Why restrictions on home loans is a good move

The government moves forward on de-risking real estate.

India’s real estate sector, many fear, is unstable. Prices appear to have reached bubble territory; balance sheets look shaky; and large amounts of debt have been taken on, with insufficient amounts of real production to show for them. 

This has worrying systemic implications - a financial system that lends too much to a heavily leveraged sector with minimal regulatory oversight is asking for trouble.

That is why the Reserve Bank of India’s (RBI’s) notification on Tuesday tightening restrictions on home loans is a good idea.

Photographs, courtesy: Oberoi Group

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The RBI told banks that they should not hand out money up front for qualifying home loans; they should only lend in instalments, linking each tranche to the stages of actual construction.

This closes a major loophole being exploited by cash-hungry real estate developers.

Banks, under so-called “20-80” or “25-75” schemes, allowed people buying houses to put in as little as 20 or 25 per cent of the cost of the house up front, and finance the rest themselves.

Real estate developers would incentivise homebuyers by offering to pay any monthly charges till the buyer took possession of the property.

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In effect, once the three-way agreement was signed, the developers would get 80 per cent of the price of a house that they had not yet built - which they frequently treated as working capital for other projects that they were working on.

Worse, this loophole meant the working capital was cheap, too.

It was evaluated at the appropriate interest rate for the individuals with good credit history technically taking out the home loan - and not at the usually higher rate appropriate for the heavily indebted large corporation.

Direct loans to builders carry an interest rate of 12 per cent; to individuals, it is 10 per cent.

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The real estate companies had a two percentage-point advantage right there, even aside from the possibilities for diversion of funds to other projects. Construction costs are between 40 and 50 per cent of total costs for high-end residential projects.

It is clear that this was a recipe for disaster.

It encouraged speculation: individuals would bet that property prices would appreciate while their house was being built, and put down 20 per cent of the total price with the intention of not paying the full amount ever, but of selling the house at a tidy profit once it was built.

It encouraged poor financial practices at real estate companies, which would focus on signing contracts and selling as-yet-unbuilt houses, instead of delivering on the projects already committed.

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And it was a major source of weakness for banks, which were overexposed to projects that might or might not get completed in an inherently uncertain sector. In other words, this is an important step towards de-risking real estate.

The Real Estate (Regulation and Development) Bill, which has been cleared by the Union Cabinet, adds additional measures to reduce risk and exposure in construction.

For example, developers will have to get all the required clearances before making any sales; and 70 per cent of the funds received for any individual project will have to be put in a special bank account to minimise diversion.

The Bill must be passed soon; there is still much to be done to clean up real estate.