Decoding financial schemes during property purchase
There are no free lunches for consumers in any industry. And it might be naïve to expect one while purchasing a property from a developer.
Today, let’s decode the most common financial schemes advertised during sales of new properties and how as buyers we can evaluate the true costs and benefits.
1. Deferred payment plans
This is the most common type of payment plan benefit that developers extend on a project-to-project basis.
Some examples of these schemes are:
a. 20-80/25-75 schemes: Pay 70%-80% on possession
b. Bullet schemes (10:30:30:30 / 25*4/25:25:50): Intends to ease your cash flows in the initial stages of construction
As a buyer, it always helps to get a breather with our payment outflows and these schemes are truly a win-win.
What’s the catch here?
One needs to ensure that there is no significant price differential between a construction-linked standard payment plan and these schemes. Branded developers usually build price increases between 5 and 15% for offering such schemes – specifically where 70-80% is payable on possession, in order to account for their interest costs.
In such a scenario, better economic sense is to avail the lower pricing with a standard construction-linked plan (even if involves a mortgage). If you are sold a deferred scheme (10-90/25-75) with the proposition that by the time the project hits possession you will make handsome gains by just ploughing in 10-20%, you need to be wary about the probability of this scenario playing out.
Why?
a. Property flipping specifically in real estate market is not as simple as the ecosystem wants you to believe. Barring the risk of no or little appreciation, there is supply from other investors you are competing with on project completion along with hefty transaction costs in the form of stamp duty & other taxes.
b. This is one form of ponzi where your whole investment thesis is based on finding a greater fool. Unless the property has strong fundamentals (great location & property to live), this is a risky bet. But if it was a hot cake in the first place, why would the developer sell with such a scheme that dampens his cash flows?
2. Subvention schemes
The biggest confusion among many buyers is about ‘Builder subvention’ vs ‘Bank subvention’.
Builder subvention typically means there is no bank involved in the transaction. It effectively falls in the ‘Deferred payment plan’ category above. The builder gives you a scheme like 25-75/20-80 where you pay the largest bullet on/closer to handover.
A typical interest subvention scheme is where the bank/lender is involved as a third party. Usually these are tri-partite agreements between the buyer, builder & the bank wherein the bank agrees to pay milestone-linked instalments to the builder but not collect EMIs/collect partial EMIs from the buyer until completion of the project. The developer funds the interest gap to the bank. All was well until a market slowdown kicked in.
What happened with these schemes?
1. As the market slowdown kicked in post 2015, developers struggled to complete projects on time due to cash flow constraints.
2. Developers stopped paying EMIs (interest costs) to lenders after the ‘possession date’ on paper.
3. Lenders started harassing the property buyers for payments and this impacted credit ratings of buyers. Many buyers ended up paying rent and EMIs for flats they had no visibility of being delivered.
4. After much bloodbath for buyers and buyer appeals, the courts stepped in and ordered lenders to rectify their credit ratings in cases of execution default by developers.
The RBI and NHB gave a rap on the knuckles of HFCs way back in 2013 when RBI released the first warning circular but a growing RE demand and absence of stringent regulations fed greed into many NBFCs/HFCs in growing their housing loan book. We all know how this ended post the IL&FS debt crisis in 2018.
Let’s have a look at a sample subvention scheme clause in a tri-partite agreement:
In layman terms, the lender is bluntly saying that the buyer cannot get away if the builder defaults and the lender will ultimately get hold of the buyer (borrower) for all his recoveries.
What can you do to protect yourself as a buyer from these schemes going awry?
a. Never sign up for an agreement that places full accountability on you as a buyer, how much ever the banker’s and developer’s sales team prod you that ‘these are procedural T&Cs’.
b. Contest that the lender will ensure subvention until you get possession of the flat. Typically, the legal phrasing goes - ‘possession or a certain date, whichever is earlier’. This is the loophole the builder exploits to stop making interest payments to the lender.
c. Understand if the subvention is offered till handover or any other milestones. These milestones include application or receipt of occupation certificate (OC). At times, there is a gap of 3-6 months between receipt of OC and actual occupation and you might have to bear the EMIs in this period.
d. Clarify different scenarios in writing with both the developer and the lender’s representative on one single platform (say email). This ensures neither starts passing the parcel when the project execution gets messed up.
3. No stamp duty / No GST
This is one of the more straight-forward schemes offered by developers offering you a saving of 5-7% depending on the city of property.
· Some developers offer you a ‘No stamp duty’ offer but factor this cost through an increase in flat cost/agreement value. Ensure you’re not fooled around in the name of an offer.
· In Maharashtra, the state government offered a concession on development premiums to developers in 2021 with the condition that developers pay the buyer’s stamp duty. If this is being marketed as an ‘offer’, understand that it does not offer any incremental value to you.
· GST offers are common – the developer absorbs partial or entire GST (typically 5% for under-construction projects commenced after April 2019 and 1% for affordable projects in certain cities). This is largely passed on as a discount on the agreement value.
· Projects with occupation certificates attract no GST. Most developers pass on the input cost differential onto the pricing to ensure cost neutrality and hence there is no actual value beyond optical satisfaction of paying no GST to government.
Say, the agreement value is 1 Cr prior to completion with standard 5% GST. On receipt of completion certificate, the price you pay is 1.05 Cr with zero GST. The impact is neutral for you as a buyer unless the developer lowers the price loading of GST to say 2% instead of 5%.
Developers also offer offers like no maintenance for 2 years, waiver of club charges, etc. These are fairly straight-forward as long as they are clearly documented.
4. Choose your pre-EMI/ Step EMIs
You might appreciate flexibility as a buyer in how you would like to structure paying pre-EMIS (pay-outs until handover) and actual EMIs. Lenders have recognized this and rolled out schemes to enable you choose the amount of pre-EMI you would like to pay in the initial years.
It’s good to be aware that while the flexibility to pay lower EMIs initially help you manage short term cash flows, the interest gets accrued and compounded and adds to your overall repayment chunk. This scheme also reduces your overall Loan-To-Value eligibility. These schemes are great for developers and lenders to grow their business but as a buyer it is good to reassess – the larger overall interest you pay on your property, the larger is your effective acquisition cost and lower is your overall return on investment.
5. Initial down-payment/stamp duty support
Globally the largest concern for a first-time property buyer is the down-payment (20-30%) required for property purchase.
There are new-age fintech firms offering down-payment assistance in collaboration with developers to fund part of the down-payment (say 5%) or the stamp duty quantum. The developer pays the interest cost to these firms and the buyer repays only the principal in instalments. This works great as sales enabler for developers and offers healthy interest margins with low risk for the lending NBFC which partners with these fintech firms.
As a buyer,
a. Ensure this interest quantum payable by developer is not loaded on your price.
b. Clarify that this borrowing does not interfere with your mortgage eligibility
c. Clarify with developer on your liability in case of a cancellation
6. Developer pays rent until handover
This is a popular scheme with the second tier of developers and below, where the proposition is that you do not pay both your existing rent and pre-EMIs.
As with other schemes, you need to ensure this is an incremental offer and not optical.
A better way to avail benefit of these schemes is to ask the developer to pass on the present value of these rental pay-outs as an upfront discount on your agreement price.
This ensures that:
a. you pay lower government taxes on a lower sale price and don’t get into income tax complications on receiving rental income
b. lock in the benefit upfront negating risk of developer not honouring the offer
Developers target investors by offering ‘guaranteed rentals’ for a certain period post hand-over through their rental helpdesk. The offer is great if the developer has a strong in-house team to care of rental operations. One needs to be wary if these guaranteed rentals are unsustainable (say 10-15% above standard rental yields in that market) as your earning will be limited to real market-benchmarked rentals once this initial guarantee period of 1-2 years expire.
Some developers specifically in markets like NCR market rental yields of 10% or above - ensure to understand how the scheme works from the developer and read the fine-print carefully to avoid disappointment in the future.
7. Pay upfront and get price discount
As buyers, we always seek the best bargain deal out there. A lot of times to achieve least pricing for the shortlisted property, we offer developers to pay upfront bullet payments in exchange of a price discount.
In these transactions, we need to be mindful of the category of developer we are dealing with.
a. Grade-A/branded developers typically pass on a much lower discount on upfront payment compared to the second tier developers as their cost of borrowing is lower.
b. The discount is also a function of the interest rate cycle. Within the same category of developers, you might get yourselves a higher discount if you’re paying upfront bullets in a high interest rate regime (as the one we are getting into) and vice-versa.
An illustration between price discounts for upfront bullet payments with different developers:
As you can observe in the illustration, the end discount is a function of the developer’s borrowing cost. This is a classic risk-reward trade-off. Good quality developers borrow at a lower rate from the market and hence offer you lower discount rates and vice-versa. Most branded developers borrow below 10-11% p.a. (on average; expected to increase now with increasing interest rates) and hence it is not prudent to quote discounts offered by second tier developers when you are negotiating with leading developers.
Unless there is a compulsion on account of capital gains or unwillingness to deploy funds in financial assets, it might be wiser to earn a larger return from alternative deployment of this capital rather than locking the amount with developer.
Typically, most experienced buyers who have experienced multiple RE cycles and purchased properties mostly with local developers are used to the expectation of 10-15% price discount for upfront payments. This is from an era where builders were less organized, their borrower profiles perceived to be of high risk and borrowing rates were upwards of 15-20% even for reputed names. With interest rates generally lower now and profile of developers and industry evolving, the days of hogging huge upfront payment discounts might be behind us.
How do you evaluate whether to take up a price offer for upfront payment?
Ask for the developer’s ‘Discounting rate’ – the rate at which he discounts your payments to present value. If the discounting rate is materially higher than the return you would have generated through best possible alternate investment avenue (suitable to your context), then you should avail the offer. Most buyers benchmark the best alternative to a ‘Bank FD’ rate. Sure, works if you are a conservative investor. But remember, a bank FD (with large resilient banks) is a much safer avenue without uncertainties associated with payments to a developer and hence discounting rate should be materially higher than the benchmark ‘Bank FD’ rate.
In Summary, it is prudent to invest time in assessing, evaluating and clarifying the fine-print for any financial scheme. More shiny and attractive the financial scheme, (buy on paying only 2% of flat cost, 18% rental yields, etc.), one needs to be wary of assessing the true cost of such schemes, either in monetary terms or through enhanced risk.