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Is price correction inevitable?

Is price correction inevitable?
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First Published: Wed, Nov 30 2011. 11 15 PM IST

Syamal Banerjee/Mint
Syamal Banerjee/Mint
Updated: Wed, Nov 30 2011. 11 15 PM IST
Classical economic theory states that prices will remain stable when demand is in equilibrium with supply, other things remaining constant. As a corollary, if prices swing either side, demand would shift, other variables remaining the same. Likewise with supply shifts. The residential real estate market in Mumbai is, however, experiencing a curious phenomenon of constant prices despite sharply sloping demand. Consequence: inventory escalation to levels causing concerns of bubble conditions. Of course, there are contrarian views. Developers deny any inventory pile up, pointing instead to a future supply squeeze since approvals have been held up. Some endorse this view in sharp contrast to leading industry veterans expressing serious concerns of anticipated loan defaults given poor demand due to unaffordable prices and high cost of finance. In such a scenario, it beats many how market forces are unable to effect price realignment.
Syamal Banerjee/Mint
Initial advantage causing pricing inflexibility: An industry phenomenon is to channelize initial sales, sometimes in bulk, at a discount to the eventual selling price. This provides the liquidity and opportunity to developers to recoup land cost (or a part of it). While securing the initial advantage, developers remain locked to the committed prices, lest investors lose out. If that were to happen, they would encounter obstacles in tapping this source for subsequent projects. However, this route of financing renders certain inflexibility in pricing if operating conditions turn adverse over the tenor of the project. A developer would need to compensate the investor should the price be lower than that committed. Is that a possible reason for the current price stability?
Piling inventory an escape valve: Inventory in the context of real estate has a different dimension as compared with that in other industries. If all unsold stocks under construction remain as such even after completion, the situation would be serious as that would expose the developer to high inventory risk. In the current situation, most inventories refer to work in progress with perhaps a limited number of finished flats, not counting the stock with investors who are awaiting favourable conditions to wriggle out. Hence, the developer can offload his inventory before project completion. Let’s say the project completion is two years away, so he is left with that much time to complete his sales, assuming he can manage his cash flows to fund the construction. On the other hand, if he is dependent for cash flows from sales, he will be staring at the spectre of slowdown in construction. Developers are holding on to their prices as completion dates are still some time away and they may have lined up their finances. Also, sale agreements are tailored to suit them through clauses that pre-empt any significant monetary penalty for project delays. As a matter of fact, delaying the project may turn out to be a more cost-effective option in the face of an environment that jeopardizes cash flows and is not congenial to continuing construction. Accordingly, industry practices are providing the escape valve and consequently allowing prices to be on hold.
Price reductions not the first option: To combat sluggish conditions in any business, prices are adjusted to woo back customers. Price reductions are rarely the first option. Promotional schemes are employed first. But if consumer resistance persists, price correction becomes inevitable. In the present bearish conditions, developers are offering freebies. If they see serious interest, they are willing to negotiate prices, but no one has announced new price levels. Why? One, backlash from initial investors, referred to earlier. Two, reactions of customers who have been sold at higher prices. Is there a risk of compensating them for the difference in some fashion or the other? Possibly.
A developer must reassess his situation when he sees mounting inventory against the backdrop of declining velocity of sales. If freebies are ineffective, price correction must not be ruled out but after evaluating the impact of stock coverage, if any. Since project duration is typically at least three years, it is vital to put a premium on liquidity to stay in the business. At present, only those developers who have not overleveraged themselves are advantageously placed to exploit the current environment. Some developers are resorting to disposal of land and under-development projects to manage debts.
Living on hope: If that is an option, then why not price correction. As is being reported, developers perhaps have the holding capacity to ward off price cuts in the hope that sooner than later environmental conditions may improve. That is, however, living on hope given the liquidity constraints, steep escalation in finance cost and unaffordable prices making it obvious that the options of relying on surplus asset sales or even stretching their luck by holding the price line may actually be suboptimal and treading on thin ice.
The ground reality: The slowdown and other adverse market conditions clearly point towards price correction. However, residential prices have largely remained steady implying that other factors are having a greater influence on price; for example, the holding capacity of developers. Financial analysis of some leading developers reveals that over the last four years revenues and profits have dropped sharply despite property prices witnessing an increasing trend. Debt and interest outgo have also increased substantially. The ability of companies to service the enhanced debt has deteriorated and is reflected in the debt service coverage ratio (DSCR) declining over the last four years. Lower the interest coverage and the DSCR, the greater is the possibility of default. When declining sales makes it difficult to raise fresh funds to play out the holding strategy, developers may need to alter their mindset to deal with the resultant difficult situation. There is merit in reviving buyer interest and orchestrating demand pull than to invite the domino effect from a price crash, which can occur if some companies break ranks to wriggle out of the squeeze. It must be remembered that prices dropped dramatically during the last cyclical downturn of the 1990s and took several years to revive.
Pranab Datta is vice-chairman and managing director, Knight Frank India.
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First Published: Wed, Nov 30 2011. 11 15 PM IST