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

India-Real-Estate-Market
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

Why real estate Ponzi scheme will continue despite new Real Estate Bill


On April 7, 2015, the union cabinet cleared the Real Estate (Regulation and Development) Bill. The Bill essentially mandates that every state needs to set up a Real Estate Regulatory Authority (RERA), to protect consumer interests.
Every commercial as well as residential real estate project needs to be compulsorily registered with the RERA of the concerned state. Real estate companies need to file project details, design and specifications, with the concerned RERA. They need to put up details concerning the approvals from various authorities regarding the project, the design and the layout of the project, the brokers selling the project etc., on the RERA’s website.
Consumers will be able to check these details on the website of the real estate regulator. Further, only once a project is registered with the RERA will it be allowed to be sold. Also, like is the case currently, a real estate company will not be able to go about arbitrarily changing the design of the project midway through the project. In order to do this the company will need approval of two thirds of the buyers.
If the real estate company makes incorrect disclosures or does not follow what it has stated at the time of filing the project with the RERA, it will have to pay a penalty. There are other provisions also that seek to protect consumer interests. Real estate companies will have to clearly state the carpet area of the home/office they are trying to sell, instead of all the fancy jargons that they come up with these days. Further, the bill allows buyers to claim a refund along with interest, in case the real estate company fails to deliver.
So on paper the bill actually looks great. But there is one provision that essentially makes all these provisions meaningless in a way. The Bill requires real estate companies to compulsorily deposit half of the money raised from buyers for a particular project into a monitorable account. This money can then be spent only for the construction of that project against which the money has been raised from prospective buyers.
This is an improvement from the way things currently are. The way things currently work are—a real estate company launches a project, collects the money and then uses that money to do what it feels like. This might mean repaying debt that it has accumulated or diverting the money to complete the projects that are pending. Given this, at times there is no money left for the project against which the money has been raised. In order to get the money for that, another project will have to be launched. Meanwhile the prospective buyers are stuck.
Developers love launching new projects simply because it is the cheapest way to raise money. Money from the bank or the informal market, means paying high interest. Hence, they raise money for the first project and use it to pay off debt or the interest on it. To build homes under the first project, a second 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.
The Real Estate Bill seeks to stop real estate companies from running such Ponzi schemes. As explained above, 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.
The thing is when the Bill was first presented in the Parliament in 2013, the real estate companies had to deposit 70% of the money raised against a particular project in a monitorable account and spend that money on that particular project.
Between then and now the real estate lobby has been able to dilute the 70% level to 50%. What this means that the real estate companies can still use 50% of the money raised against a particular project for other things. And this will essentially ensure that the real estate Ponzi scheme will continue.
Real estate companies will continue to launch new projects to raise money and use half of that money for things other than building the project for which they have raised the money for.
Also, this provision will allow the real estate companies to continue to hold on to their existing inventory and not sell it off at lower prices in order to pay off their debt, given that they can continue to raise money by launching a new project.
The question to ask here is why should a ‘new’ regulation allow money being raised for a particular project to be diverted to other things? It goes totally against the prospective buyers who are handing over their hard earned money(or taking on a big home loan) to the real estate company, in the hope of living in their own home.
A possible answer lies in the fact that if the government had regulated that the money raised for a project should used to build that project, it would have closed an easy way that the real estate companies have of raising money. This would have ultimately led to real estate prices coming down. And any crash in real estate prices would have hurt politicians who run this country, given that their ill-gotten wealth is stashed in real estate.

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

The column originally appeared on Firstpost on Apr 21, 2015