In a notification, banks have been told to watch all loans under “innovative” financing schemes which involve giving builders the full home loan amount even though the builder hasn’t finished construction.

Such schemes are called 80:20 or 75:25, where a buyer puts up 20% to 25% of the full property value upfront, and the banks fund the rest.

The builder, who most likely hasn’t even started building the property yet, gets all the money. He promises to pay the bank the full EMI until construction is complete, in a tri-partite agreement.

However, these schemes are hugely risky.

The builder has the full amount, without having constructed anything. They get financing in your name, and get to pay a lower interest because YOU are the one taking the loan (individuals get a lower home loan rate than developers, a distinction I totally disagree with – if anything, individual home loans should be charged a higher rate).

If they don’t construct the building, the bank now has no collateral. But since its your loan, you have to repay anyway. This can be a disaster since you don’t have a property now for which you have a loan.

The Realty Ponzi

In reality, such innovative financing promotes ponzi schemes. A real estate developer has to only start advertising, and people are ready to pump money in, in the hope of much higher returns.

Most “investors” plan to flip even before a single slab is complete.

Assume an investor buys a 2,000 sq. ft. flat at Rs. 4,000 per square foot; instead of Rs. 80 lakh, he pays only Rs. 16 lakh with a bank funding the rest and the builder paying the interest during construction. In a few months, if he sells at Rs. 4,200 per square foot, he makes a profit of Rs. 400,000 (200 rupees per sq. ft) on an investment of Rs. 16 lakhs – a cool 25% return on investment.

The ponziness lies in what the developer does with the money. Assume he doesn’t bother to actually build anything. He uses the money received to buy another plot of land, which he then advertises, gets more 80:20 jokers, and does this many times.

How does he pay the interest?

The 20% upfront ensures he can easily pay home loan interest rates of 10% a year. On the 80% of the property that is financed, interest works out to 8% of the property value per year.

You’ve paid 20% upfront. So technically the builder can last 2.5 years – and if he’s gone the ponzi way, he has cash flow from new investors to pay old ones and so on.

What’s left then is a piece of land on which someone has to build something, but won’t because he has no money left (the money was used to buy other land).

Then the blackmailing begins – pay more, or we’ll have to litigate through courts. Banks will harass borrowers because effectively the loan is in the name of the borrower. The borrower, who was either an investor or a homebuyer, has now nothing to show for it.

What To Do?

If you’re an 80:20 borrower, you need to ensure the builder is running to schedule. If he has all the money already, he has no incentive to, and unless you have serious political muscle, you can’t make them. You have to hope they care about their reputation; while some do, others may decide reputation isn’t worth the money they have to pay back.

If a builder doesn’t complete the project, or pay the EMI as he promised, you are on the hock for the money and the interest. If you don’t pay, your CIBIL score will be impacted.

Banks haven’t yet been barred from such loans. RBI’s only said that such loans “should not be made in cases of incomplete/under-construction/green field housing projects.” If banks choose to comply, it might help unwind a large part of the urban real estate bubble.

But I think the RBI will have to come out with a complete ban on such products. I don’t have data for this, but it could be a substantial portion of new loans in the last three years. A ban will kill the ponzi scheme and all such developers, but it will also hurt banks and borrowers – still, it will end up being the better thing to do.

When we lack quick justice by courts, the only solutions are bans. If judges and investigators put fraudulent builders behind bars and seized all their money, within a short time, such a fraud will not happen.

This is negative for real estate developers, of course. I would say it’s negative for banks, but right now EVERYTHING is negative for banks.

Now, tell them about it: