It is interesting to note how most people think of inflation. Apparently, the most prevalent concept of inflation is something like what happens to spectators at a cricket match. At some point during the match, the people in the front rows of the stadium rise to their feet to get a better glimpse of what is happening on the field. As a result, the spectators in the back rows cannot see the action clearly so they rise up too. Very soon, everyone is on their feet.
Another perception among most people is that inflation drives up the prices of everything uniformly. This is why it is commonly believed that real estate prices rise simply because the cost of everything else has also risen. This is incorrect. The fact is that real estate prices will either fall or remain static in an inflationary environment.
Inflation is a dynamic that is largely dictated by the cost of credit. This is how it works – the cost of essentialities such as food grains and petrol rises, while the common man’s income remains the same. In other words, his spending power reduces. Banks make a note of the fact that the baseline cost of living has increased and recalibrate their loan interest rates upward.
Because the cost of borrowing has increased while incomes have remained static, people become wary of taking loans for anything – including home purchase. The natural reaction from real estate developers would be to bring property prices down so that sales pick up again. This does happen in some cities and locations, but not everywhere. Here are the reasons.
Many developers are as dependent on the cost of borrowing as their buyers are. This is especially the case with smaller developers in Tier 2 or Tier 3 cities who have not launched many projects and have therefore not been able to create a self-sustaining churn of capital. Such developers are able to react to the reduced sales brought on by inflation by lowering their rates.
Such developers are able to do this because though the overall cost of development remains more or less constant, land acquisition costs are lower in smaller cities. Price reductions are the last recourse for ailing developers, but smaller developers with lower investments into their projects and greater dependence on the cost of lending can and will offer them if they perceive this to be the only option.
If even this last course of action fails, the developer goes bankrupt and is forced to surrender all business interests to the bank, or sell them to a more established player. This is, in fact, one of the integral factors of the process of consolidation, wherein more and more smaller operators give way to larger players.
The scenario is different for larger developers who are active in the primary cities. Having been in the real estate business longer, they have been able to achieve a degree of capitalization that reduces their dependence of debt funding. However, their investments in the land required to build projects in the larger cities are naturally higher.
Such developers are not able to bring down the pricing of their properties despite a slowing down in sales. However, they are able to weather the inflationary storm longer because of their healthier capitalization. For this reason, established developers in larger cities will not use price reductions to boost inflation-impacted sales. At the same time, they cannot raise their prices in tandem with the natural laws of property appreciation, since this would impact their competitiveness on the market.
This means that in the case of well-located quality projects by established developers, inflation will have the effect of keeping prices static until reduced inflation brings down the cost of credit. Once this happens, prices will rise again without having gone down at any point.
It goes without saying that understanding how inflation impacts short and long-term property pricing in different cities, locations and projects can make a big financial difference to prospective home buyers.