Thursday, October 3, 2013

In a notification, banks have been told to watch all loans under “innovative” financing schemes which involve giving builders the full home loan amount even though the builder hasn’t finished construction.

Such schemes are called 80:20 or 75:25, where a buyer puts up 20% to 25% of the full property value upfront, and the banks fund the rest.
The builder, who most likely hasn’t even started building the property yet, gets all the money. He promises to pay the bank the full EMI until construction is complete, in a tri-partite agreement.
However, these schemes are hugely risky.
·       The builder has the full amount, without having constructed anything.
·       They get financing in your name, and get to pay a lower interest because YOU are the one taking the loan (individuals get a lower home loan rate than developers, a distinction I totally disagree with – if anything, individual home loans should be charged a higher rate).
·       If they don’t construct the building, the bank now has no collateral.
·       But since its your loan, you have to repay anyway. This can be a disaster since you don’t have a property now for which you have a loan.

The Realty Ponzi
·       In reality, such innovative financing promotes ponzi schemes.
·       A real estate developer has to only start advertising, and people are ready to pump money in, in the hope of much higher returns.
·       Most “investors” plan to flip even before a single slab is complete.

Assume an investor buys a 2,000 sq. ft. flat at Rs. 4,000 per square foot; instead of Rs. 80 lakh, he pays only Rs. 16 lakh with a bank funding the rest and the builder paying the interest during construction. In a few months, if he sells at Rs. 4,200 per square foot, he makes a profit of Rs. 400,000 (200 rupees per sq. ft) on an investment of Rs. 16 lakhs – a cool 25% return on investment.

·       The ponziness lies in what the developer does with the money. Assume he doesn’t bother to actually build anything. He uses the money received to buy another plot of land, which he then advertises, gets more 80:20 jokers, and does this many times.

How does he pay the interest?

·       The 20% upfront ensures he can easily pay home loan interest rates of 10% a year.
·       On the 80% of the property that is financed, interest works out to 8% of the property value per year.
·       You’ve paid 20% upfront. So technically the builder can last 2.5 years – and if he’s gone the ponzi way, he has cash flow from new investors to pay old ones and so on.
What’s left then is a piece of land on which someone has to build something, but won’t because he has no money left (the money was used to buy other land).
·       Then the blackmailing begins – pay more, or we’ll have to litigate through courts.
·       Banks will harass borrowers because effectively the loan is in the name of the borrower.
·  The borrower, who was either an investor or a homebuyer, has now nothing to show for it.

The other side of the story....! 

  • Developers and bankers who were banking on these schemes would now have to adjust their cash flows. 
  • The scheme was a win-win situation for both developers and buyers as it helped buyers avoid the double burden of rent and EMI by preventing buyers from paying pre-EMI and it helped developers improve their cash flows.
  • Any discounts that we see this festive season will be a function of developers’ need to sail through the current difficult market conditions. With the slightest indication of a recovery in economy, this window of opportunity will close, as has been amply evidenced in the past. 

Moral of the Story ....!

In the short term the move will pinch developers but in the long term it will benefit consumers, banks and developers as speculators would keep away and only actual buyers would come forward.

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