The Housing Opportunity in India

It’s a well-established fact in modern economics that homeownership is a big driver of economic activity. Homeownership is directly correlated to several factors including, but not limited to purchasing power or affordability, employment, availability of mortgages, interest rates on mortgages, physical and social infrastructure, taxation and property rights etc.

Housing in major Indian cities has traditionally been unaffordable for the average middle-class buyer. In the past, housing demand was concentrated in city centers due to limited physical infrastructure that resulted in long commute times from peripheral areas. Social infrastructure such as schools and hospitals were limited in both quantity and quality and as a result, those who chose to live in peripheral areas had a much lower quality of life than their peers who lived inside cities.

The trifecta of dysfunctional capital markets, illicit cash in the economy and high interest rates on mortgages played their role in making housing further inaccessible and unaffordable for the average buyer. Dysfunctional capital markets resulted in concentration of capital and a tendency among homebuilders with access to capital to hoard land. This was further accentuated by illicit cash in the economy which fueled purchases of land as a store of value. High headline inflation of between 4% to 6% resulted in high nominal mortgage rates of between 8% and 10% for mortgages that extended for a maximum duration of 15 years. This made it difficult for an average home buyer to make monthly mortgage payments for homes with the needed standard of living.

The entire housing and real estate industry in India was therefore an overleveraged, capital appreciation game where lenders, developers, wealthy buyers and so-called investors were all in a nexus of convenience to the detriment and exclusion of the average homebuyer. It is no wonder then, that according to a KPMG-NAREDCO study, India has an urban housing shortage of 18 million units while tens of thousands of completed homes remain unsold in major Indian cities.

The scenario has changed materially in India in the past few years. Urban infrastructure, though far below what would be desirable, has improved steadily with the construction of metro rail systems, rapid bus transit systems, bypass roads, ring-roads and in-city overpasses. Significant investments have been made in expansion of water, sewage and waste management infrastructure. Social infrastructure like schools and hospitals has improved in both quality and quantity. As a result, the quality of life in peripheral areas of cities has improved.

The curbing of illicit cash in the economy has had a deflationary impact on the real estate sector. Land as a store of value has been steadily losing sheen and capital allocated to the real estate sector has been moving to productive and yield generating assets like offices, warehouses and housing. This has upset the erstwhile capital appreciation business model of real estate developers. Equity in a real estate project is less valuable than before and only marginally more remunerative than high cost debt. This has disincentivized overleveraging by developers. Real Estate development is gradually becoming a volume throughput game. Developers who can efficiently utilize capital and deliver value are able to scale rapidly with external capital (equity and debt) and in the process are able to earn high returns on their own capital.

The government’s thrust on housing for all through the PMAY scheme has been a game changer for homeownership. Under this scheme, housing loans under LIG (Low income group), for homes below 650 sq. ft. in size and for loans below USD 8,700 in value, receive a 6.5% interest subsidy per year. Housing loans under MIG-1 (Middle income group), for homes below 1,725 sq. ft. in size and for loans below USD 13,000 in value, receive a 4.0% interest subsidy per year. Housing loans under MIG-2, for homes below 2,150 sq. ft. in size and for loans below USD 17,400 in value, receive a 3.0% interest subsidy per year. With unsubsidized mortgage rates on 15-year loans at 8.5%, the interest subsidy under the PMAY scheme has had a catalytic impact on housing demand.

The Real Estate Regulation Act (RERA), the Goods & Services Tax (GST) and the Insolvency & Bankruptcy Code (IBC) have empowered home buyers of under-construction properties and have caused weaker developers to close shop. This has expanded the market opportunity for strong and scrupulous developers. With reforms in place and a reset from the sins of the past, housing is likely to be a big driver of economic growth in India and it presents a large opportunity for allocators of capital looking to invest in India.

The Opportunity in Indian Government Owned Banks

In my 20 years of investing I have learned that calling the bottom of anything is fraught with
danger. I am still going to go ahead and call a multi-decade bottom in India’s government owned
banks. Indian government owned banks remind me of where Indian government owned oil
marketing companies were in August 2013 except that the banks are even more depressed. In
August 2013, the dollar rupee exchange rate peaked at 69.00, oil peaked at USD 108 per barrel
and the government of the day refused to let oil marketing companies raise retail fuel prices. It
seemed then like the ventilator had been switched off on a critically ill ICU patient. Hindustan
Petroleum Corporation bottomed at INR 37 per share in August 2013 and today trades at INR
380 per share. The opportunity to make ten times one’s money in 4 ½ years in a plain vanilla
business like oil refining and marketing is possible only when one has the courage to invest
during times of extreme stress.

The narrative that has permeated the Indian financial sector over the last decade is that private
sector banks are good and that government owned banks are bad. That private sector banks
possess almost invincible superhero lending powers and that government owned banks are
dishonest, lethargic and incompetent. The story that has driven the valuation of private sector
banks through the roof and depressed the valuation of government banks is that private sector
banks are better in all aspects and that they will take market-share away from government owned
banks making them disappear into oblivion. The examples that are usually cited are those of
private telecom operators eating the lunch of government owned operators BSNL and MTNL
and private airlines taking away market share from Air India. While it is true that private sector
banks have been growing and gaining market share and government owned banks have been
losing market share, the above narrative and comparisons are completely false. Banking is a very
different business from telecom and airlines and the incumbents in banking are very strong
despite recent events.

With a multi-billion dollar fraud at Punjab National Bank (PNB) coming to light recently, it is
probably not the best time to say this but Indian government owned banks are not universally
corrupt and not all loans made are influenced by upper management corruption or government
interference. While the autonomy of government owned banks has improved dramatically during
the Modi administration, they were quite independent even under prior administrations. While I
am not a proponent of government ownership of any businesses including banks, privately
owned banks are no panacea for an economy. One must remember that the Global Financial
Crisis was created not by government owned but by privately owned financial institutions and
banks running amok.

India has experienced a severe economic and investment downturn in the previous 7 years. This
has been accompanied by a forced contraction of the economy by long term structural reforms
like GST implemented by the government. In such an environment, any bank with balance sheet
exposure to corporate loans has done poorly. The only banks that have managed to outperform
this contraction phase in the economy are HDFC Bank and Kotak Mahindra bank. There are a
handful of government owned banks like IDBI Bank and Central Bank of India that have done an
excessively poor job of managing their risk exposures, however in aggregate, government owned
banks have not done much worse that privately owned banks. The books of private sector banks
like Yes Bank and IndusInd bank are completely rotten. If a forensic audit of their books was
forced by the regulator, one would discover that both banks rank equal to or worse than IDBI
Bank and Central Bank in their loan books and processes. Private sector banks like Axis Bank
and ICICI Bank are no different from government owned banks except for their larger retail
franchises. Their books are equivalent to that of a State Bank of India or a Bank of Baroda and
they do not deserve a valuation premium over them. Old private sector banks like Karur Vysya
Bank, Karnataka Bank, South Indian Bank and City Union Bank all carry rotten books with
loans that have been discretionarily evergreened and are no different from government owned
banks in their performance.

Can HDFC Bank and Kotak Mahindra Bank take over the entire banking system in India in
time? And is there nothing wrong with the government banks in India? The edge that HDFC and
Kotak possess is exactly the mirror image of the weakness in government owned banks. HDFC
and Kotak are nimble and their model is to front run government owned banks. While much
noise has been made about their retail loan franchises, a disproportionate amount of their income
originates from providing high value fee-based services to companies where the fund-based
loans and balance sheet exposure is carried by government owned banks. Even where they have
exposed their balance sheet with fund based loans to companies, they have been quick to exit at
the first sign of trouble. Government owned banks on the other hand, are incredibly slow and
derive almost all their income from fund-based balance sheet lending. Their slow reaction time
has also made them victims of large scale fund diversions by fraudulent entrepreneurs. The
business models of HDFC Bank and Kotak Mahindra Bank have their limitations and their
opportunity is finite. As they become larger, the inevitability of fund-based lending by these
banks will become apparent. While they might still do a better job of exposure management than
government owned banks, their economics will change and their loan books will get impacted in
the next contraction cycle.

On the other hand, things are changing quickly and dramatically for government owned banks.
One can state with absolute certainty that government owned banks are now completely
autonomous. One can also state that the severity of the current bad loan cycle and the size of the
frauds and diversions that have come to light in this cycle have made the owner (the
government), the regulator (the RBI) and statutory agencies (the CVC, CBI and ED) and the
management and employees of these banks hyper-vigilant. The likelihood of these things
repeating and especially at the scale witnessed recently is almost zero. The banking sector in
India has been completely empowered with the passing and implementation of the Insolvency &
Bankruptcy Code (IBC). And finally, the mood of the nation and the administration is to undo
the Bank Nationalization Act of 1969 by which the government will be able to bring its
ownership in these banks below 51%. Once that happens, these banks will be free to recruit in
the way that commercially makes sense for them independent from the rules for employment in
government institutions.

Government owned banks are 70% of India’s banking system and this cannot be wished away.
If India has to grow at 8%+ rates, credit in the economy will have to expand and government
owned banks will have to grow. While employees at government owned banks may not be as
well exposed and as driven as those at privately owned banks, they are extremely competent and
understand the business of banking. They have not been empowered, motivated or threatened
and that has made them underperform. One can do adjusted book value calculations and state
that many of these banks are insolvent and therefore should not be bought. This would be grossly
understating the case for these banks. They possess bullet proof liability and low-cost deposit
franchises that have remained unshaken through this downturn due to the perceived sovereign
guarantee behind them. One just needs to speak with IDFC bank to understand how hard it is to
build a liability franchise and how much time it takes. Government owned banks also possess a
deep reach into the economy with their strong branch network and historical relationships with
companies and the general public. This gives them a phenomenal capacity to grow the asset and
lending side of their business profitably. This franchise will become invaluable as India’s
economy expands. One needs to speak with RBL bank to understand how hard it is to build reach
and a strong lending and asset franchise.

I believe that there are more than a few government owned banks that have solid businesses and
are trading at multi-decade lows. These select banks provide phenomenal asymmetries and
opportunities to generate superior returns over the next five years and are worthy of
consideration by investors.