Why corruption can't drive house prices higher forever

The safest argument for higher property prices is the corruption factor. The nexus between real estate promoters and politicians is always spoken of when there is talk of unsustainable high property prices.

Politicians invest black money in property and it is in their interests to keep property prices high. Politicians also pressurise bankers to go soft on loan defaults by real estate promoters and that leads to the promoter being able to maintain prices despite a clear lack of demand.

These arguments for property prices staying high and going higher may hold true in the very short term, but in the longer term, it does not hold true.

 Why corruption cant drive house prices higher forever

Lack of funding to the real estate sector forces builders to resort to the informal markets, where costs are usurious. Reuters

In fact, the corruption factor has become a selling point for builders, while investors justify paying high prices citing corruption. But buying property based on the corruption factor can only lead to disaster.

Corruption actually kills property prices

Corruption has costs and these costs impact property prices adversely. For example, a bank forced to restructure loans to real estate will cut down its exposure to the sector leading to a lack of bank funding to the sector and high cost of loans for consumers.

Lack of funding to the real estate sector forces builders to resort to the informal markets, where costs are usurious. The builder usually cracks when servicing debt becomes unmanageable. The result is half-way constructed buildings or unsold inventory leading to depressed sentiment in the markets.

The high cost of loans for the consumer leads to postponing of genuine purchases leading to demand coming off. The consumer who is aware of unsold inventory will keep away from making purchases on hopes of builders lowering prices down the line. High supply coupled with falling demand leads to prices coming off down the line.

How real estate stock investors react

Equity investors, in comparison, do not factor in corruption when selling real estate stocks when the going gets tough.

Equity investors look at balance sheet strength, growth potential and return on capital; when all three signs show of stress, they sell the stock. The BSE Realty index is down 88 percent from its high of 13,848 hit in January 2008 and is currently trading at around 1,650.

The sharp fall in the value of realty stocks is in stark contrast to property prices either staying high or going higher.

Equity investors are assigning lower property values to builders, while property investors are assigning higher property values to builders.

Property prices usually follow equity prices on the way down as builders cannot get access to equity capital for leverage and with both sources of funding - equity and debt - cut off, builders will have a tough time staying afloat.

Ultimately, market forces win

The market is a great leveller. Equity markets have levelled the highflying ambitions of realty companies, which built up huge expectations of unfettered growth.

Real estate markets will do the same as the patience of investors (whether it is a politician investing in black money or a speculator seeking to make leveraged gains) wears off on the extension of a return horizon. Investments made with a three-year time frame have now been extended to six years.

The time factor brings down returns and with interest rates high in the system, the opportunity cost becomes higher. The market then follows the supply-demand principle: with supply far higher than demand, there is a fall in prices.

Arjun Parthasarathy is the editor of www.investorsareidiots.com,a web site for investors.

Updated Date: Dec 21, 2014 04:45:32 IST