1. Financing Mechanisms for Affordable Housing: Demand and Supply Side
Intermediation
CEMS Working Paper AH-07
August 2012
Authors:
Dhaval Monani
Nikhilesh Sinha
Shahen Dastur
Working Papers Series
Supported by:
Rockefeller Foundation
2. August
2012
FINANCING
MECHANISMS
FOR
AFFORDABLE
HOUSING
CEMS,
ISB
1
Table
of
Contents
Introduction
.................................................................................................................................................
3
The
Definition
of
Affordability
.....................................................................................................................
4
Affordability
by
Income
Group
................................................................................................................
6
Objectives
....................................................................................................................................................
8
Problem
Statement
.....................................................................................................................................
9
Buyer’s
Perspective
.................................................................................................................................
9
Developer’s
Perspective
..........................................................................................................................
9
Proposed
Solutions
....................................................................................................................................
10
Solutions
to
Mitigate
Buyer-‐Side
Risk
....................................................................................................
10
Payment
Protection
Insurance
(
PPI
)
................................................................................................
10
PPI
with
payback
clause
.....................................................................................................................
13
OPTION
–
by
Bank
..............................................................................................................................
14
Comparative
analysis
of
the
three
proposed
solutions
.....................................................................
16
Solutions
to
Mitigate
Developer-‐Side
Risk
............................................................................................
17
Introduction
.......................................................................................................................................
17
Previous
Work
Done
..........................................................................................................................
17
Hedge
Product
...................................................................................................................................
18
Limitations
of
the
Study
.............................................................................................................................
24
Conclusion
.................................................................................................................................................
25
A
Discussion
of
the
Solutions
Proposed
for
the
Buyer
..........................................................................
25
A
Discussion
of
the
Solutions
Proposed
for
the
Developer
...................................................................
25
References
.................................................................................................................................................
26
Appendix
....................................................................................................................................................
27
Abbreviations
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CEMS,
ISB
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EMI
Equal
Monthly
Installments
PPI
Payment
Protection
Insurance
PD
Probability
of
Default
VaR
Value
at
Risk
OPC
Ordinary
Portland
Cement
PPC
Pozzolana
Portland
Cement
LME
London
Metal
Exchange
Income
Groups
Monthly
Household
Income
(INR)
Monthly
Household
Income
(USD1
)
EWS
(Economically
Weaker
Section)
Less
than
3,300
Less
than
60
LIG
(Lower
Income
Group)
3,300
-‐
7,500
60
-‐
136
MIG
(Middle
Income
Group)
7,500
-‐
14,000
136
-‐
255
HIG
(Higher
Income
Group)
More
than
14,000
More
than
255
1
USD 1 = INR 55
4. August
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FINANCING
MECHANISMS
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CEMS,
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Introduction
The 25 million gap in urban housing identified in the 11th
Five year Plan is a monumental
challenge. As discussed in detail in our report titled New Frontiers in Affordable Housing:
Notes from the Field, government and private initiatives aimed at tackling this issue have
met with limited success. One of the key elements required for the success of market-based
solutions to the housing problem is finance. There is a need for the development of financial
products specific to the affordable housing sector to address constraints supply as well as
demand side constraints.
This report explores the potential for two financial mechanisms, which could significantly
help in stimulating the affordable housing market in India. The first is a financial hedge
product that would allow affordable housing developers to guard against risks of input price
volatility, which is of particular concern in a low-margin business. The second is a demand
side intermediation that protects both the home loan borrower as well as the lender in the
case of an involuntary default situation due to loss of employment or ill-health.
First-hand experience of unpredictable spikes in the prices of inputs such as cement, sand
and brick during the implementation of the project at Rajkot prompted us to explore ways of
managing this risk. The usual practice of using high margins to absorb the shock of sudden
increase in costs cannot be employed in the low-cost housing sector. The focus is to provide
houses at the lowest cost that remains viable to the developer. The idea of creating a
financial hedge was first discussed in 2010. While it remains an elusive goal, our
investigations have yielded substantial gains in our understanding of how such a hedge
could be structured.
The idea of payment protection insurance, or an insurance against asset loss due to a
sudden change in economic status, seems appropriate in the context of affordable housing.
The family home is often the single biggest investment for a low-income household. The
idea of payment protection was inspired by a similar product that is bundled with student
loans for MBA candidates. This product ensures the banks receive instalments on their loans
even when candidates fail to find employment or get laid off. The challenge in the scenario
of affordable housing loans, is tackling the agency problem arising from the borrowers
incentive to shift the burden of repayment on to the insurance company even when they are
employed and able to pay.
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The
Definition
of
Affordability
“Affordability is used fairly loosely in common parlance and may refer to housing that
meets a wide range of affordability criteria. Defining affordable housing in India is a difficult
task given that the dynamics of the market can change dramatically as you move from one
part of the country to another2
. For the purposes of this report we will limit our analysis to
the market for houses priced at INR 200,000 and below.3
“Keeping in mind that the housing shortages affect mostly the EWS and LIG, the definition
should apply to houses ranging from about 300 square feet (super built up area) for
Economically Weaker section (EWS), 300 square feet to 600 square feet for Lower Income
Group (LIG) and 600 square feet to 1200 square feet for Middle Income group (MIG), at
2
Affordable Housing, KPMG Advisory
3
All amounts are in INR
DEVELOPER
BANK
BUYER
The
Bank
pays
installments
to
the
Developer
over
the
period
of
construction
or
a
single
payment
The
buyer
makes
a
down
payment
towards
the
purchase
of
the
property
The
Buyer
of
the
property
makes
EMI
payments
to
the
bank
over
the
tenor
for
which
loan
is
taken
(usually
15-‐
20
years)
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costs that permit repayment of home loans in monthly instalments not exceeding 30% to
40% of the monthly income of the buyer”4
.
Group Income Level Size of unit EMI
EWS Less than INR 150,000 p.a. Up to 300 sq. ft 30% of monthly income
LIG INR 3 – 5 00,000 p.a. 300 to 600 sq. ft 30% of monthly income
MIG INR 3 – 10 00,000 p.a. 600 to 1200 sq. ft 40% of monthly income
4
Guidelines for affordable housing partnership, Ministry of Housing & Urban poverty Alleviation
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Affordability
by
Income
Group
When a home-buyer decides to buy a house he or she usually approaches a bank and
applies for a home loan. The loan is customarily paid back over a period of 15-20 year in
Equal Monthly Installments (EMI). The value of each of these monthly installments (EMI) is
a function of the value of the loan, the tenor or period of the loan and the interest rate that
the bank decides to charge. The interest
rate
may
vary
depending
on
the
credit
profile
of
the
buyer.
There
is
also
variability
in
the
rates
charged
by
different
banks.
EMI
options
for
a
loan
of
100,000
(INR)
Interest
10
years
15
years
20
years
1
2
3
A
9%
1,270
1,010
900
B
10%
1,320
1,070
970
C
11%
1,380
1,140
1,030
D
12%
1,430
1,200
1,100
In the Indian context we find that the average buyer cannot afford to contribute more than
40 per cent of their monthly income towards housing costs. Therefore a buyer’s monthly
income can be used to determine the maximum amount he or she can pay towards a
monthly installment on a loan, and thereby determine the upper bound on the value of the
property he or she is able to afford.
The following table illustrates the EMI options (above table) for the buyer given his income
level and loan amount.
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Loan
servicing
ability
and
options
exercisable
Yearly
Income
Monthly
Income
Capacity
(30
%)
Property
Val
(INR)
Loan
Val
(INR)
500,000
400,000
750,000
600,000
1,000,000
800,000
1,250,000
1,000,000
200,000
16,670
5,000
A1,
A2,
A3
A3
NA
NA
300,000
25,000
7,500
All
A1,
A2,
A3
A3,
B3
NA
400,000
33,330
10,000
All
All
A1,
A2,
A3
A2,
A3,
B3
500,000
41,670
12,500
All
All
All
A1,
A2,
A3
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Objectives
• To identify the risks faced by the developers of affordable housing segment and the
buyer of the property.
• To understand the various factors which affect the segment.
• To propose solutions to mitigate identified problems.
• To assess the effectiveness of the solutions proposed.
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Problem
Statement
Buyer’s
Perspective
if a buyer is unable to make the monthly payments on their home loan, the bank reserves
the right to seize the collateral i.e. the property from the buyer. The bank then usually
recover the outstanding amount along with interest after selling the asset, and gives the
residual to the buyer.
The buyer’s inability to pay may arise due to the loss of employment, prolonged illness,
accident or an unforeseen expense. These short-term problems can result in the buyer
losing ownership of the property.
Developer’s
Perspective
The time required for the construction of a low-cost housing project from inception to
completion may vary between 2 and 4 years depending upon the size and location of the
project, as well as upon the developer.
In the affordable housing segment, developers aim to sell a majority of the units of the
project during the initial period of construction. This allows them to finance construction
using the initial deposits, which removes the need for debt financing and simultaneously
improves the rate of return on the project. On the downside, selling units upfront exposes
the developer to the risk of a drastic rise in construction costs, ex post. It is possible for the
cost of inputs used in the construction to increase substantially. If there is a steep
unexpected rise in the input costs, the profit margin for the developer could diminish or in
extreme cases may result in a loss. Some of the factors resulting in an increase in cost of
inputs are rise in inflation, increase in freight, demand & supply constraints and increase in
the production cost of the construction materials.
11. August
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Proposed
Solutions
Solutions
to
Mitigate
Buyer-‐Side
Risk
Payment
Protection
Insurance
(
PPI
)
A Payment Protection Insurance (PPI) product aims at providing insurance cover to a buyer
in the event of involuntary default on a home loan. In the event that the buyer is unable to
make his payments, the insurance provider steps in to prevent foreclosure and loss of the
asset.
The premium on the insurance would be paid once at the time the loan is taken. If at any
time during the tenor of the loan the buyer defaults on an EMI payment, the insurance
company will make the payments of his behalf. The insurance company would cover a
maximum of 12 and 18 EMI for a loan of 15 years and 20 years respectively.
Input
required
Developing and pricing the premium for the insurance product requires data on a number of
input variables. The Probability of Default (PD) is one of the most important variables in
premium calculation. PD calculation requires consideration of factors like credit history of
the buyer, his job security, number of people dependent on him, mortgage outstanding,
tenor of loan and others.
Methodology
for
calculating
premium
for
Insurance
Calculation
of
Premium
given
default
rate
Given a range of PD and Recovery rates it is possible to form a matrix to illustrate the
insurance premium. The insurance premium is calculated by equating the present value of
the default leg with the present value of premium leg. The variables that were considered
while calculating premium are PD, recovery rate, loan amount, risk free discount rate. The
12. August
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MECHANISMS
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CEMS,
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difference between the present value of default leg and premium leg should be zero at the
inception of the insurance and the premium is the balancing variable in the equation.
PV
of
Default
Leg
–
PV
of
Premium
Leg
=
0
PV
[Loan*(1-‐R)*PD]
–
PV
[Premium
amt]
=
0
INSURANCE
PREMIUIM
(for
a
loan
of
INR
100,000)
At
end
of
year
1
Probability
of
Default
(in
bp)
Recovery
rate
65
60
55
50
45
40
40%
361.11
333.33
305.56
277.78
250.00
222.22
45%
331.02
305.56
280.09
254.63
229.17
203.70
50%
300.93
277.78
254.63
231.48
208.33
185.19
55%
270.83
250.00
229.17
208.33
187.50
166.67
60%
240.74
222.22
203.70
185.19
166.67
148.15
65%
210.65
194.44
178.24
162.04
145.83
129.63
Output
The PPI product allows the buyer to insure against the risk of losing his or her investment in
the house through involuntary default and forfeiture. In the event of involuntary default, the
insurance company steps in to pay the EMI to the bank.
STRATEGY
Insurance
cover
Premium
Default
risk
INSURER
BUYER
BANK
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Limitations
• The basic structure of the insurance contract provides a huge gap for malfeasance.
The insurance company faces the risk of moral hazard due to the structure of the
contract and the difficulty of verifying whether default is voluntary or involuntary.
• The buyer has an incentive to default, and to force the insurer to pay the bank even
when he or she is solvent.
• The claims made need to be scrutinized and followed through by the insurance
company. This involves high transaction and monitoring costs and may reduce the
feasibility of the product.
Checks
and
Controls
to
address
limitations
• The buyer has to get a certificate from the employer which states loss of the job and
the reason for the same. This would serve as a proof for loss of job and also help
assess if it was deliberate or not by the reason stated in the certificate.
• The buyer has to submit his income tax return for the past three years. It will help
us analyse whether the buyer has any savings or investments that can be
channelized towards EMI payments.
• All bank account statements for the past 3 years also are required to be submitted.
It would be useful to assemble other sources of income and the buyers spending
patterns.
• One option for reducing risk of default might be to get the spouse of the buyer to co-
sign, in case he or she is also employed. Joint liability contracts may be more
feasible and could be made more attractive if these are associated with a lower
premium. In case of loss of job of one person, the spouse will have the liability and
ability to pay the EMI.
14. August
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PPI
with
payback
clause
In this variation on the PPI product the buyer repay the insurance company with the total
amount of EMI paid once the buyer’s financial stability is re-established. The repayment will
be made in installments to suit the buyer’s situation. The buyer can start repaying the
insurance company at any point during the tenor of the loan or at the end of the tenor.
Insurance companies can have the option of including an interest component for the
outstanding EMIs owed by the buyer.
Tenor
of
the
Loan
Insurance
can
be
invoked
any
time
during
tenor
Premium
paid
Key
points
of
the
solution
• The premium associated with this option would be much lower compared to the
standard PPI product
• The incentive for voluntary default on the part of the buyer is reduced.
• The insurance company also holds the property as collateral but next in line to bank.
In case the buyer continues to default for a period exceeding that covered by
insurance, the insurance company can claim their share after the bank has recovered
its outstanding debt.
• The bank will release the collateral only after it has received a letter from the
insurance company that all of its dues are paid by the buyer.
• The option to repay the sum to insurance company after completion of the loan tenor
reduces the burden on the buyer. Otherwise the buyer would have to pay
installments to the bank and insurance company simultaneously for a period once he
or she regains employment.
T0
T15
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OPTION
–
by
Bank
In this third variant the bank gives an option to the loan holder to buy a right to skip a
maximum of 12 monthly installments. The buyer can avail of this option at any point during
loan period. The cost of the option can be paid either in lump sum at the start of the
repayment period or can be included in the loan installments. The exercise period
commences once the lump sum payment or installments towards the option have been paid
to the bank. In the illustration below, it is assumed that installments towards the option are
paid over the first seven years of the tenor of the loan and the exercise period commences
in the eighth year of the tenor period. The cost of this option is the present value of 12
installments during the exercise period.
This option will help the loan holder to retain the ownership of the house despite of the
short-term difficulties and saves bank from the hassle of foreclosures.
Tenor
of
Loan
(15
Years)
Cost
to
be
paid
in
installment
Option
can
be
exercised
any
time
in
this
period
OR
Cost
in
lump
sum
T0
T7
T15
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EXAMPLE
Description
Amount
(INR)
Total
of
EMI
for
8th
year
(8,000
p.m.)
96,000
PV5
of
EMI
of
8th
year
at
7th
year
end
92,073.11
Price
of
option
(beginning
of
year
1)
52,690.83
Price
of
option
(along
with
EMI
during
the
7
years)
821.25
Key
points
of
the
solution
• The option does not entail any additional charges / premium as the cost of the option
is the present value of the future EMI.
• The transaction takes place between the bank and the buyer. There is no need for a
third party, such as an insurance company. This reduces the complexity of the
transaction and also the regulatory and legal requisites accompanying it.
• The buyer is covered for his future short-term financial uncertainties for 12
installments in case of 15 year mortgage. It supports the buyer in case he
experiences any financial instability for a short duration.
• The exercise period of the option starts later in the year so that the cost of the
option does not increase in present value terms. The later the exercise period in the
tenor of the loan, the smaller the cost of option in present value terms.
• This option will reduce the amount of restructuring normally undertaken by the bank
and also protect the buyer from having to undergo the negotiations during
restructuring.
• The cost of the option is the present value of the first 12 EMI in the exercise period.
This would be preferable for bank in case someone exercises the option during the
initial period.
5
PV is calculated using risk free rate of 8%
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Comparative
analysis
of
the
three
proposed
solutions
Solutions Advantages Limitations
PPI
• Will support buyer and he
does not have to repay the
amount to the insurance
• Premium will be paid only
once in the beginning.
• Buyer may make false claims to
avail the insurance cover
• Lot of time needed to be
invested in authenticating and
keeping track of buyer’s claim
PPI
with
Payment
Clause
• Number of false claims will
reduce
• Premium paid would be much
less comparatively
• The insurance company may
have problems recovering the
amount paid by them towards
the EMI
Option
–
by
Bank
• Eliminates the need to enter
into a transaction with the
third party (insurance
company)
• No additional price is paid for
the option as its cost is the
present value of the EMI
• Does not cover the buyer for the
part of tenor before exercise
period
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Solutions
to
Mitigate
Developer-‐Side
Risk
Introduction
The Hedge product is designed to protect affordable housing developers from input price
volatility during the construction period. The product would help developers hedge
construction costs, allowing them to operate with lower margins without adversely affecting
profitability.
The hedge product is a basket of securities with a high price correlation to the costs of
construction materials. The developer would buy the hedge product and any increase in the
input costs would be set off by the gain in assets underlying the product.
About 30% of the construction cost can be attributed to labour, which is difficult to hedge as
changes on wages are hard to predict and are not strongly correlated with any specific
economic factor. However expected increases in labour during the construction period can
be considered while calculated the estimated cost. A 70% hedge of the construction cost is
a practical second-best solution and one that invites further exploration and research.
Previous
Work
Done
An earlier study6
conducted at ISB on the affordable housing segment envisaged a cross
hedge product to address the problem faced by the developers. In the report, major cost
drivers (Cement, sand, brick, steel & labour) of construction projects were identified along
with their contribution to total construction cost.
The report presented a correlation analysis based on the cost of construction material vis a
vis a the value of a basket of selected equities and commodities. It was suggested that an
optimum portfolio might be used as a hedge once each individual cost driver is determined.
The correlation of sand, brick and cement to their respective hedging portfolio was found to
be 0.774, 0.544 and 0.523.
These coefficients are far too weak and cannot provide an effective hedge, except possible
in the case of sand. However it is important to keep in mind that correlation variables are a
notoriously deceptive measure. These correlations may vary considerably for different data
sets and measurement periods. The correlation can be relied upon only if there is convincing
economic rationale between the input cost and the hedge product.
6
ISB-‐CEMS,
(2011),
“Preliminary
Report
on
Hedge
Product
for
Construction
Materials”
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Hedge
Product
Risk
Identification
1. Commodity Risk: Cement, Sand and Brick constitute about 42% of the total input
cost. Any increase in cost of these commodities increases the cost of the construction
compared to the initial budgeted projection. The increase in commodity prices is
driven by cost of production, inflation, demand and supply and other factors.
2. Labour cost Risk : Cost of labour contributes to about 30% of the cost of
construction. It is the single largest component of construction cost. A slight increase
in labour cost can lead to erosion of profits. Labour cost is primarily a function of
Inflation, demand and supply and government directive of minimum pay for men &
women.
3. Interest rate Risk : Developer is affected by the fluctuation in interest rate if he has
taken a loan to fund his project cost. A change in interest rate affects the
development cost of the project.
4. Default Risk : In case of sale on installment basis, Developer faces a possibility of
the buyer defaulting in periodic installments. Some of the factors resulting to default
are loss of job, accident, prolonged illness, death or other reasons like unexpected
expenses in the family.
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Risk
Measurement
Risk faced by developer need to be quantified to get a clear understanding of its potential to
reduce or wipe out profits. Identifying the range of price change and degree of possible
impact will help eliminate the effect of price volatility on cost estimates.
Data
used
and
sources
1) Data on prices of construction materials was gathered from developers in Rajkot and
Mumbai (Sumit Woods).
2) Data on equity prices of selected stocks was downloaded from the NSE online data
portal.
3) Data on commodity exchange prices was taken from MCX historical data repository.
4) Dollar INR exchange rate over the period under analysis is taken from
www.oanda.com
Scenarios
1) Cement prices are highly volatile (based on data from Rajkot project)
2) Cement prices display low volatility (on data from Sumit woods, developer in
Mumbai)
Assumptions
made
Scenario 1
1) Data points related to material prices were irregular i.e. the interval between data
points was not constant. Because of the frequency of data points being inconsistent,
comparison with asset was tricky. Therefore averages of the previous prices have
been taken at missing points.
2) In some cases, there were several prices quoted within a single time period i.e. one
time period is associated with 5 different prices of cement. In these cases, the
average of values is taken.
3) Data for bricks (bricks & fly ash bricks) was merged to get a consistent data point for
a single interval.
4) A lag of 1 month, 2 months and 3 months of cost index has been taken in gold,
crude oil and dollar rupee prices respectively to construct hedge index.
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Scenario 2
1) In case of cement and brick, there were two different types of inputs i.e. OPC and
PPC in cement and two different sizes of bricks. Here both types of inputs are
considered equal for the purpose of analysis.
2) A lag of 1 month, 2 months and 3 months of cost index has been taken in gold,
crude oil and dollar rupee prices respectively to construct hedge index.
Risk is measured using VaR taking a 99% confidence interval for a cost of construction of
INR 100,000 (Cement – 15.90%, Sand – 10.90% and brick – 14.80%)
Scenario 1
Daily VaR cement = 824 i.e. 0.82%
Daily VaR sand = 306 i.e. 0.31%
Daily VaR brick = 940 i.e. 0.94%
Scenario 2
Daily VaR cement = 185 i.e. 0.19%
Daily VaR sand = 140 i.e. 0.14%
Daily VaR brick = 1,254 i.e. 1.25%
22. August
2012
FINANCING
MECHANISMS
FOR
AFFORDABLE
HOUSING
CEMS,
ISB
21
Methodology
used
A Hedge index is developed to mimic the movement of the key input materials i.e. cement,
sand and brick. The index is created by taking assets that have an economic association to
the prices of the material. The Index is developed using the following steps:
• Collecting monthly data of cement, sand and brick prices for a period
• Corresponding prices of equities and commodities like Gold, Crude oil, dollar rupee
exchange rate, cement and coal prices from selected sources.
• Forming a cost index of the construction input in the ratio of their contribution
towards total construction cost.
• Developing a hedge index using equities and commodities taking equal weights.
• Optimizing weights of the assets achieving high correlation with the cost index.
Risk
Control
The hedge index developed under both the scenarios does not confer a strong hedge with
construction cost. Under Scenario 1 and Scenario 2, the correlation is 0.66 and 0.50
respectively. This correlation is not strong enough to be used as a basis for hedging. A
minimum correlation of 0.80 is required for a hedge to be effective. Otherwise the cost of
hedging will exceed the benefits derived from it.
Risk
Report
Several assets were considered and analysed to develop a hedge. The selected few were
chosen based on correlation as well as theoretical plausibility. In addition, various equities
and commodities were used to analyse the correlation between them and to determine the
final set. A strong economic relationship between two variables is a prerequisite for the
correlation to be considered meaningful and effective. Any purely numeric correlation
between asset returns and construction input price changes is likely to prove ineffective as a
hedge in the long-run.
One of the main drivers of the price of construction inputs over the recent years has been
inflation. Commodities are a good hedge for inflation though not a perfect hedge. Interest
rate derivatives are normally used in developed nations to hedge against inflation.
23. August
2012
FINANCING
MECHANISMS
FOR
AFFORDABLE
HOUSING
CEMS,
ISB
22
Construction
Index
It is possible to form a fairly robust index based on cement and steel prices. Cement and
steel approximates about 16% and 10-12% of the construction cost respectively. So the
index would help manage about 26-28% of the construction cost. The developer can buy
units in index and as the prices of steel and cement will increase the index value will
increase thus setting off the increase in construction cost.
Input
In order to be able to trade the index and provide liquidity, daily prices of the index will be
required. Daily prices of cement and steel are required as an input, and it is necessary to
determine the appropriate weights of cement and steel for use in the index.
Methodology
The Index prices are derived by multiplying the prices of the underlying basket of traded
commodities and equities with their respective weights, and summing them up. Steel is
traded quite heavily in LME (London Metal Exchange) so we use LME prices after converting
them to their equivalent in Indian rupees. Cement however is not traded on any exchange
making it difficult to obtain daily prices. This was tackled by getting daily quotes of cement
from the top 10 cement suppliers in India, discarding the top and bottom two quotes and
taking the average of the remaining six values to arrive at daily price. The weight of steel
and cement in the index was taken as 57% and 43% respectively i.e. (16% and 12% in the
construction cost).
Getting daily input prices from cement companies and compiling it proved to be inefficient.
We recommend developing a software solution that utilizes remote access to cement
companies to feed in daily prices. The software would then take cement price and add to it
the steel prices from LME and give daily index value.
24. August
2012
FINANCING
MECHANISMS
FOR
AFFORDABLE
HOUSING
CEMS,
ISB
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Challenges
faced
while
developing
Hedge
and
Construction
Index
1. Cement
Cement prices exhibit low volatility in some regions compared to others. In such
situations, developing a single hedge for the affordable housing segment becomes
infeasible as the price of cement is not a constant throughout the country. Also the
recent revelation that cement companies customarily forming cartels to manipulate
prices, poses a huge hurdle. Such associations interfere with the natural
determination of equilibrium prices.
2. Steel
The low trading volume in steel on MCX makes it an unsatisfactory source of prices.
Therefore prices of steel were taken from LME because of which we were forced to
consider foreign exchange fluctuations within the index.
3. Sand and brick
Sand and brick used for construction is normally supplied locally. This sector is
unorganized. Additionally, sand and brick are not traded and we have been
unsuccessful in identifying a suitable proxy.
25. August
2012
FINANCING
MECHANISMS
FOR
AFFORDABLE
HOUSING
CEMS,
ISB
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Limitations
of
the
Study
1) Data Availability
Apposite data is a pre requisite for obtaining a relevant and usable analysis. A product
developed based on inappropriate data will not be effective.
During the study, a comparison was made between material prices and assets. For
this, data of daily change in prices of materials was needed. However this data was not
available. So monthly data points were considered and averages used to fill in missing
data points.
2) Depth of commodity exchange markets and availability of financial products
Although steel is listed on MCX, we found the traded volumes too low to support useful
analysis. This limits its usage as an underlying index.
Inflation adjusted bonds and interest rate derivatives are useful products to hedge cost
against inflation. However no such financial product is available in India.
26. August
2012
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CEMS,
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Conclusion
A
Discussion
of
the
Solutions
Proposed
for
the
Buyer
With a financial product for affordable housing buyers, we have proposed a few plausible
financial structures. These can be easily converted into viable financial products and should
prove to be useful for buyer segment. Some of the proposed products could be discussed
with general insurance companies and banks to fine tune them and can be easily offered to
the potential buyers.
A
Discussion
of
the
Solutions
Proposed
for
the
Developer
Our research and investigation towards the development of a suitable hedge product for
Developers building affordable housing did not yield a satisfactory hedge strategy. The
primary reason for this is was the challenge in finding suitable proxies for the prices of
construction inputs. Of the total construction cost associated with an affordable housing
project 30% is labour cost, which is notoriously difficult to hedge, especially in the Indian
context. 70% of the cost of materials are accounted for by cement, steel, brick, sand and
other costs. We did not find a suitable proxy for bricks and sand, in the liquid market. In the
case of cement, sand and brick we found some sort of correlation by creating an index
consisting of gold, USD/INR and oil price. We believe that the recent price surge (in 2-3
years) in these commodities has come about largely because of inflation and supply and
demand imbalance. Once the inflation comes under control the high volatility of cement
would come down almost to a level, which would be equivalent to about annual inflation
level.
We also believe if we get access to better and richer data for these materials, we should be
able to explore better and effective hedge possibilities. Overall it certainly remains a
challenge to create a suitable hedge for the Developers who are involved in building
affordable housing.
Alternatively, we could also explore a synthetic product (both in cash and in future market)
which exactly represents the cost of 70% of the commodities used in the construction of the
building.
27. August
2012
FINANCING
MECHANISMS
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AFFORDABLE
HOUSING
CEMS,
ISB
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References
JNNURM
Mission
Directorate,
“Guidelines
for
Affordable
Housing
in
Partnership.”
available
at
http://mhupa.gov.in/w_new/AffordableHousing.pdf
(Last
Visited
on
September
30,
2011)
KPMG,
(2010),
“Affordable
Housing
-‐
A
Key
Growth
Driver
in
the
Real
Estate
Sector?”
available
at
http://www.in.kpmg.com/TL_Files/Pictures/Affordable_Housing.pdf
(Last
Visited
on
March
13,
2012).
ISB
–
CEMS,
(2012),
“New
Frontiers
in
Affordable
Housing:
Notes
from
the
Field”
ISB-‐CEMS,
(2011),
“Preliminary
Report
on
Hedge
Product
for
Construction
Materials”
