Demonetisation Impact: If Real Estate Prices Fall, Dual Financing Might Be Next Big Headache.

The demonetisation of Rs 500 and Rs 1,000 notes is expected to lead to a fall in real estate prices. I had discussed this point in detail in a column last week by vivek Kaul. 

I think that real estate prices will fall, but I am really not sure whether they will crash. The reason for that is straight forward. Every time in the past, real estate prices have started to slowdown, lending from the banks to the sector has gone up. 

Banks probably fear that the real estate companies will default on their loans, if prices fall. The loans ensure that the real estate companies do not need to cut prices and the real estate bubble continues to stay inflated. My guess is that the public-sector banks are essentially forced to lend to these companies by politicians. 

Hence, my point is that the real estate prices will come down dramatically, if the government wants them to fall. If public sector banks are not forced to lend to these companies, then real estate prices can come down. 

Having said that there is another issue that needs to be discussed here. It's called dual financing and doesn't get discussed much in the media. Let's try and understand this through an example. 

A builder wants to build apartments. He takes a loan from a bank for construction. He offers the project (basically the land) in which the flats are to be built as a collateral to the bank. At the same time, he starts selling flats which are yet to be built to the prospective buyers. 

The genuine buyers take a home loan from the bank and hand over a portion of it to the builder. The buyers offer their flats that will be built as a collateral to the bank from which they are taking on the home loan. 

So, what is happening here? The builder before marketing the project had taken on a loan from the bank against the project. What happens after that? The buyers take on home loans offering the flats that are being built in the project as a collateral. 

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Basically, the same asset has been offered as a collateral twice. This is referred to as dual financing. If the apartment is built and handed over to the prospective buyer, there is no problem at all. Everyone lives happily ever after. 

But if the builder defaults on the loan he had taken from the bank to construct the flats, there is a problem. The project has been offered as a collateral to a bank. The flats on the other hand are collaterals against which buyers have taken home loans from other banks. 

Given that the builder has taken the loan first, the first charge is created in favour of the bank which gave the loan to the builder. A first charge ensures that the loan given by the bank to the builder takes precedence over the home loans that have been taken on against the same collateral. 

The Reserve Bank of India(RBI) has reiterated the same in a letter to the banks dated January 20, 2016, wherein it said: "if builders/promoters fail to repay the loan availed from the bank... the bank would have first charge over the property". 

This basically means that if the bank seizes the flats to sell them to recover its loan in case the builder defaults, there is nothing much that the buyers can do about the same. This is because the bank giving the loan to the builder has the first charge. 

What happens to the buyers? They must fight a legal battle trying to establish their ownership over the flats. Meanwhile, they must continue paying their EMIs on the home loans that they had taken on. If they stop paying their EMIs, their banks will come after their other assets. In India, home loans are recourse i.e. the banks can go after the other assets of the borrower as well, other than the home offered as a collateral, to recover their loan. 

What are the safeguards built into the system to protect the prospective home-buyers? Banks giving loans to builders need to make sure that the builder tells the prospective buyers very clearly that he has already borrowed money against the project. 

In fact, as the RBI Master Circular on Housing Finance for Scheduled Commercial Banks points out: "while granting finance to specific housing / development projects, banks are advised to stipulate as a part of the terms and conditions that:

(a) the builder / developer / company would disclose in the Pamphlets / Brochures etc., the name(s) of the bank(s) to which the property is mortgaged.

(b) the builder / developer / company would append the information relating to mortgage while publishing advertisement of a particular scheme in newspapers / magazines etc.

(c) the builder / developer / company would indicate in their pamphlets / brochures, that they would provide No Objection Certificate (NOC) / permission of the mortgagee bank for sale of flats / property, if required.

(d) Banks are advised to ensure compliance of the above terms and conditions and funds should not be released unless the builder/developer/company fulfils the above requirements." 

What the circular basically says is that the builder taking a loan from the bank needs to tell the buyer buying a flat about the project being mortgaged with the bank. Also, it is the bank's job to ensure that the builder is following this instruction. Further, if the builder does not follow this instruction then the bank should not release funds to him. 

If this regulation was being followed, the borrowers would have known that something called "dual-financing" exists. But most home loan borrowers continue to be unaware about this part of our financial system. As the RBI letter to the banks dated January 20, 2016, cited earlier in this piece points out: "It has been observed on several instances that banks are not insisting builders/promotors who avail the credit facilities for their building projects disclose the details of mortgage/terms and conditions of the bank loan availed by them to the borrowers/potential borrowers purchasing the flats through advertisement/pamphlets." 

The point being that builders are not telling the flat buyers who are taking on home loans, that the project is already mortgaged. If the builder does not reveal these details, it is very difficult for the prospective buyers to go figuring out details on their own. 

The interesting thing is that the RBI does not allow Urban Cooperative Banks to carry out dual financing. As the Master Circular on Housing Finance for Urban Cooperative Banks points out: "Builders/contractors generally require huge funds, take advance payments from the prospective buyers or from those on whose behalf construction is undertaken and, therefore, may not normally require bank finance for the purpose. Any financial assistance extended to them by primary (urban) co-operative banks may result in dual financing. Banks should, therefore, normally refrain from sanctioning loans and advances to this category of borrowers." 

The question is how can one logic apply for Urban Cooperative Banks and not apply for the Scheduled Commercial Banks? This is something that the RBI needs to explain. 

So, the question is why am I discussing this in today's column? The dual financing problem has been around for a while, and did not crop up recently. The answer lies in the fact that dual financing becomes a problem only when the builders default on the loans they have taken from banks. 

The demonetisation of high-denomination notes has led to a lot of talk about real estate prices falling. A major reason for this lies in the fact that people won't be able to put together the black component of the payment, given that the old high-denomination notes are invalid and there aren't enough new ones going around. 

This is likely to lead to lower prices, the experts who follow real estate have been saying. One risk that this runs is that lower prices may lead to builders defaulting on their loans to banks. In this situation, the banks will seize the collateral and want to sell off the flats to recover their money. 

This is likely to lead to problems for those buyers who have taken on home loans to buy these flats. It will also lead to problems for those buyers who haven't taken a home loan to buy these flats. This is one fall out of low real estate prices because of high denomination notes which is possible. 

And if anything like this were to happen in the days, the middle class is likely to get hurt. When the middle class gets hurt, it tends to make a lot of noise. It's extremely possible that such a thing can happen in the time to come. The Modi government needs to be prepared for this because it is important the real estate prices fall, to improve the affordability of real estate in the days to come.