Sunday, May 09, 2010

Residential Property: Time for a Simple Reform

Recently, I visited an exhibition organised by an builders' confederation (MCHI) in Thane, where I live. I was struck and amazed by the unfairness that the industry has been able to visit upon buyers. The biggest unfairnesss is the increase in the rates. A year ago, apartments were available for Rs. 3,200-3,500 per sq ft in a then newly developing locality west of Ghodbunder Road. At that time, people wisely shook their heads and said that the rates were too high and hence the time was ripe for a "correction".  Now the rates ranged from Rs.4,900 to Rs.5,900 in the same locality, an increase of 53 to 84% in just about a year. What is this because of? There is no word I know which describes the opposite of "correction", except "correction" itself. Be that as it may. Let me now list the "unfairnesses" that the typical home buyer labours under.
  1. Most of these rates apply to buildings that have just been "launched" -- which means that not even a hole has been dug. In some cases, even the permission to start construction work (which comes after several clearances) may not have been received. Deliveries are rarely promised before June, 2013 for such apartments. This means that any money paid by a buyer to the developer represents risk capital. If for some reason, the builder does not deliver the apartment, the investor will be left holding the can; and civil rights are notoriously difficult to assert and execute in Indian courts in anything less than a whole generation. 
  2. The buyer is "allotted" a cube of space in the air called a proposed flat. He cannot transfer that right to the apartment without  the developer's consent. The typical developer will not allow the transfer, and if he deigns to allow it, he will charge a hefty sum, enough to make the sale much less worthwhile to the hapless buyer.  Or, he will offer to repay the sum paid less a small percentage. If the buyer accepts it, the builder will line up another such buyer at a rate much higher than the "booking rate" paid by the earlier buyer, justified by market conditions and the fact that the building construction has progressed considerably. Push a builder on why he does not allow such transfers before possession, and he will say that he cannot allow them to "spoil the market" thereby giving away that the market is nothing but a cozy cartel or oligopoly.
  3. Instalments have to be paid as and when slabs are cast, and with 30 and 40-floor apartment blocks coming up nowadays, 2% to 3% of the agreed total consideration comes up for payment every month or two months, reaching 80% of agreed consideration when all the slabs are cast. This stage is reached faster if the building is not so tall. Non-payment or slightly delayed payment would visit the buyer with an interest burden. Consider this: a typical buyer who funds 20% of the consideration on his own and 80% through a home loan has to pay up 20% immediately (i.e., 100% of his own contribution before initial excavation) as this is a normal rule with lending institutions and another 60% using loan disbursements, whereas the builder has incurred only 20% to 30% of the total cost of construction. While one may make an allowance for some reputed builders, there is nothing to stop builders from diverting the resultant temporary cash surplus into other projects, or land acquisitions. The temptation is very high -- after all, he will be using zero-cost funds and the risk will substantially be borne by the buyers who have no alternatives. 
  4. Now look at the builder's position. He has collected 80% of his money but has yet to spend 70% to 80% of the cost of construction. He has already used up the cash -- and will have to generate liquidity to finish the remaining work. What is his incentive to do the remaining work and deliver on the promised date, when it means that he now has to cough up more than he has collectible?  Every delay works to his advantage. Small wonder that most builders fail to deliver as per first promised schedule. 
  5. Now look at our typical buyer's position. He is living in a rented house. As soon as loan disbursements begin, he is keen on reducing overall interest costs, so he agrees to start paying his EMI (or pre-EMI) to mitigate borrowing costs. He then (let us say) gets married to a working girl whose earnings also come in handy. The marriage took away whatever financial cushion he still had remaining. And he (and his newly wed wife, too) have to pay (for 18 months to 36 months) a loan instalment in addition to the rent -- which, if they can afford it, leaves them with even less money in hand. Despite education, and despite well-paying stressful jobs, they are living from hand-to-mouth, with too much of month left at the end of their money. And then, after paying all his life's savings and incurring a huge debt burden, when the slabs are fully cast, they both are in the weakest bargaining or negotiating position that they will ever be in -- much worse than at the start. What's more, he does not even know the other people who share his plight, because only the builder knows who else has bought apartments. Add to this mix an implacable builder who does not recognize the concept of fairness, and you have a buyer who is extremely angry, but totally vulnerable and soft-as-putty. He does not have any money left to launch a legal fight, and the agreements are worded totally in favor of the developer, he discovers too late. At this point, it only needs an event like a job loss (which would not have been very stressful if he still had his savings, and was not servicing a home loan) to push him beyond the brink.
  6. If property prices are under downward pressure while construction is in progress, the builder is cool: his costs are already covered; and the  buyers are already locked in at the old price. He will have a few flats unsold, but if he does not need the money, he won't sell in a depressed market. His locked in buyers too, cannot sell without his okay. So the market price never really falls, and buyers at lower levels will not find builders willing to sell very easily. 
  7. If property prices rise, it is even better. Delaying delivery will make existing buyers desperate. Some will have reached the end of their financial tether, and become willing to sell out at much less than current market prices. The builder only switches the old buyer with a new one, who is willing to pay a much higher price. 
How can the situation be remedied?  There is a crying need for One Simple Reform: Ban builders/ developers from selling apartments or shops till they are ready to be occupied, and till an occupation certificate certifying that the entire building is fit and ready for occupation, has been received from the Municipal Corporation.  Indeed, they should not be allowed to even issue allotment letters or collecting advances linked to blocking of a specific apartment, shop or office. No document should be recognized as a sale agreement unless it is stamped and registered, and this cannot be back-dated. How will this help?
  • Builders/ developers will be keen on completing construction and making the property ready for possession because their own money is locked in till that happens.
  • Their traditional source of funding, prospective buyers, will dry up. So will "investors" who get in with the builder and get out with the builder, because they cannot get anything but a stated rate of return, and will be much more uncomfortable without a valid letter of allotment.
  • If the project gets "stuck", then the risk is entirely on the builder because he has his own and borrowed money invested, and the longer it takes, the higher the cost of funds.Also, the builder will be under much greater pressure from lending institutions who have (hopefully taken) collateral securities and who have the financial muscle to take control of the project, if needed, and sell the unfinished project to another bidder. Individual flat buyers will never be able to do that.
  • Prospective buyers will not become lightning rods for risks of this business because they cannot invest early. They can only buy ready flats, so they won't get "stuck".
  • The negotiation balance will be much less lop-sided, because prospective buyers can dangle full immediate payment as a carrot, and can demand better rates because the average builder is under much higher pressure to sell. 
  • Builders will be unable to overextend themselves to buy land because cost-free and risk-free funds to create land banks will disappear.
  • If property prices fall, some builders who have unsold, ready flats will be unable to bear the financial burden of waiting through the downward cycle of prices, and will be forced to sell at lower prices.
Along with this simple reform, there should be stringent punishment and fines (collected on behalf of those who have funded him) for those breaking this rule, and provisions for handling the interests of buyers who are already stuck" with a particular builder. A real estate regulator should be set up (could be additional powers to SEBI itself).
I know that there will be enough naysayers who will object to this simple reform and dub it simplistic and unrealistic, but in my view, problems resulting from this would be manageable.

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