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Friday, 25 March 2022
easynomics
A newsletter that demystifies complex economic jargon and explains how it impacts your everyday life
By Vivek Kaul

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How real estate speculators are leaving Indians homeless

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I noticed two things last week after many years.

The first was a song infused with a strong Goan melody. Jolly O Gymkhana is a song from the Tamil movie Beast, starring the actors Vijay and Pooja Hegde. It was composed by Anirudh Ravichander, written by Ku Karthik and sung by Vijay. I can’t tell you how much fun I have had playing this song on loop since it was released on 19 March.

     

The second thing I noticed was the return of real estate advertisements egging people to invest in real estate. While the real estate sector has been down in the dumps at least since 2015, the big real estate companies never stopped advertising. It’s just that the word invest wasn’t used in those advertisements.

There could be multiple reasons for the word invest making a comeback. The upper-middle class and the rich, whom most big real estate companies target, have had a few good years on the money front. They have largely been stuck at home due to the spread of the covid pandemic.

This has led to fewer opportunities to spend money and thus led to higher savings. Also, stock prices have rallied and helped those who already had invested in stocks the most, which means the rich have become richer.

So, there is a lot of money going around. At the same time interest rates on fixed deposits continue to be lower than the inflation rate. In this scenario, the story of investing in real estate is a tellable story and is being told all over again. I would request you to hold this thought till we come back to it later in the newsletter.

Regular readers know what I think about owning residential real estate as an investment, so I won’t go down that road again, but I will try and make a slightly different point in this newsletter. Nonetheless, before I do that, we need to take a slight detour as usual.

Chicago in the nineteenth century

In the 19th century Chicago became the foodgrain capital of the US and North America. As Rupert Russell writes in Price Wars—How Chaotic Markets Are Creating a Chaotic World: “Farmers would arrive in Chicago at the same time with their freshly harvested wheat. Supply soared, prices plummeted, and farmers ended up dumping their worthless grain into Lake Michigan.”

Futures contracts were invented to get around this problem. This allowed farmers to sell their future crops in advance at a fixed price to buyers like hotels or bakeries. The wheat had to be delivered by a certain date in the future.

The trouble was that enough genuine buyers who had some use for the wheat they bought weren’t around throughout the year. To get around this problem, Russell writes: “private investors—later called ‘speculators’—were invited into the market to make sure that somebody would always be available to buy the farmer’s contracts.”

The speculators would guarantee a price. The farmers would then use this guarantee to get a bank loan to be able to finance the wheat crop. At the same time, “the speculators were given a small discount to compensate them for the risk they were taking, called the risk premium”.

This sounded fair given that the speculators helped take the risk of future price uncertainty for the farmer out of the equation. Nonetheless, what happened was that over time, the paper market for wheat became bigger than the physical market.

As Russell writes: “In 1875, the Chicago Tribune estimated that the physical market was $200 million, but the paper market was 10 times greater at $2 billion. Rather than just taking the risk premium, speculators were making large bets on their future prices.”

This essentially ensured that the price of wheat was split into two, “one price was rooted in the real world, the other in finance”. In that sense, speculators could drive the price up even if the demand-supply dynamics of wheat and other traded commodities hadn’t changed.

This was seen post-2008. In the aftermath of Lehman Brothers going bust and other large financial institutions having to be rescued by central banks and governments, the rich world’s central banks decided to print a lot of money to drive down interest rates and encourage private consumption. This was done in the hope of preventing an economic depression.

Once money printing started, the general belief seemed to be that high inflation was on its way as more money would chase the same amount of goods and services and, in the process, drive up prices.

At this point in time, a lot of money found its way into gold and commodities to hedge against the possibility of the coming high inflation. Of course, most speculators were not buying and storing physical commodities; they were simply buying futures contracts.

As Russell writes: “This is what financialization means. It means that the prices of commodities enter into a constellation of financial prices. They are unmoored from physical reality. Prices become disconnected from very real fluctuations in the real world—the weather, wars, new technologies.”

This speculative demand ultimately led to food prices going up dramatically. As Russell writes: “Between 2005 and 2008, global food prices had risen by 83 per cent as the price of wheat more than doubled. As the prices surged, over 155 million people were pushed into poverty and 80 million into hunger in 2008 alone. Riots broke out in forty-eight countries.”

All this happened primarily because of the financialization of commodities. They had also become an investment and the speculative demand that came along drove their price up. This, in turn, created a problem for many people for whom food was just food, something they ate and not traded.

What does this mean in the context of Indian residential real estate?

The price of residential real estate in India, like agri-commodities in the US and other parts of the world, has “one price… rooted in the real world, the other in finance”. The demand for residential real estate doesn’t just come from those who want a home to live in but also from those who don’t really know what to do with all the money they have and, in the process, become buyers of residential real estate, buying more homes than they need to live.

The so-called real estate investors hurt those who want a home to live in two ways. First, they add to the demand for residential real estate and drive up the prices in the process. The real estate companies aren’t really bothered about the end-use. They just want to sell. This price rise makes homes expensive or even unaffordable for those who genuinely need them.

Second, many real estate investors keep their homes locked and don’t like to get involved with the hassle of renting them out. This, of course, makes getting rental accommodation difficult. Of course, rental yield (annual rent divided by market price of the house) continues to largely remain around 2% across large parts of the country. This tells us that house prices remain high for those who want a home to live in them.

What can be done about this?

You can’t stop people from buying residential real estate even if they don’t need it. You can’t also force people to rent out something they have bought. If they want to keep it locked, that’s their choice.

Also, owning more than one home helps people convey a certain status in society, something money in the bank or investment in stocks or mutual funds cannot convey.

There is no way to tackle the points raised above. But nonetheless, this doesn’t mean the situation is hopeless.

Up until a few years back, the income tax law essentially encouraged people to speculate in real estate. The interest paid on a second, third, fourth…nth home loan was totally deductible against taxable income, as long as a notional rent was taken into account as income. This worked out beautifully for many in the middle and top-echelons of corporate management.

Interest rates on home loans were close to 10%, and rental yield was 2%. This helped people come up with a huge income tax deductible, report a lower taxable income, and, in the process, pay a lower income tax than they would have if they hadn’t bought a house as an investment. At the same time, they ended up owning another asset.

Thankfully, this loophole was closed a few years back. These days the interest paid on a single home loan or multiple home loans that can be deducted against taxable income is limited to Rs 2 lakh.

This has been one of the minor reasons over the last few years in ensuring that residential estate prices have been largely flat or gone up at extremely slow rates.

There is another thing that the government can do on the tax front. When a house is sold, the income tax law allows the seller to take indexation into account. Indexation essentially allows the seller to take inflation into account while calculating the cost of acquisition of the house and, in the process, the capital gains on which the tax has to be paid. Hence, this helps the seller report lower capital gains and pay a lower income tax when selling a house than would be the case with indexation.

I don’t see any reason why this facility should be available to a real estate investor who has bought and then sold a house as an investment. A house that is bought and then locked up is just a huge wastage of financial capital, and the government shouldn’t be encouraging this in any way. Given this, while calculating the capital gains, the indexation facility should be available only once in the life time of an individual. Once that facility has been availed, the tax laws should not allow it to be availed again. Also, this facility should be available only to individuals.

The non-availability of indexation while paying taxes on capital gains made by selling real estate will push down overall returns, discouraging people from buying homes as an investment.

The government’s aim should be to encourage home buying for living and not for speculation. While some speculation is necessary for the system to work, it shouldn’t be encouraged like it has been until now.

Of course, just this won’t bring down real estate prices to affordable levels; that would need a massive cleaning up of the black economy and political funding at the level of states. And that is easier said than done.

     

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Written by Vivek Kaul. Edited by Saikat Chatterjee. Produced by Nirmalya Dutta. Send in your feedback to newsletters@livemint.com.

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