Anatomy of Indian real estate crisis

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?

Experiential Learning : Fallacies of Human Mind - I

After having spent significant time of my short career on the quantitative aspects; I was intrigued by behavioral science and so sometime a year back I took course by Prof. Dan Ariely on this subject. I found course to be quite insightful and practical. Since then I have been consciously trying to recognize and overcome common behavioral mistake in my decision making process. I must confess that my success ratio is pathetic but now I am at least aware of my mistakes. As part of my experiential series, I would like to introduce few concepts I learnt during the course with examples from non financial world and then elaborate on my experience from the investment side.

‘Human mind likes to select default option and therefore decision making tends to be more default. This issue is exacerbated as complexity (option) increases. Default option is not always bad or always good. It is just an option which is easy for our brain to select ’. I have always enjoyed solving complex problems and therefore I took time to accept this. But now I am able to appreciate the same over period of time. Marketers exploit this behavior to make us buy stuff which they want us to buy. For example cell phone manufacturer sells phones under different brand name with almost similar specs at similar price that it is difficult for buyer to make rational decision. In such cases, instead of buying based on ones need, buyer tends to buy stuff that is sold to him. This is because mind selects default option instead of choosing right one from the many available options.

On the investment side, this problem is even more difficult to recognize. We spent so much time on selecting right stock/investment so as to beat the market returns but once the investment is made then our behavior moves to default option. Though every trader would agree that once the position is marked to market on previous day, holding on to the existing position is similar to taking fresh position but very few traders put that to practice. We have tendency to continue with default option that is to hold on to existing position. That's the reason of the industry practice of having stop loss; to force the trader to think of his existing position. So many times in past I have exhibited such default behavior while trading and in fact still continue to do. For me, ability to exit an existing position is still a challenge which I continue to face but now I am aware of it and working on it.

This concept applies to the quant world also. Industry still continues to use archaic models that assume normal distribution of returns irrespective of market behavior since it is more familiar to them and hence is their default behavior. VaR continues to dominate risk management world rather than mix of complex stress scenarios which can quantify tail risk also. Management still needs one simple risk metric even though it may be inadequate under stress scenarios. Only change post crisis is recognition that these models may fail. In era of negative interest rate, CAPM still continues to be base model. Inspite of ballooning deficit, US still remains standard for risk free rate. And the list is endless…

This concept also applies to every human being when s/he makes the important decisions of their life. If I look back today to see how the most important decisions of my life were made then I feel lot of them have been influenced by this default option especially when stakes were high. Just take few minutes and ponder how you made your most important decisions of your life. Most of us must have been influenced by this default option. I have currently no standard method or process which helps me avoid this pit fall except that I now recognize the issue. My way of overcoming it is to reduce the available options and then consider default option as unviable and then let my grey cells identify second best option. Then problem is reduced to evaluation between default and second best option just selected. Still it continues to be challenge to ensure rational decision making. Any suggestions to handle the issue better?

New India : Post Demonetization ?

Whether you like him or hate him, you have to laud Mr Modi for his courage to take bold decision that can disrupt the society/nation. There have been many business leaders in recent times who have adopted disruption as model to change the industry dynamics but very political leader have adopted such model for governance.  It is double edged sword and not many are willing to risk so much when the stakes are so high.  Before you carry any impression of this post being the diatribe by one of his staunch followers, I would highlight that I only acknowledged his courage to take such bold decisions. Whether the decision is good or bad that time will only tell us but it will definitely have far reaching impact on our society.  I have attempted to put across my objective assessment of the event and its possible consequences without taking ‘for or against’ view. 

East Asian crisis is said to have imprinted financial crisis fear in minds of the people living in those countries at that time and hence for years later they have preferred to save rather than spend unlike their western counterparts. This fear led these countries to maintain much higher reserves as safety net for any future crisis. Similarly in India, high inflation observed in last decade has led to erosion of wealth for savers in India and this has given rise to new generation of spenders. I believe demonetization has potential to have such behavioral change on our society and therefore have tried to focus such long term effect rather than taking myopic view that focuses only on immediate consequences.

Greed and fear are two emotions which determine large part of people’s behavior when it relates to money management.  Current demonetization of high value currency notes will immediately alter the current equilibrium of these emotions in people. People at large seem to have overcome the fear of corruption/black money and it is the greed that seems to be driving their behavior towards current form of society. Years of inaction against corrupts/black money hoarders has reinforced the moral hazard.  Like all moral hazard problem, everyone knows it exists but don’t know how to avoid the same. Mr Modi seems to believe that his decision will end this moral hazard issue in the society. He is trying to make it difficult for corrupt people/black money hoarders to avoid erosion in their wealth by his policy decision. Hypothesis here could be that the pain such people will go through while losing their wealth which they have always believed to be theirs would be immense and would prevent them from hoarding black money in future. The consequences they will face will serve as deterrent for others in the society to commit on this path of corruption & black money. Also people who have paid their taxes on time will get pleasure of seeing the pain of others who don’t fall in their group and would reinforce their FEAR in future. (In fact it is this pleasure which led to initial positive assessment of his decision). If this succeeds then we may see an end of parallel black economy that has existed for years. It would make it difficult to fund terrorism, bribe officials etc since source & use of funds can be known easily. Already news have been flashing of the difficulties naxals are facing to exchange their loot and they may also see erosion in their wealth. Here FEAR is expected to bring about positive change in people.

Let’s try to take contrarian view about the same event. The high valued notes earned by the people have suddenly become worthless instills FEAR about monetary currency. The current monetary system exists mainly because of the people faith that it will be honored without much hassle.( Of course in current form, one can deposit or exchange currency notes up to certain limit but it is certainly not hassle free.) If people start having doubts about high value currency notes then in future they will not like to accept it or keep it as saving instrument. Would they then prefer gold over them in future since in our society gold’s acceptance has never been questioned yet? Further its global acceptance provides additional comfort for liquidation and removes one’s dependency on nation central bank. This can lead to situation wherein savings would not get channelized into useful development but into gold hoarding. Of course government and central bank may have other means to change this behavior but it would take years to acknowledge and act on the same.  Lot of black money hoarders were believed to have rushed to buy gold, USD post demonetization announcement. Of course they intended to convert black money into gold for future use. But will this immediate gold buying end once these two months are over? Answer could be NO!!! Government would like to believe it will create enough incentive to move people to digital currency. Phew, new disruption model for country where literacy rates are so low; where gullible people have been duped so many times in past that they don’t even trust the banks.

Black money incentives risk taking, discretionary spending among the people. Demonetization will lead to overall decrease in wealth in the society as such and would either strengthen central government or central bank balance sheet. Even if government increases its expenditure, it will take time for this wealth to be accumulated by the society large. Now what do we expect from such society which witnesses mass wealth (legal/illegal) destruction due to act of government? FEAR ? People would spend less, less corporate gains, lower number of new jobs etc. Coupled this with highest population in age of 20-30 years, global slowdown & protectionism and rising terrorism imagine the potential social unrest it can create in huge nation like ours.  In both above cases, FEAR seems to have negative consequences for the society.

The actual consequence of this event may lie in between both the extremes described above.  It is very difficult to gauge people’s behavior and predict the future especially when population is more than billion. But it is certainly one of the exciting times to be in India to experience the same.  Government and its policies will definitely have key role in influencing people behavior. But I firmly believe it is us and our behavior that will shape up the future of this society and government response will be guided by them. So let’s keep our emotions in check; objectively assess situation with open mind post immediate fallout before forming any firm opinion about the event.