Some house truths

Indian Express, 8 June 2007

The government has been making it difficult for foreign capital to flow to real estate companies. The objective is to prevent the real estate bubble from getting bigger. But the correct response to a sharp increase in house prices caused by higher household incomes and rising urban housing demand is to augment supply through greater investment in housing and townships. Measures that reduce the flow of capital and slow down investment in the sector only exacerbate the problem.

Houses do not have a fixed supply. If man-made laws are changed, land is effectively unlimited in supply. Cities can be expanded outwards as well as vertically upwards by changing the regulations governing land use and the floor space index (FSI), the ratio of total floor area of building to the area occupied on the ground. Scarcity of land is only a manmade scarcity caused by the mistakes of governments. But instead of the focus being on augmenting supply, the policy response to rising prices has been to combat demand.

It is often felt that there is not enough land in an overpopulated country. A simple calculation clarifies. Suppose we assume that there are 4 people per household in India, so that a population of 1.08 billion requires 270 million dwellings. Suppose we assume that on average, dwellings are a 1000 square feet (much more than the present). So, a built-up area of 270 billion square feet is required. Suppose the FSI is 1. Then, the built-up area to house all of India works out to 25,092 square km or 0.76 per cent of India.

This calculation is a conservative one at many levels. The average dwelling size is a bit below 1000 square feet and houses a bit more than 4 people. Most importantly, there is no reason for the FSI to be 1. The FSI ranges from 5 to 15 in most Asian cities. If an average FSI of 3 is assumed, then the land area drops to 0.25 per cent. These calculations suggest that the land needed to house India ranges between 0.25 to 1 per cent of Indias area. Shortage of land is clearly not the issue.

The government is attacking the demand side of real estate because it is claimed that speculative activity is the source of a real estate bubble. Prices are too high because too many people think that they will rise in the future and are buying houses. In the process, they are creating excess demand and pushing up prices. It is claimed that this is a bubble because price levels have grown very sharply and should be lower.

And why should the government intervene? Because higher house prices are bad for the aam aadmi, that is those who do not yet possess houses. Now they cannot afford to buy houses. So, it is felt that the government must intervene in the market to ensure affordable houses for all. Since the rise in house prices is seen to be the consequence of demand pressures, the way to control prices is to control demand. If it becomes more difficult and expensive for people to buy houses, they will buy less of them and house prices will go down.

This policy framework has been tried in other countries and failed. So, what is wrong with this recipe?

The first mistake relates to the source of demand. People demand more and bigger houses as they get better off. Fundamentally, demand for housing is a function of rising incomes of households. In a fast growing economy there may be episodes when demand outstrips supply. But in a market in which millions of trades are taking place all over the country, it is not possible for a few speculators to dominate. The millions of households building and buying houses because their incomes are growing are the biggest participants in this market. When there is a sharp rise in incomes, such as in good times as now with a GDP growth of 9 per cent, it is not surprising that demand is growing faster than supply.

House prices can also be brought back to affordability by increasing supply as fast as possible. The correct policy response is for the government to create an environment with a strong supply response to high prices. The demand control policy does not give people more and bigger houses to live in.

Greater investment in housing is the key to increasing the supply of houses. Apartments in high-rise buildings are more affordable than bungalows and constructed more cheaply by builders, rather than individual households. This requires capital upfront. Townships with good infrastructure require capital and professional management teams rooted in corporations, rather than family-style builders. The right policy environment is one which supports participation in the real estate sector by the formal financial sector, venture capital firms, private equity firms, and foreign capital. All these are the channels through which a serious supply response can come about.

There is plenty of labour available for construction activity. Big and small companies are emerging all over the country engaged in real estate projects. So among the four factors of production ? land, labour, capital and entrepreneurship ? the one genuinely limited in supply is capital. The way forward, then, requires the removal of capital controls which hold back debt/equity and FDI/FII flows into real estate.

The basic logic is simple. If car manufacture was restricted by the government, if cars were built in family workshops, then there would be a shortage of cars. If cars are built by professional corporations with access to foreign capital, and if the government does not hinder production of cars, there is no shortage of cars.

Politicians and existing house-owners often do not like supply augmenting policies because that brings down housing prices. No wonder then that the policy measures focused on the real estate sector in recent months have been the exactly wrong response. Then there is a knee-jerk fear of foreigners. Surely we are not afraid that foreigners will run away with the houses they build! In the event of a crisis, they can only sell them cheaply to Indians before they run away.

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