Indian realty on Surge

September 29, 2007

Domestic and foreign demand for property in India has surged alongside rapid economic growth. There are now concerns that the market may be overheating.

Following a decade of stagnation in property prices, the real estate sector has been experiencing an unprecedented boom since 2004-05, with prices rising by over 50% on a compounded annual basis in some cities. Price appreciation has occurred across the board, in major cities such as Bangalore, Delhi and Mumbai (so-called “Tier I” cities); “Tier II” cities such as Chennai, Hyderabad and Pune, which have established themselves as alternative outsourcing centers and business locations; and satellite cities and towns–“Tier III” cities–that have experienced price appreciation as economic activities have diversified and infrastructure has improved.

The Indian real estate market has been particularly buoyant; this can be attributed to unprecedented rises in disposable incomes, sharp increases in global liquidity, selective capital account liberalization, looser credit policies, a greater availability of leverage due to financial liberalization and a consequent increase in mortgage lending and price increases that have themselves fueled a speculative boom.

There are concerns that the property market has risen too much and too fast in relation to economic fundamentals, which remain robust. Several structural factors should ensure that property prices continue to grow robustly, assuming that the economy maintains a trend growth rate of 7% to 9%. These factors include rising incomes and a growing middle class, a favorable demographic structure, the nuclearization of families and subsequent drop in family size, increased urbanization (currently 30%), high population concentration (one in every six people in the world lives in India) and greater financial and capital market development, which will boost the under-developed mortgage market.

Nevertheless, there are concerns that the market may be on the verge of a sharp downturn. In the near-term, the key challenge for the Reserve Bank of India is reining in inflation and cooling the market through monetary and credit tightening without creating a hard landing that could have significant political and economic consequences. The RBI has taken steps to curb liquidity by tightening monetary policy. It has increased interest rates several times over the past few months, to 7.75%, and the resulting squeeze appears to be cooling the property market.

The RBI is also closely monitoring the exposure of banks and financial institutions to real estate, urging them to exercise due diligence in assessing credit risks, and tightening loan regulations. However, the banking sector is strong and diversified enough to withstand a property price correction, provided it is localized.

Over the longer term, improving transparency would strengthen the property sector (particularly in Tier II and III cities). The sector remains fragmented, and transactions costs are high. The regulatory framework also needs to be improved substantially to ensure that the rights of both home sellers and buyers are taken care of. Fostering financial and capital market development–including the promotion of asset securitization–will also be critical in ensuring the availability of a strong retail market for housing finance, while ensuring that banks are not overexposed.

Property prices have soared on the back of rising purchasing power, relatively easy financing and significant optimism about growth prospects. While there is a risk that the market may be overheating, the RBI has moved to minimize the impact of any correction on the financial system and the rest of the economy. Beyond the current cycle, growth in the sector is likely to remain strong on the back of rising demand for houses, malls and office space.

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