On August 1, 2018, Monetary Policy Committee (MPC) had taken a decision to hike the repo rate for second consecutive time by 0.25 % to 6.5%, retaining the monetary policy stance to ‘neutral’. The move is in congruence with keeping the inflation at the predetermined target rate. Real Estate, like many other sectors is expected to be affected by this ‘macroeconomic’ update.
Given the backdrop, there have been a mixed set of reactions by real estate veterans on how this will affect the market.
Before moving ahead, let’s brush up some theory. One of the sources of borrowing funds for banks is Reserve Bank of India (RBI). The rate at which banks borrow funds from RBI is decided by the repo rate. Moreover, banks act as intermediaries that give out various loans to its customers for financing different activities, home loan being an imperative one. The rate at which banks give loan to its customers is decided by Marginal Cost of Lending Funds (MCLR). MCLR is the internal benchmark lending rate of a bank, below which the bank cannot lend, unless specified by the government. As MCLR is pegged to repo rate, increase in repo rate will result in increase in MCLR, consequently increasing the home loan rate and thus the Equated Monthly Installment (EMI).
In terms of its significance, the raise of 0.25% is fairly marginal which is less likely to affect the organic demand for real estate. In 2014-15, the repo rate touched 8%, gradually falling down to 6% in 2017. Hence, the recent increase to 6.5% is still substantially lower than the 2014-15 levels, which is fairly in line with the overall economic growth of the country. Furthermore, Interest rates are cyclic (as interest rate are closely correlated with the economic cycle) in nature and as home loans are generally long term, the effect of increasing/decreasing interest rate gets netted over the period. However, it needs to be seen how banks will be setting their MCLR with respect to this change. For instance, HDFC has raised it’s lending rate by 0.2%, effective from 1st August, 2018.
Now, let’s explore the possible effect of this move on REITs. Increase in the interest rate may delay the listing of the I-REITs. Consider two asset class, risk free government treasuries and REITs. As we know, high interest rate environment favors investment in bonds and government treasuries, investors may have less inclination towards the REITs, given the comparative risk-adjusted return of these two investments classes. For instance, 364 day T-bills yield 7.21% and the rental yield from commercial building is anywhere between 7-9%. So, investors might be unwilling to take on the extra risk for a marginal increase in the return. However, unlike bonds, REITs provide capital appreciation which can play considerable role in increasing the return further by 3-4%, hence improving the overall attractiveness of I-REITs.
Minor effects can be expected in terms of valuing investment in real estate projects. Discounted Cash Flows (DCF) is generally the preferred method. In DCF, future income is discounted at a rate which depends upon the investor’s required rate of return. These rates are determined by adding risk premium to the risk free return (or interest earned through T-bills). Hence, the discounting rates would be revised.
To conclude, interest rate has been increased keeping in mind the current depreciation of Indian Rupee and the mounting inflation. The step is usually taken for the long term betterment of the economy. Increase in interest rate is expected to affect foreign exchange market and attract foreign investments which would boost the Indian Rupee. As foreign private equity players, pension funds and other financial institutes are already keen on the Indian real estate. The move by MPC is expected to enhance their current investment and interests.
Interest rate and inflation are dynamic in the financial environment of any country. However, real estate gives a substantial advantage in terms of providing hedge against both anticipated and unanticipated inflation. This is supported by the statistical and economic evidence. So, investment in real estate for inflation-hedge and constant stream of cash is expected to remain immortal.