Introduction
Interest rate, especially the repo and reverse repo rate set by the Reserve Bank of India (RBI) have a profound effect on the value of real estate like any other investment vehicle. Because of great influence of the interest rate on an individual’s ability to purchase houses by increasing or decreasing the cost of the total mortgage amount, many people assume that interest is the only factor in real estate valuation. However, this assumption is not true. Interest rate definitely plays a big role in determining the housing prices, but it is not the only factor influencing the price of a house. Interest rate also influences capital flows, demand for capital, supply, and investors’ required rate of returns (Arslan 2014). Interest rate drives property prices in various ways apart from influencing the buyers in making a decision on purchasing a house (Ben David 2013). This essay will discuss how interest rate influences the housing prices from a macro-economic perspective. The essay will specifically take the example of Delhi-NCR housing prices to show the effect of interest rate on real estate price movement.
Theoretical Background
In order to understand how the prime interest rate such as repo and reverse repo influences property values, one should have a basic understanding of the income approach of property values. Although property values are influenced mainly by the supply and demand of property in a region and by the replacement cost of developing new properties, the income approach is the most common technique used by the real estate investors in understanding the movement of housing price in the case of interest rate changes (Ben David 2013).
Supply and Demand situation in Housing Market
Before delving deep into the details of the valuation technique, it is important to understand the dynamics of interest rate versus housing prices. Like any other commodity, house prices also follow a similar supply-demand curve. If the demand of houses in a region goes up, then definitely the housing prices also go up. Similarly, if a lot of houses are available in a particular place for sale, then the housing prices will go down irrespective of the interest rate or other macro-economic factor (Arslan 2014). During the first decade of the 21st century, the Indian property market has witnessed a huge increase in real estate prices. One of the reasons for the sudden escalation of housing prices is the sudden increase in demand for houses in India and this increase in housing demand can be attributed to the high GDP growth rate and substantial rise of income among the middle class section.
Capital Flow
Before entering into the actual discussion on valuation, another factor to be taken into account is the availability of capital. During the first decade of the 21st century, due to the boom of information technology, a huge number of people started going abroad and earning money in foreign currencies. Most of these individuals started using the foreign earnings to invest after purchasing houses. This not only increased the housing demand, but also increased the capital flow in the real estate market, which was also a major factor for the mercurial rise in the housing prices during the initial 10 years of the 21st century (Arslan 2014).
Valuation Model
In simple terms, housing valuation starts with forecasting the income from property that can take the form of lease payment for rented properties, selling price for individual houses and apartments, and the occupancy rate in hotels. In valuation terms, these are known as cash inflows. Often, cash inflows start happening many years after the actual cash outflow. Cash outflow consists of cost of material, licensing cost, cost of land, and financing cost. Inflation also negatively impacts the cost inflow and outflow (Arslan 2014). Housing prices in a perfect market are determined by taking into account the cash inflow and outflow.
It is now important to understand how the interest rate plays a role in the whole valuation process of houses. Firstly, it is important to take into account the aspect of cash outflow in housing valuation. Buyers acquire the affordability to buy a house if the interest rate in the market is low (Arslan 2014). As the interest rate goes down, an increased number of buyers can afford to buy houses. Similarly, in the case of interest rate going up, the number of buyers willing to buy houses will decrease. Therefore, interest rate is negatively correlated to the housing demand, and housing demand is positively correlated to housing prices (Arslan 2014). Based on this parameter, it can be concluded that interest rate is negatively correlated to the housing prices.
The influence of the interest rate on cash inflow is not that simple. It influences the cash inflow in multiple ways. Suppose if the interest rate goes up, then the cost of financing for the real estate companies will also go up. This indicates that the real estate companies will be able to build fewer housing units given the fixed amount of capital, because they will have to pay more interest on housing construction project loans (Arslan 2014). Therefore, as the supply of the number of houses goes down, the price of houses goes up. On the other hand, an increased interest rate is often used by RBI to keep inflation and money supply under check. Often while increasing the repo and reverse repo rate, RBI forces the banks to increase the capital reserve ratio (CRR). An increased CRR means less amount of money supply in the system that leads to reduced inflation (Arslan 2014). Inflation often may not have an immediate impact on the real estate price, but in the medium and long term, it definitely moderates the property values. Therefore, it can be seen that increasing interest rate makes different types of influence on the cash inflow side of the real estate market.
Foreign Influence on Housing Price and Interest rate
Foreign direct investment (FDI) and investment in foreign currencies also have an impact on the housing prices. 20 years back, when India was not open to the global market, the flow of FDI and investment in foreign currencies was minimal and therefore, they had no influence whatsoever on the housing prices. However, from 2000 onwards, the capital inflow of foreign currencies has increased significantly. Real estate investors can now avail loans even from foreign banks whose interest rates are not tied to RBI governed repo and reverse repo rate. Also, foreign buyers (mostly non-residential Indians) who buy houses in the Indian market are influenced by the exchange rate rather than the interest rate existing in India. Hence, in recent years, owing to the increased number of foreign buyers, the positive correlation between interest rate and housing prices has reduced considerably.
Historical Correlation between Interest Rate and Housing Prices in Delhi
Period between 2001 and 2008
Figure 1: Changes in Repo and Reverse Repo Rate (“Key rates” 2015)
Housing loan rate is highly dependent on the repo rate and reverse repo rate set by the RBI. Repo rate was a paltry 2-3% before the turn of the century. However, since 2000, the RBI has consistently increased the repo rate from about 4% in 2003 to almost 9% in 2008 (“Key rates” 2015). Between 2008 and 2010, the repo rate has again decreased from 9% to 4.5% within a year, but from 2010 onwards, the RBI is slowly increasing the repo rate again. The repo rate has increased to 8.5% in 2012 and is currently set at 7.5% (“Key rates” 2015).
Figure: Housing Price Movement for Indian Cities (“City Wise Housing Price Index” 2013)
It is now time to take a look at the housing price movement of the Delhi region in the last 10-15 years. Between 2001 and 2008 when the whole of India was going through a major housing boom, Delhi witnessed the maximum appreciation in housing prices among all the metro cities. If 100 is assumed as the base price for 2001 for all the metro cities, then almost all the metro regions witnessed about 200% increase in housing value during the next seven years till 2008. The housing prices in Bangalore went up by 238%, Mumbai by 314%, Kolkata by 332%, and Chennai by 301% (“Key rates” 2015). However, Delhi witnessed the maximum hike in housing price during this period when the overall housing price went up by 387%. Any buyer who bought an apartment worth Rs. 50 lacs in 2001 was easily able to sell that house in 2008 at a price more than Rs. 1.80 crore (“City Wise Housing Price Index” 2013). Hence, it can be seen that with the increase of repo rate between 2001 and 2008, the housing prices increased consistently. Therefore, it can be concluded that there existed a strong positive correlation between housing prices and interest rate in Delhi and the whole of India during that time.
2008- 2009 Period (Brief period of recession)
Figure: Housing Price Movement between 2007- 2012 (“City Wise Housing Price Index” 2013)
In 2009, the RBI consistently reduced the repo rate to keep the economy safe from the effects of global subprime recession that took the world by storm. However, in this one year, almost all the Indian metro cities, with the exception of Mumbai and Kolkata, either experienced stagnation in the housing prices or experienced a decline. Mumbai witnessed an increase of 15% in 2009 while Kolkata experienced a hike of 25% in the housing prices. On the other hand, other cities such as Hyderabad, Bangalore, and Chennai witnessed a decline in the housing prices. During this one year, Delhi also experienced a 15% decrease in the housing prices. Therefore, in 2008 and 2009 also, the Delhi region showed a positive correlation to the interest rate fluctuation.
Period from 2010 to till date
Figure: Housing Price Movement between 2008- 2014 (“Indian House Prices are falling” 2014)
Since 2010, Delhi housing prices have gone up by a small amount. Between 2009 and 2013, the repo rate has increased from 4.5% to 8%. During this period, Delhi witnessed a small average increase in the housing prices by 20% (“Indian House Prices are falling” 2014). Although still the positive correlation between the interest rate and housing prices was noticeable in the Delhi region, the degree of positive correlation decreased significantly during this time. This may be attributed to other macro-economic factors such as the high inflation rate and decrease in the GDP growth rate. Between 2013 and 2015, the RBI has changed the repo rate several times, sometimes increasing it and sometimes decreasing it. Astonishingly, during this time, Delhi, specifically the Delhi-NCR region witnessed a fluctuating demand of houses, which made the housing market volatile (“Indian House Prices are falling” 2014). Delhi continues to follow the repo rate closely by changing the housing prices. Many critics may argue that this trend is not unique to Delhi and can be found in other metro cities of India. However, this assumption is not true, because cities such as Mumbai, Pune, Chennai, and Kolkata have witnessed a consistent growth in the housing prices regardless of the repo rate fluctuations. It seems that Delhi is the only city to have a high positive correlation between the interest rate and housing prices. The only other city coming close to this trend experienced by Delhi is Bangalore.
Reasons for Positive Correlation between Housing Prices and Interest Rate
There are several reasons contributing to the positive correlation between the prime interest rate and housing prices in Delhi-NCR. Firstly, the reason behind the RBI to increase the repo rate during the first few years of the 21st century needs to be understood. The RBI noticed a huge growth taking place in the Indian market during the first 8 years of the 21st century. Suddenly, the middle class section of India had a lot of money available as disposable income. This increased the demand for houses exponentially in the Indian market. However, the housing industry was not ready to fulfill the market demands. Therefore, in order to reduce the demand, the RBI continuously increased the repo rate to force the interest rate on housing loan to go up. Here, the RBI acted as a moderator to attenuate the exponential demand. Hence, it can be stated that the interest rate is not the primary driver to escalate the housing prices. The economic growth in India during that period is the primary contributor to the escalation of the housing prices. As the interest rate followed the growth rate, apparently it may seem that the interest rate influenced the housing prices, but in reality, it played a secondary role. In subsequent years, the RBI repo rate changes echoed the economic situation of the country. Therefore, the positive correlation between the interest rate and housing prices can be witnessed in the later years as well.
Results and Limitations
It is discussed in details in the above paragraphs about the positive correlation between housing price in Delhi and prime interest rate. Let’s now look at the mathematical correlation between the two. Data for repo rate (average for the year) and housing price rates (average increase for the year) for the years 2001 till 2014 are used for the regression analysis.
The above graph shows how housing prices varied with varying interest rates. As assumed previously, the graph also suggests positive correlation. Only in last 2 years, it seems that interest rate and housing price movements were loosely correlated. Housing prices kept rising even through the interest rates remained constant.
As can be seen in the scatter plot above that there is a distinct positive correlation between the two variables. The trend line in the graph is upward sloping which indicates positive correlation.
The main limitation of this analysis is non-consideration of other macroeconomic factors. During the period 2001 and 2013, interest rate was not the only factor which was influencing the housing prices. It may so happen that the housing price movement was getting influenced by some other factors and that factor also was influencing the interest rates (Iossifov, Plamen and Amar 2008). To overcome that limitations, a more comprehensive study should be conducted with all macroeconomic parameters included in the analysis. Then it will be possible to predict with more accuracy if interest rate is really influencing the housing prices in Delhi.
Current Scenario in Delhi-NCR
Value of Properties
Figure: Skewness in property values in Delhi-NCR Region (“City Wise Housing Price Index” 2013)
Presently, the Delhi-NCR region has more residential properties than any other metro city except Mumbai. In fact, the Delhi-NCR region has two times more new residential properties available than Bangalore, which comes a distant second. Mumbai continues to lead the pack with the highest number of properties as well as high value properties. The Delhi-NCR region, on the other hand, has more new properties between Rs. 25 lacs and 1 crore than Bangalore, Chennai, and Kolkata put together (“City Wise Housing Price Index” 2013). The housing interest rate in recent years has not come down. The repo rate is also hovering around 8% for the last 2 years. Although the repo rate and the Delhi-NCR housing market have demonstrated a remarkable correlation till date, that can, however, end sooner.
Dependence on two industries
Figure: Supply and Demand of Residential Properties in Delhi NCR Region (“Emerging corridors of Delhi NCR” 2014)
The two major industries occupying the Delhi-NCR apartments as office space are Information Technology (IT) and Information Technology Solutions and Consulting. Both the industries are stagnant in terms of growth in Delhi-NCR. IT is witnessing growth in some other metro cities such as Bangalore, Ahmedabad, Pune, and Chennai, while Consulting is seeing a period of growth in Mumbai. The vacancy rate in the Delhi-NCR region has been hovering around over 30% in the last 3 years (“Emerging corridors of Delhi NCR” 2014). Unlike other metro cities, Delhi-NCR is seeing stagnation in the residential market. Noida and Greater Noida are showing some level of increase in housing demands and it is the only place in the Delhi-NCR region to witness growth in the housing market.
Decrease in Demand (Buyer’s Market)
In the January-March quarter of 2015, the Delhi-NCR region witnessed a 50% decline in the residential property sales. In 2014, the property prices also fell by 25% in the region (Chadha 2015). It is also expected that an additional 15% drop in housing demand will take place in the next few months (Chadha 2015). For the first time in the last 15 years, the Delhi-NCR region may be witnessing a decrease in housing price irrespective of interest rate changes, because of a huge availability of housing units. The number of residential units sold during the first quarter of 2013 was more than 26,000, while the same number reduced to only 5,700 units during the first quarter of 2015. Almost 170,000 units are unsold in the Delhi-NCR region (Chadha 2015). Although Delhi and the Delhi-NCR region have shown a positive correlation to the interest rate changes, that will not happen in the near future owing to huge supply of housing units versus lukewarm demand. The Delhi-NCR housing market, which was the investors’ market for a long time, is slowly turning into a buyer’s market.
Conclusion
Interest rate influences the housing prices in a variety of manners. Interest rate is usually negatively correlated to the housing demands, whereas it is positively correlated to the supply side. Therefore, it is not always easy to figure out the exact effect of interest rate on the housing prices. In the case of Delhi in the last 15 years, the Indian prime interest rate showed a remarkable positive correlation to the housing prices. However, other Indian cities showed a deviation from the trend of Delhi. The prime interest rates changes by the RBI were triggered by the economic growth indicators. Often the repo rate was increased to soften the exponential demand for houses between 2001 and 2008 and the same was decreased to increase the flow of money supply in the system in 2008 to save the Indian economy from the effects of global recession. Therefore, it can be stated that the interest rate is not the primary factor to influence the housing prices. The interest rate is probably an indicator of the economic condition of the country and plays a secondary role to influence the housing prices. This kind of correlation can be found in the investors’ market. The Delhi-NCR region is entering a buyer’s market because of its huge inventory of unsold residential properties. As and when the Delhi-NCR region turns into a buyer’s market, its correlation to the interest will completely evaporate.
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