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Assessing the impact of rising interest rates on real estate demand

Would it be different this time?

Two interest rate hikes cycle over the last two decades – demand impact seen post 150bps hike

* Over the last two decades, the industry has experienced two interest rate hike cycles, both before and after the global financial crisis in 2008. (1) Between FY05 and FY08, the Reserve Bank of India (RBI) raised the repo-rate by 300bps to 9% in Jul’08 and (2) between Mar’09 and Mar’11, it was once again increased by 375bps to 8.75%.

* Although we did see an impact on residential demand as depicted in Exhibit 1, the impact was largely visible for rate hikes beyond 150bps.

* We are witnessing a similar trend this time with demand momentum continuing despite a 90bps hike in repo-rate. While the quantum of interest rate hikes from here-on is anybody’s guess but we continue to believe that mortgage rate beyond 8.5% will likely witness some push-out in housing demand.

Previous interest rate cycles were accompanied by sharp price hikes

* Both the previous instances of rate hikes were accompanied by a strong pricing cycle. As per National Housing Board (NHB), housing prices in top cities witnessed a cumulative 70% rise between CY04 and CY07 and the same rose by 25% over CY09-11, adding onto the increased EMI burden owing to rate hikes.

* Despite a sharp recovery in demand over the last two years, prices on a broader market basis has remained flat this time around, thereby limiting the impact on affordability.

* Further, in CY11, when demand declined due to rate hikes, absorption in each cities were average 1.6x higher than previous 12 quarter average suggesting peak of demand

* Currently, except for Mumbai and Pune where absorption were helped by low stamp duty rates, average volumes for other top cities are 1.2x of average volumes prior to Covid pandemic.

Cost inflation and Interest rate hikes to accelerate consolidation

* Market share for top-10 players in volume/value terms increased to 18%/22% in FY22 versus 17%/20% in FY21.

* We expect the market consolidation to accelerate from here on, given the (a) inability of Tier2/3 developers to entirely pass on the commodity inflation and (b) increase in interest cost which is likely to impact the IRR and the viability of the projects.

* As per the scenarios depicted in Exhibit 6-9, the pre-tax IRRs for Tier 1 developers continue to remain at >20%, despite the increase in construction and interest cost; however, it is expected to decline to 12% (from 15% prior to the inflation) for Tier 2/3 developers, which is in-line with the cost of capital, leaving less margin for delays and making the project unviable.

Near-term uncertainty imminent; but impact unlikely to be severe for large developers

* While uncertainty around quantum of interest rate hikes is likely to impact the performance of real estate stocks in the near term, longer-term thesis on revival of housing cycle remains intact. 

* Due to (a) limited impacted on affordability (on account of stagnant prices); (b) overall demand still largely at average pre-covid levels, and (c) acceleration of market consolidation, the demand recovery is likely to remain constrained to not more than 12 months from the day full rate hikes are accounted for.

* Moreover, certain large developers have introduced schemes such as fixed EMIs for two years and deferred payment schemes to mitigate the impact of higher EMI and sustain the demand momentum.

* We continue to prefer players with an ability to generate robust cash flow over next three-four years and invest in developing its pipeline, providing growth visibility.

* Among our four covered stocks, we continue to prefer LODHA (BUY) and OBER (BUY) over DLF (Neutral) and GPL (Neutral).

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