Real Estate : Derivatives is the way to go

 

 

Real Estate : Derivatives is the way to go

 

 

Vanilla products can take real estate achieve a limited target. As asset markets mature, one needs to look for product-innovation to deepen the market as well as to address the evolving need of new kinds of customers

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Real Estate business today is in a complex situation.

• High Capital requirement. High interest rates….and yet few lenders
• Higher land valuations. Rising constructions costs…and still marginal increase in finished good prices.    
• Large tax for exchequer. Huge employment for society….. but…thin profits for the sector

 

How does one approach a complex situation as this ?

 

L’Hospital rule ( or Bernoulli’s rule) in Calculus says that when computing limits of a complex function is not possible through normal means, its derivative may provide the answer.

 

And to me this 17^th century rule could provide the clue to real estate. 

 

But before that why is it so critical to have a healthy real estate sector ? One, of course, because of the employment potential but more importantly because there is growing need of a larger section of society to diversify their asset allocation to include real estate. In fact, it is this need that has led to large appreciation in land prices in many parts of India like Hyderabad, Ahmedabad, Indore etc. and that has happened at a time when apartment prices have only increased marginally across India. The recent rise in demand for residential plots is largely driven by the need for having real estate as part of investment portfolio.  However, there is only a limited amount of land that can be brought in as an investible asset.  Further large capital of the nation blocked in idle urban land is not a healthy sign.  The need of the moment to make available large investment opportunities in the constructed space that generates business activity and also fair returns to all stakeholders. The solution lies in shifting focus from vanilla real estate products to derivatives.

 

 

1. Call option

 

One of the solution to raising early stage money for developers lies in introduction of  call option. In a call option the purchaser and the seller (developer), during early stage of construction, would agree on a fixed price at which the purchaser will have the option to buy ( or call )  the apartment when ready. Towards this,  the purchaser pays a risk premium of  5/10/20% of the strike amount.

 

If the purchaser decides to take delivery of the apartment when ready, he pays the balance 80/90/95 % money. If he does not, he losses the risk premium.

 

The advantage to the developer is that since the risk premium is a non-refundable money, the same becomes developer’s equity which would help him raise debt from banks. The purchaser would typically be HNI investor who would invest in risk premiums across multiple projects . He would multiply his money in some and lose his money in others. The home buyer can avoid taking any risk and pay money only  the apartment is ready - whether to the developer or to the HNI investor. Govt too benefits through GST on the risk premium.

 

 

 2. Introduction of NFTs (Non Fungible Tokens) 

 

The record of ownership of housing units is today kept by the Registrar of Land Records and/or  the relevant home owners association. If these records of a particular building are transferred onto a blockchain and made into NFTs where each token represents a specific apartment then not only it will ease up the transfer, mortgage, liquidity, title certification and record keeping in real estate but also open up huge market for fractional ownership of real estate through creation of derivative NFTs that represent fractional ownership in any apartment/office unit etc. For rented office complexes, it could be an alternative REIT product at low costs.

 

 

3. Limited period long lease transactions

 

There are many retirees who do not need the apartment for their kids (either they don’t have kids or kids are abroad). There are others who cannot afford to invest large sums in apartment. For all such home seekers, developers  can enter into a long but fixed period lease or a lease for the entire duration home seeker and spouse’s lifetime. After they pass away, the apartment comes back to the developer, which the developer can sell/lease at the price in future. 

 

The home seeker saves on purchase cost. And the developer – if it is a rental building - can use the receipts from long lease as his equity capital and thus raise debt more cheaply. If a building comprises of ownership apartments, then this transaction would help the developer in deferring his income tax liabilities.

 

All the above derivative products will require minor modifications in legislation. However, since all of them work towards making real estate markets deeper and more efficient, there is a good case for such modifications.

 

World over, in most assets classes  (bonds, equities, commodities, currencies etc.), the derivative market is far bigger than those for the underlying product. May be time to bring in differentiation in real estate from its current bouquet of vanilla products.

 

After all in calculus, what is differentiation ? Nothing but a synonym for derivative. 

 

 

 

 

-       - Deepesh Salgia