There are several different ways of understanding the concept of inflation. One way to explain it that most of us can relate to is the behavior of spectators of a cricket match in a stadium. On seeing some interesting action on the field, the people in the front row rise to their feet to get a better view of the ground. Now the people in the rows behind them are obstructed, so they rise to their feet as well. This behavior then transfers itself to everyone present in the stadium and soon enough, everyone is standing.
In simple terms, this is how inflation works. The increase in price of one commodity leads to a price rise of a supplementing product, and soon enough inflation spreads uniformly throughout the economy. Many believe that this dynamic is also applicable to the rise of property prices. However, this is quite incorrect. A proper analysis will reveal that inflation does not quite impact real estate prices in this manner.
Inflation, as put forth by economists, is a global phenomenon that is largely governed by the cost of credit. While the prices of essential items like food grains or fuel rise, the income of the common man remains at the same level. In economic terms, the consumer’s disposable income or spending power decreases. Banks in turn witness that the basic cost of living has increased and work on recalibrating their loan interest rates higher.
This brings us to how both consumers and developers are dependent on the cost of borrowing (the interest rate on loans). Since interest rates have risen, the common man becomes more averse to any kind of debt, which includes applying for a home loan. Consequently, some real estate developers fear a severe business slowdown and may resort to lowering their property prices so as to revive buying sentiment.
This dynamic is often seen among smaller developers with a limited number of projects, especially players operating in Tier 2 and Tier 3 cities where demand is not high at most given times. In such cities, the reduction in property prices as a reaction to inflation can be viewed as a method of survival.
A justifiable question here would be how such developers are able to reduce their property rates when inflationary pressures decrease demand. The answer is that land acquisition and property development costs in smaller cities remain more or less constant and increase only a little bit over a long lengths of time. Price reduction is indeed the last resort, but also the only option left with these developers.
In case reduction in property prices fails to attract buyers, such developers will ultimately be forced to surrender their project (and other assets) to the bank and declare bankruptcy. In many cases, they would sell their buildings and land parcels to bigger, more established developers with better capitalization. This is how consolidation takes place, wherein the bigger players are always winning.
For bigger developers the other hand, the scenario is quite different. Since they have been in the business for quite a long period of time, they have been able to create a good saturation of assets and achieve higher degrees of capitalization. This works in their favour in situations where debt funding becomes more expensive, such as unrelenting inflation. Their investments are primarily in larger projects and despite the rising borrowing rates, these property prices remain the same. What keeps them afloat is their capital.
This is why bigger developers do not resort to cost reduction even when buying seems to slow down because of inflation. However, it is also true that they do not have the option to raise their property prices either, since this would only help competing developers to attract buyers away from them.
In other words, for real estate projects by large developers in quality locations, inflation with only keep the property prices static before they moves up again, following the natural course of economy. For prospective home buyers, understanding these exact ways of how inflation can affect property prices in different localities can be an important financial consideration.
Authored by Arvind Jain, Managing Director – Pride Group
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