so it doesn’t matter much. But there are other cases when people need liquidity to meet expenses, like the higher education of their children, their weddings, a medical emergency, and so on. In a real estate market like the one that exists today, selling a property quickly at the right price (if at all there is anything like that in Indian real estate) is never easy.

Of course, one can always take a loan against property, but then even that has to be repaid and the regular income may not be good enough to repay that loan.

This is something that everybody who swears by real estate as the best form of investment, should keep in mind.

Real estate may not have the liquidity, when you need money the most.

What happens then?

The column originally appeared on Equitymaster on October 24, 2017.

 

 

Why smart people fall for Ponzi schemes

ponzi
Sometime back a friend called and had a rather peculiar question. He wanted to know how he could go about stopping one of his friends from peddling a Ponzi scheme.

This was a rather tricky question. Just explaining to someone selling a Ponzi scheme that he is selling a Ponzi scheme, does not really work. The first question I asked my friend was how was his friend doing in life? “He is doing well for himself,” said my friend with a chuckle. “He works in a senior position with a corporate and has managed to sell the scheme to at least ten people in the housing society that he lives in.”

“If he is working at a senior position, why is he doing this?” I asked my friend, and immediately realised that I had asked a rather stupid question. “I was hoping you would be able to answer that,” my friend replied.

This column is an outcome of that conversation.

Over the last ten years of writing on Ponzi schemes I have come to the realisation that many people who sell and in the process invest in Ponzi schemes are not just victims of greed or a sustained marketing campaign, as is often made out to be.

There is much more to it than that. Many individuals selling and investing Ponzi schemes (like my friend’s friend) come from the upper strata of the society, are well educated and know fully well what they are doing. In case of my friend’s friend he was selling a multilevel marketing scheme for which the membership fee is more than Rs 3 lakh. So, the scheme is clearly aimed at the well to do.

On becoming a member you are allowed to sell products, some of which cost as much as a lakh. Of course, you will also be making new members as well. The bulk of the membership fee paid by the new members you make, will be passed on to you. Hence, the more people you get in as members, the more money you make. Selling products is just incidental to the entire thing, given that a membership costs more than Rs 3 lakh.

This is a classic Ponzi scheme in which money being brought in by the new investors (through membership fee) is being used to pay off old investors (who had already paid their membership fee), with the business model of selling products providing a sort of a façade to the entire thing.

So, the question is why does the smart lot fall for Ponzi schemes? As John Kay writes in Other People’s Money—Masters of the Universe or Servants of the People: “Even if you know, or suspect, a Ponzi scheme, you might hope to get out in time, with a profit. I’ll be gone, you’ll be gone.”

People feel that the money will keep coming in. Or what the financial market likes to call ‘liquidity,’ won’t dry up. And this is the mistake that they make.
Kay defines liquidity as the “capacity of the supply chain to meet a sudden or exceptional demand without disruption…This capability is achieved…in one or both of two ways: by maintaining stocks, and by the temporary diversion of supplies from other uses.”

Kay in his book compares the concept of liquidity to the daily delivery of milk in the city of Edinburgh in Scotland where he grew up. As he writes: “In the Edinburgh of fifty years ago fresh milk was delivered everyday…At ordinary times our demand for milk was stable. But sometimes we would have visitors and need extra milk. My mother would usually tell the milkman the day before, but if she forgot, the milkman would have extra supplies on his float to meet our needs. Of course, if all his customers did this, he wouldn’t have been able to accommodate them.”

What is the important point here? That people trusted the milkman to deliver every morning. And given that they did not stock up on milk, more than what was required on any given day. If the trust was missing then the system wouldn’t have worked.

Take the case of how things were in the erstwhile Soviet Union. As Kay writes: “In the Soviet economy there was no such confidence, and queues were routine, not just because there was an actual insufficiency of supply – though there often was – but because consumers would rush to obtain whatever supplies were available.”

And how does that apply in case of Ponzi schemes? As I mentioned earlier, the individual selling Ponzi schemes feel confident that the money will keep coming in. Those they sell the scheme also become sellers. And for the Ponzi scheme to continue, the new lot also needs to have the same confidence.

In the milk example shared above, if people of Edinburgh had started hoarding milk, the liquidity the system had would have broken down. The confidence that milk would be delivered every day kept the system going. Along similar lines, the confidence that money will keep coming into a Ponzi scheme, gets smart people into it as well.

Of course, this confidence can change at any point of time. And if a sufficient number of people stop feeling confident, then the scenario changes. The money coming into the Ponzi scheme stops and the moment the money coming into the scheme becomes lesser than the money going out, it collapses. So that’s the thing with liquidity, it is there, till it is not there.

In my friend’s friend case, members down the line would stop making more members. Also, members who had bought the membership from my friend’s friend are likely to turn up at his doorstep and demand their money back.

And given that he has told membership to many people in his housing society, he can’t just get up and disappear, given that he is essentially not a scamster. He is a family man with a wife, children and parents, who stay with him.

Hence, he will have to refund them, if he has continue living in the housing society in a peaceful environment. How will he do that? Let’s go back to the definition of liquidity as explained above. Liquidity is maintained by “by maintaining stocks, and by the temporary diversion of supplies from other uses.” So my friend’s friend can pay up from the money he has already accumulated by selling these Ponzi schemes. If that is not enough, he can dip into his savings. And if even that is not enough, he can hopefully take the money being brought in by the new members (if at all there are people like that) and hand them over to the members demanding their money back.

Of course, by doing this he will only be postponing the problem, given that he would have to later deal with the new members.

Long story short—he is screwed!

The column originally appeared on The Daily Reckoning on Oct 13, 2015