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Real Estate and Interest Rate

, February 14, 2013, 0 Comments

Interest rate is one of the important monetary tools used by the central bank to give direction to the overall economic activity. In India, the RBI uses the Bank Rate, Repo Rate, Reverse Repo Rate and Cash Reserve Ratio (any one or more in combination) to increase or decrease the interest rate and/or Liquidity in the economy.

The Central bank may increase the interest rate when it wants to control the inflationary pressures in the economy. It generally decreases the interest rate when it wants to give a push to the economy in the short run. Lower interest rates will result in higher demand for goods and service and also increased investment in new manufacturing and infrastructure projects thereby giving a fillip to the overall economy.

Impact of changes in interest rate on Real Estate

Real Estate is highly capital intensive. Hence, any change in the interest rate will have direct impact on this sector.  Lest us examine how the key players i.e. the property buyer, the property developer (seller) and the property financier (Banks/Institutions) are affected by changes in interest rate.

Property Buyers/Owners

Cost of Loan
Since Floating Rate Home Loans have become a norm nowadays, change in interest rates directly impacts the cost of borrowing for the property buyer. The interest on floating rate loans is linked to the bench mark lending rate of the bank which is often referred to as the Base Rate or the Prime Lending Rate.  For e.g. the contracted rate for Home Loan from Bank is say 250 basis points below PLR. In this case, if the bank’s PLR is 13%, the effective Home Loan rate would be 10.50 % (13% less 2.50%).  Now, if the bank’s PLR is reduced to 12.50%, the Home Loan rate would also come down to 10% (12.50% less 2.50%). Reduction in interest cost would automatically result in lower EMI as can be seen below.
Thus, it can be seen from above that a 50 basis points reduction in interest rate would result in reduction of Rs. 833 in EMI for a loan amount of Rs. 25 lacs.

Amount of Loan
Another significant impact of change in the EMI as above (due to change in interest) would be on the amount that one can borrow for the property, since the loan eligibility is directly linked to the EMI payment capacity of the borrower as can be  seen below.
As can be seen from above, the loan eligibility has increased from Rs. 25 lacs to Rs. 25.87 lacs due to reduction interest rate by 50 basis points, the EMI remaining same.

Property Prices
Real Estate being highly capital intensive, the interest cost constitutes a signification portion of the total cost of development of property. Hence, technically, any reduction in interest cost should result in reduction of the property price. However, in reality such reduction in cost is seldom passed on to the property buyers. On the contrary, it has been seen that in anticipation of increase in demand for property, due to lower interest rate, the property prices tend to go up.

On Property Developers
As discussed above, any reduction in interest rate results in significant cost saving for the developer which results in increase in profit margin. Hence, it is usually observed that the share prices of Realty companies tend to go up with the news of reduction in interest rate.

On Home Loan providers
Reduction in interest rate results in more demand for home loans due to lower cost and higher eligibility. This leads to increase in the loans portfolio (assets) of the bank resulting in growth in profitability and Balance Sheet size.  Hence, share prices of banks/financial Institutions tend to go up with reduction of interest rate.

Thus it can be seen that lower interest rates create a win-win situation for the property buyers, property developers and property financiers.

About author
Paresh Karia is a Chartered Accountant with an experience of over 15 years in the banking and financial services sector. His past experience includes working with reputed organizations like HDFC Bank, ICICI Bank and ABN Amro Private Banking. ...more