Last Updated on Jul 19, 2023 by Anjali Chourasiya
With a massive population, rapid urbanisation and growing incomes, the demand for housing and commercial spaces in India has soared. Additionally, real estate holds a special place in the hearts of many Indians, and owning property is often seen as a significant milestone and a symbol of stability and success. All of these factors make real estate a popular choice of investment among Indians. In fact, real estate is a preferred mode of savings for 49% of Indian households, much higher than other asset classes such as equity, gold, bank deposits, etc.
When considering real estate investments, one crucial factor to consider is the impact of interest rates. The repo rate, which represents the interest rate at which the RBI lends money to commercial banks, affects the overall cost of borrowing for both individuals and businesses. When the repo rate increases, it can have a direct impact on the borrowing costs of banks. These increased costs are typically passed on to customers, resulting in higher interest rates for loans. Consequently, consumers are discouraged from taking loans such as housing, personal, or auto loans. This tightening of credit availability can have ripple effects across various sectors, including real estate.
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Interest rates and direct real estate investments
Traditionally, many people invest in the real estate sector directly by buying properties to earn rental income or make a profit by selling at a higher price. Theoretically, when interest rates are high, it can become challenging for individuals to buy properties, as they often rely on loans for financing. This can lead to a decline in the demand for real estate, which can put downward pressure on property values because of the mismatch between supply and demand.
On the other hand, borrowing costs become more affordable when interest rates are low, making it easier for individuals to finance property purchases. This stimulates the demand for real estate, driving up property values. Lower interest rates create favourable conditions for individuals to invest in real estate, as they can take advantage of lower borrowing costs and potentially benefit from property value appreciation over time.
We compared the National Housing Price Index (Residex) and the repo rate in India to examine whether the general theory of real estate prices declining during a rising interest rate scenario holds true. Our findings revealed no clear evidence to support this notion.
During the period from June 2013 to December 2014, when interest rates were on the rise, the median quarterly change in property prices was 4.2%. This figure exceeded the long-term median of 2%. This indicates that property prices were increasing despite the increase in interest rates.
Scenario 1 – Housing prices in a rising interest rate scenario
Subsequently, when interest rates were falling between January 2015 and October 2017, the median quarterly price change was just 1.6%. This suggests that during a period of declining interest rates, property prices increased, but the increase was relatively lower.
Scenario 2 – Housing prices in a declining interest rate scenario
Interest rates and REITs
A new way to get exposure to the real estate sector is through REITs or Real Estate Investment Trusts. They are companies that own, operate, or finance real estate properties. They allow individual investors to invest in real estate without personally owning entire properties, similar to mutual funds. By pooling money from multiple investors, REITs generate dividends from rental income and capital appreciation on the stock market.
REITs often rely on debt financing to acquire properties and fund their operations. When interest rates rise, REITs may face higher interest expenses on their debt obligations. This is particularly true if they have existing debt that was raised at lower interest rates in the past and is set to expire or be refinanced in a new, higher interest rate environment.
If REITs refinance their debt, the new debt will likely carry higher interest rates due to the prevailing market conditions. This leads to an increase in interest expenses for the REITs, as they need to pay higher interest payments on the newly issued debt.
At the same time, the impact on revenue can vary depending on several factors. One important factor is the presence of rent escalations in the REITs’ lease agreements. If the REITs have rent escalations in place, they can pass on some of the increased costs to their tenants, leading to higher rental income. For example, in FY 2023, Embassy Park REIT saw a 14% rent escalation which helped to mitigate the impact of high-interest rates.
However, if the pace at which the expenses increase outpaces the increase in revenue, it may result in a decrease in dividends distributed to the investors. This makes the dividends generated by REITs less attractive compared to other investment avenues.
In simple terms, if people are not earning as much income from their REIT investments, they may be less interested in buying or holding onto these investments. This lack of demand can put downward pressure on the shares of REITs.
Interest rates and realty stocks
Another way to get exposure to the real estate market is to buy realty stocks. Realty companies are engaged in buying and selling commercial and residential properties.
They may also finance the purchase of new properties through loans. So whenever the interest rate goes up, it makes the buying cost for new properties expensive. This may increase the operating costs for companies. And since the demand for properties may be low in periods of high-interest rates, the revenue of realty companies also takes a hit.
As a result of poor financial performance or general negative market sentiment, the stocks of realty sector companies may experience a decline in value, particularly for those companies operating in the affordable housing sectors. However, luxury property market companies are less affected by interest rate hikes because wealthy individuals can still afford to purchase properties. Therefore, realty companies operating in the luxury sector may not face the same challenges as their counterparts in other segments.
Interestingly, despite the interest rate hikes in 2022, real estate companies demonstrated robust sales growth. In FY 2023, many of the top 12 listed real estate companies reported significant year-on-year growth of 43% in pre-sales. Furthermore, the first quarter of 2023 witnessed a remarkable surge in housing sales, with over one lakh units (1.14 lakh) sold across the top 7 cities, according to ANAROCK Research. This growth was driven by the demand in mid-range, premium, and luxury housing segments, in which most large real estate companies operate.
Economic growth and interest rates
The global challenges posed by COVID-19 and the Russian-Ukraine war contributed to inflationary conditions worldwide. To counter the same, central banks across the world raised interest rates. Despite the increase in interest rate by 2.5% within one year, housing prices in India have continued to increase by 4.84% between March 2022 and March 2023, as reflected by the National Housing Price Index.
This can be attributed to India’s unique position as one of the fastest-growing economies, with a promising outlook for the future. The Indian government estimated a GDP growth rate of 7% during the fiscal year 2022-23, which is higher than other emerging and developed economies. This robust economic growth has sustained the demand for housing, particularly in segments like mid-range, premium, and luxury housing, leading to the upward trajectory of prices.
The takeaway
It’s important to understand that a multitude of factors influences the performance of the real estate sector, and the interplay between macroeconomic conditions, interest rates, and market conditions can be complex. Investors should carefully evaluate these factors and consider all aspects, including individual risk-return profiles of the asset and the overall economic conditions, before making investment decisions.
Disclaimer: The content in this article is purely the author’s personal opinion and is for informational and educational purposes only. It should not be construed as professional financial advice and nor be construed as an offer to buy/sell or the solicitation of an offer to buy/sell any security or financial products.
The views and opinions stated in the content belong to the author. Windmill Capital Private Limited does not uphold nor promote any of the views/opinions.
The views and opinions stated in the content belong to the author. Windmill Capital Private Limited does not uphold nor promote any of the views / opinions. | Windmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645)
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