India’s real estate sector, with its unique characteristics, is facing an estimated shortage of 25 million homes and has become an enigma to investors and homebuyers as many residential properties sit empty.

In fact, the combined sales of residential properties in India’s top eight cities—including Bangalore, Chennai, Delhi and Mumbai—actually contracted 44 percent year-on-year to 40,936 units in the last quarter of 2016.

Sluggish demand implies the piling up of unsold inventories—255,000 residential units unsold in the Mumbai Metropolitan Region alone—leading to blocked up capital.

This is creating problems for India’s real estate and related sectors.

Broader Economic Impact

With sales taking a hit, realty companies are finding it difficult to repay bank loans and are forced to rely on high-cost private equity or loan sharks that cut into their margins. And the effects are being felt across the Indian economy.

Slowing property sales are adversely affecting related industries such as cement, steel, electrical components and electronic appliances and services such as interior decoration, housekeeping and security. It is also complicating things for India’s banking sector, which is already troubled by slowing credit demand and non-performing loans.

The banking system has high exposure to the realty sector through loans to realty companies and homebuyers, and any large-scale default by either companies or borrowers will add to its volume of bad loans.

To deal with the sluggish demand, realty companies have lobbied hard for lower interest rates and favorable changes in tax laws. Since January 2015, the central bank has reduced interest rates by 175 basis points. Yet, demand for apartment homes has not picked up. To make matters worse, the Union Budget in February 2017 capped income tax deduction on interest payments to 200,000 rupees ($3,081) for a second home loan, which until now had no such limit. This will discourage prospective homebuyers and add to the woes of already financially stressed realty firms.

Genesis of Demand Slowdown

There is a serious demand and supply mismatch in India’s realty market as most developers cater to high margin premium homes when there is more demand for affordable homes. Property prices have become unaffordable even for upper-middle-class households. Municipal authorities are equally responsible for jacking up housing prices by maintaining high circle rates (a well-intentioned but ineffective move to curb black money transactions) and stamp duties.

While home prices have increased rapidly, rental rates remain low at around 2 percent of the property prices, even though the average mortgage interest rate is 9 percent. Capital appreciation can’t compensate for lower rental yield (even for investors who may not have an affordability issue) when property prices are either stagnant or declining gradually. As a result, buying properties at current prices isn’t attractive. Unless the prices correct enough to raise the rental/price ratio, or interest rates fall to 2-3 percent, demand will not pick up. However, interest rates will not decline because of increasing inflation and the recent rate hike (and expected hikes) by the U.S. Fed.

There are other issues, too. Unethical business practices, such as the failure of even the top realty companies to meet basic contractual obligations on quality and project timelines, have also driven homebuyers away.

With limited help from the government, India’s real estate sector will have to take matters into their own hands.

Delayed completion increases the effective cost of apartments for buyers. For instance, a three-year delay (which is quite common these days) in handing over possession of a finished apartment priced at 5 million rupees will increase its price by 1.5 million rupees (assuming a 10 percent simple interest per annum for three years) to 6.5 million rupees. This reduces the potential return on investment and turns a good investment into a bad one.

One sided “apartment-buyer contracts” mean realty companies can easily escape paying any damage to the buyers or can cap the damage at 2 percent for any delay in the completion of projects. Several methods are being deployed to delay the implementation of a real estate regulator or dilute key provisions that would impose accountability on real estate companies and help restore buyers’ trust.

A short-term factor in the slowdown is the falling demand from non-resident Indians (NRIs) because of the relative strengthening of the rupee against the dollar and long delays involved in getting possession of finished homes. Additionally, a sluggish sale market has also contributed to reduced NRI demand.

Many believe that India’s banking system, which has a huge amount of capital to recover from several stakeholders invested in the property markets, will not let the property prices fall below a certain level. Further, like in 2008-09, lower interest-rate-induced bank credit may come to the rescue of the troubled real estate sector.

Will Low Interest Rates be Enough to Drive Demand?

Things are different now in at least four ways:

• There is a mismatch between what most prospective buyers want and what most builders are offering.
• Builders are defaulting on delivery timelines and quality, and that is driving away homebuyers.
• Buying homes at current prices doesn’t make sense for investors from the rent/price ratio perspective.
• Banks, especially state-owned ones, are struggling with non-performing assets, and that means they will be cautious when it comes to extending loans to realty companies or homebuyers.  

Given the extent of the slowdown, even an unlikely drop in interest rates won’t help revive housing demand. Therefore, builders are postponing new launches or slowing construction work. The latter will delay the completion of ongoing projects and further drive away homebuyers.   

There is a possibility that, seeing the value of their properties fall, buyers default on their mortgages—similar to what happened in the U.S. Many will counter this by arguing that buyers will not surrender their properties as they are emotionally attached to them, and that banks in India finance only 75-80 percent of the total cost of the apartments.

However, it is only a matter of time (as home prices are headed for sharper correction) before foregoing 20-25 percent of the property investment will start making sense. In fact, in many realty pockets average home prices have already corrected by 30-40 percent from their peaks.

The Way Forward

With limited scope for any help from the central bank and the government, realty companies will have to take matters into their own hands.

They need to ensure that the Real Estate Regulator Bill is implemented in letter and spirit, as this will help restore the trust of homebuyers. Moreover, they should complete delayed projects as soon as they can and compensate buyers appropriately. Indians love buying properties—that remains the key demand driver for real estate and an interest-free source of capital for realty companies. Realty companies will be better off if they treat customers better.

Additionally, realty companies should stay away from marketing gimmicks such as compact homes, celebrity endorsements (as the endorsement fee is eventually borne by homebuyers), and interest rate subvention. It is time they focus on the product rather than marketing and work to reduce prices to attract new buyers who can’t afford homes at current price levels.

Getting policymakers to reduce long-term capital gains tax and stamp duties can also help the sector deal with demand slowdown, if it happens.