There are so many articles attributing current Indian real estate crisis to improper financial planning, operation failure and malicious industry practices. But I haven’t read any analysis on their failure of business strategy and its related risk management practices. So I intend to explore this subject and have penned down my quick thoughts on the topic.
Successful organizations like Amazon base their business strategy with customer at center. Their product offering, go-to-market plan etc are all devised based on clear customer segment identification and their needs. Organization known for innovation also define their research priorities keeping in mind customer preferences. Can we say the same about realtors in India?
Dichotomy of India is that while she houses significant poor population, there also exists handful of super rich families of the world. If population is grouped based on household income, we form famous pyramid with few rich at top; majority poor at bottom and struggling middle tier aspiring to reach the top. Strategic choice for any business in India is to determine whom they want to cater to among this population segment and why. I believe this is where realtors lost their way somewhere post subprime crisis.
Post sub-prime crisis, liquidity taps were opened and rates were slashed to keep economic growth in India. Super low rates to negative rates in developed countries led to flow of capital to risk assets in EM like India. Indian entrepreneurs were taking big bets in the country & abroad and economy seemed to be bouncing back against the fragile developed economies. PE firms entered Indian real estate market; realtors employed marketers who created new segment of super luxury residential complex for super rich & ‘future to be rich’ to meet their high financial return requirements. Initial set of such projects were taken up by rich segment and profit margins were much better than the usual vanilla apartments. Many factors were at work:- high liquidity, low rates, optimistic domestic business outlook, easy avenue to invest black money, NRI investment from abroad and new culture of extravagance display.
Similar to capital markets, I believe any market is broadly composed of hedgers/users(people who need); speculators(traders who want to take bet) and arbitragers(who sells something overvalued and buys undervalued). First set of supply was taken up by high demand from hedgers(super rich looking for extravagance); speculators (expecting growth to continue and burgeoning middle class to become rich) and arbitragers (sell old flat in premium locality to new extravagant flat in less premium locality). In market, when higher returns are available with lower entry barriers, more competition enters and that’s what happened soon with all realtors launching super luxury projects. Arbitragers demand made realtors move away from premium localities to developing new land parcels at outskirts of cities. Soon economic cycle turned, speculators no longer added to their bets; hedgers demand had fallen; arbitragers didn’t see possibility of necessary infrastructure being developed in near future in new localities and thereby put off their plans to move outside premium localities for increased facilities. By mid 2013, liquidity dried up, taper tantrum led to higher rates and impending election led to lower approvals and construction came to standstill. NPA’s started accruing at banks with economy in doldrums; new capital was not available for growth. Then new government came with its tighter vigil on black money and higher focus on cleaning banks balance sheet. Speculators started sale of their real estate asset and book their PnL, banks started fire-sale of mortgaged asset leading to increased supply. Realtors got support from new set of financiers like NBFC which provided them time to survive but at much higher cost. From there on the sector has undergone both time correction and price correction.
During all this time, there was majority of population whose need for housing was not catered to by the industry. Huge population found it unaffordable to buy house and industry simply ignored their need. Not many realtors business plan focused on innovation to keep cost down/lower margin and make it affordable to this customer segment. There was always a price point wherein flats were easily sold but most realtors simply ignored these hedgers segment at lower bottom of income pyramid for higher returns. We had classic case wherein most wanted to be premium player in the market and market sizing of this segment was based on optimistic assumption by industry players. In simple words, everyone wanted to provide Apple’s iphone and very few saw the need for Micromax in the industry. So along with all the malpractices attributed to sector, somewhere I believe not being able to target right customer segment and their needs is also one of the contributor to the current real estate mess.
It’s easy to comment today knowing the outcome of situation but it is always difficult to act in similar real situation then. Risk management learning - let’s go back and revisit the strategic question as a realtor and see if we could have identified the risk then with sound risk management practices. There were 2 options: - Launch super luxury project with expected returns of say 25% or mass project with expected returns of say 15%. Is it right way to compare? Any investor would look for risk adjusted return so let’s relook with this perspective. Risk primary with super luxury project relates to ability to sell them in reasonable time apart from operation risk that exists in all projects. So scenario analysis should be done on this parameter as variable and risk should be quantified atleast on expert judgment basis, in absence of any data or scientific methodology. Additionally such high value properties are highly illiquid so returns must be adjusted for liquidity risk also. Once adjusted for these risks, would the differential returns be high? Not sure if such risk management practices are followed by the industry and does it make sense to realtors. I certainly believe such quantification should be useful but views are biased.
I would like to end this with an admission that above quick thoughts are novice view of the sector and any alternate views are welcome. Few points to ponder as I end the post:- Do we examine business risk with similar focus as financial risk? Should ERM as an approach resonate with all industry and not only financial services? Do you see similar situation in other industry where there is latent demand for x product but market players are providing only y product which has limited demand but higher returns?
