The Housing Opportunity in India

It’s a well-established fact in modern economics that homeownership is a big driver of economic activity. Homeownership is directly correlated to several factors including, but not limited to purchasing power or affordability, employment, availability of mortgages, interest rates on mortgages, physical and social infrastructure, taxation and property rights etc.

Housing in major Indian cities has traditionally been unaffordable for the average middle-class buyer. In the past, housing demand was concentrated in city centers due to limited physical infrastructure that resulted in long commute times from peripheral areas. Social infrastructure such as schools and hospitals were limited in both quantity and quality and as a result, those who chose to live in peripheral areas had a much lower quality of life than their peers who lived inside cities.

The trifecta of dysfunctional capital markets, illicit cash in the economy and high interest rates on mortgages played their role in making housing further inaccessible and unaffordable for the average buyer. Dysfunctional capital markets resulted in concentration of capital and a tendency among homebuilders with access to capital to hoard land. This was further accentuated by illicit cash in the economy which fueled purchases of land as a store of value. High headline inflation of between 4% to 6% resulted in high nominal mortgage rates of between 8% and 10% for mortgages that extended for a maximum duration of 15 years. This made it difficult for an average home buyer to make monthly mortgage payments for homes with the needed standard of living.

The entire housing and real estate industry in India was therefore an overleveraged, capital appreciation game where lenders, developers, wealthy buyers and so-called investors were all in a nexus of convenience to the detriment and exclusion of the average homebuyer. It is no wonder then, that according to a KPMG-NAREDCO study, India has an urban housing shortage of 18 million units while tens of thousands of completed homes remain unsold in major Indian cities.

The scenario has changed materially in India in the past few years. Urban infrastructure, though far below what would be desirable, has improved steadily with the construction of metro rail systems, rapid bus transit systems, bypass roads, ring-roads and in-city overpasses. Significant investments have been made in expansion of water, sewage and waste management infrastructure. Social infrastructure like schools and hospitals has improved in both quality and quantity. As a result, the quality of life in peripheral areas of cities has improved.

The curbing of illicit cash in the economy has had a deflationary impact on the real estate sector. Land as a store of value has been steadily losing sheen and capital allocated to the real estate sector has been moving to productive and yield generating assets like offices, warehouses and housing. This has upset the erstwhile capital appreciation business model of real estate developers. Equity in a real estate project is less valuable than before and only marginally more remunerative than high cost debt. This has disincentivized overleveraging by developers. Real Estate development is gradually becoming a volume throughput game. Developers who can efficiently utilize capital and deliver value are able to scale rapidly with external capital (equity and debt) and in the process are able to earn high returns on their own capital.

The government’s thrust on housing for all through the PMAY scheme has been a game changer for homeownership. Under this scheme, housing loans under LIG (Low income group), for homes below 650 sq. ft. in size and for loans below USD 8,700 in value, receive a 6.5% interest subsidy per year. Housing loans under MIG-1 (Middle income group), for homes below 1,725 sq. ft. in size and for loans below USD 13,000 in value, receive a 4.0% interest subsidy per year. Housing loans under MIG-2, for homes below 2,150 sq. ft. in size and for loans below USD 17,400 in value, receive a 3.0% interest subsidy per year. With unsubsidized mortgage rates on 15-year loans at 8.5%, the interest subsidy under the PMAY scheme has had a catalytic impact on housing demand.

The Real Estate Regulation Act (RERA), the Goods & Services Tax (GST) and the Insolvency & Bankruptcy Code (IBC) have empowered home buyers of under-construction properties and have caused weaker developers to close shop. This has expanded the market opportunity for strong and scrupulous developers. With reforms in place and a reset from the sins of the past, housing is likely to be a big driver of economic growth in India and it presents a large opportunity for allocators of capital looking to invest in India.

Voluntary Suspension of Disbelief

The dictionary defines suspension of disbelief as a willingness to suspend one's critical faculties and believe the unbelievable.  Suspension of disbelief is essential for the enjoyment of works of fiction like movies, books, magic shows etc.  However, we humans seem to excel in the art of disbelief suspension in many other areas of our lives as well.  Investing is at the top of that list.

In the words of Warren Buffett, price is what you pay and value is what you get.  But investing based on value is very difficult to practice.  Investing based on value requires one to take a position that the market is wrong.  Our belief in prices set by the market or to put another way, our willingness to suspend disbelief about the prices set by the market makes it hard for us to disagree with the value ascribed by those prices.  Once the link between the price of a security and the value of its underlying asset is broken due to the voluntary suspension of disbelief by market participants, interesting things start to happen.

Benjamin Graham noted that the market then becomes a voting machine instead of a weighing machine and success begets success and failure begets failure.  Graham had said that the markets behave like a voting machine in the short term and a weighing machine in the long term.  Unfortunately he did not define the duration of the long term.  John Maynard Keynes on the hand did articulate it and said that in the long term we are all dead.  

Recent experience in the markets would make one believe that the long term in the market is nothing but a series of short terms and since the market behaves like a voting machine in the short term, it should theoretically also behave the same way in the long term.  This hypothesis is being proved by the rise and rise of passive index based investing.   The most recent semiannual report on fund manager returns produced by S&P Global (SPIVA report) showed that 90% of actively managed US mutual funds underperformed their benchmark indices.  As an active money manager and one who makes a living picking stocks, I have managed to find myself in the 10% of managers who do beat their benchmarks.  However, I can tell you from experience that it has been incredibly hard to beat the index and it is getting increasingly harder to do so.

As more money goes into passive index based funds, demand for securities that make up the indices increases and their trading volumes and liquidity increases.  The increase in demand leads to higher prices for the indices and securities thereby creating more demand of index based funds.  As money skews towards indices and their components, it moves away from non index securities thereby depressing their prices, trading volumes and liquidity.  This amplifies the perception that securities in the index are safer than those not in the index and that larger companies, which by definition are in the index, are safer investments than smaller companies.  This phenomenon is exaggerated in emerging markets which are less liquid to begin with and are dependent on foreign capital flows.

It is important then to step away from this madness and ask whether the value of the underlying matters?  Does the market ever behave like a weighing machine?  Can the fictional and voluntary suspension of disbelief result in the emergence of an alternate reality?   If we truly are in an alternate reality then again in the words of Warren Buffett, I am out of touch with present conditions, and if not then I believe that this has to all end very badly.

The Lonely BRIC

I would like to take this opportunity to wish all readers of my blog a very happy and profitable new year. The world is a crazy place and seems to be getting crazier. Stay safe, stay optimistic and in the words of Johnny Walker, "Keep Walking!"

In the words of Yogi Berra, "It is tough to make predictions, especially about the future." But, it is even tougher to write a new year blog post without making predictions. So, continuing with the clichés, here I go putting my foot in my mouth and painting myself into a corner.

Despite my optimistic predisposition towards life in general, some things are clearly visible to the naked eye and refusing to believe them makes one delusional. Therefore, 2016 is going to be a tough year for Brazil, Russia, China, South Africa (the BRICS minus India) and as a result for emerging and frontier markets across the board. They have a lot of structural issues to sort out and these things by their nature take time. India has been sorting out its structural issues for the last few years and the light at the end of the tunnel is now visible. This makes India the lonely BRIC that is likely to have a stable economy in the first half of 2016 and a potentially accelerating economy into the second half of 2016 and well into 2017 and 2018 in a cohort that is in trouble.

The interesting challenge for investors in India will be dealing with the duality of a downward drag from emerging markets and an upward pull from domestic growth. The result, in my opinion, will be a market that is likely to completely divide into two. Any industry/sector that is uncoupled from imports and exports either directly or indirectly (pricing power) is likely to see a wall of money descend on it. And those that are affected by the goings on in other emerging markets are likely to wallow in misery. Given that the supply of domestically driven stocks is limited and their float is even smaller, ridiculous valuations will drive a gigantic revival of the primary markets in the such sectors. To the envy of public markets investors, this will make venture capital investors look like rock-stars. This will likely funnel even more money into early stage investments leading to a frenzied blow-off. The nearest analogue in history to the scenario that is likely to play out is the technology, media and telecom (TMT) boom of the late nineties. Those looking for a repeat of the broad based emerging market (and easy money) driven run of 2004-2007 are likely to be left holding a lot of lemons. India therefore will be an exciting and difficult place for investors in 2016 and it will behave like a lonely survivor in stormy waters. The financial markets as always will give us plenty to do and will keep us busy in 2016.

My concluding cliché then; may your stocks go up in 2016 and if they don't, may you not buy them!