Indian real estate and California forest fires' lessons

India’s real estate sector has been down in the dumps over the last five years. The central government recently announced a Rs 25,000-crore bailout for the sector. The revival of the sector is very important in the broader context of the Indian economy. The history of economic development shows us that the excess workforce in agriculture gradually moves away from the farm when low-skilled jobs are created, primarily in the real estate and the construction sector. This is not happening in India now, as construction of new homes has slowed down big-time. Also, homes that are ready to be sold are not selling.

In this scenario, what will it take to revive the Indian real estate sector? The only way that the sector can see a genuine long-term revival is if home prices go through a major correction. Of course, anyone who works in the real estate industry will tell you that a price correction is not possible, and that the builders have already cut prices by as much as they could, and that any further price cut will be a recipe for disaster for them.

Now, allow me to deviate a little from Indian real estate and talk about fire control policies in the American state of California and the Mexican state of Baja California. The states have very similar vegetation and forests but have different fire control policies. California puts out small fires regularly. Baja California does not. Hence, Baja California experiences lots of small fires. But it does not experience major fires. California, on the other hand, experiences very few small fires, but it does experience big fires.

When the policy is to put out all fires, it leads to a situation wherein the trees age. Old trees are not replaced by new trees. At the same time, dead wood, grass, twigs, dead leaves, etc., keep accumulating. These make for excellent fuel for any fire. Hence, there is combustible material everywhere, and even a single strike of lightening or a cigarette butt can start off a big fire.

As John Mauldin and Jonathan Tepper write in Endgame: “Economies are like forest fires… Avoiding small problems creates greater systemic problems when the brush between the trees builds up.”

The point here being that for any system to emerge stronger in the long term, it needs to go through its fair share of crises in the short term. These crises end up cleaning up the system and, in the process, makes it stronger and more viable.

How’s this linked with Indian real estate? Currently, the sector does not have a problem on the supply front. There is a good supply of unsold homes which people aren’t buying. The problem is basically on the demand front. People are not buying homes sold by builders because of high prices and, at the same time, due to a lack of confidence in their economic future.

The only way for builders to get demand going is to cut prices. This, as builders have been telling us, isn’t a viable proposition for them. The trouble is, as long as they keep holding on to high home prices, the demand will continue to remain subdued.

In that sense, like small forest fires which are not put out in Baja California, some sort of destruction is required in the Indian real estate sector. If home prices go down, a few builders are going to go down as well. Banks and housing finance companies will also get into some trouble. But at lower prices, consumer demand will kick in and the revival of the sector will begin as homes become more affordable.
The trouble is that no one can force the real estate companies to cut prices. This is a decision that they need to make. But from how things are currently, they don’t seem to be in the mood to cut prices.

It’s a mug’s game trying to predict whether builders will cut prices in the future or not. Common sense and some basic economics suggest that they need to do that.

But one thing I can say with a little more surety is that even if Indian real estate does not go through a price correction, it will definitely go through – in fact, it is currently going through -- a time correction. Prices haven’t gone up much, or have perhaps even fallen (on the whole) in the last five years. If you take inflation, the cost of maintenance, taxes and the general risk of owning real estate in India into account, home prices have actually come down in real terms. If there is no price correction, time correction will gradually work its way through and that, like the large forest fires in California, will mean bigger trouble for the sector.