Low cost housing finance - an emerging market

D. Vidana Pathirana-DGM (Finance and Planning), HDFC Bank

Housing finance markets are expanding and is a powerful engine for economic growth in many emerging countries and is a catalyst for socio-economic development. Sri Lanka is no exception to this scenario. The achievement of the Government's Millennium Development Goals set for 2015 could be aided by the development of the low-income housing market, which can be considered a crucial sector of the economy.

The key benefits envisaged are an increase in the GDP growth rate, increased social stability, creation of new employment opportunities, growth in the construction sector and a reduction in the Government's Budget on social infrastructure - allowing redirection of funds to other areas of concern.

Adequate housing units is a pre-requisite for the less privileged to benefit from changing economic conditions and to take advantage of the opportunities created.

While the Government has actively involved itself through specialised institutions - to support housing development - for the bottom line of the income pyramid. A gap still prevails in the low and middle income sector which could be bridged by private sector participation. It is felt that an integrated and well focused system of housing finance can reduce this gap, while fuelling the demand for houses.

Housing

Guided by the findings of the census in 2012, the population has grown over the past 30 years, by 37 percent, from 14.9 million to 20.3 million. The annual growth rate of 0.7 percent is the lowest in the region. Over the same period, housing units had increased by 97 percent, from 2.9 million to 5.7 million, reflecting a substantial decline in household size from five persons to 3.5 persons.

The census reveals that Sri Lanka has been successful in managing the national housing backlog, which was approximately 350,000 units in 2001. However, a gap still prevails within the low and lower middle income sector particularly because of the natural expansion of the housing need. It is believed that a sizeable portion of the existing units are substandard, hence require substantial improvement and upgrading.

Housing investment and affordability

The house is the biggest investment of an average income family. World Bank research reveals that personal residences amount to 75-90 percent of household wealth in emerging economies. Costs of an average affordable house is claimed to be approximately 400 percent of a householder's annual income in developed countries and 600 percent to 700 percent of the annual income in emerging economies.

In Sri Lanka, even in the best of environments, due to the ever-increasing cost of real estate coupled with rapidly increasing prices of construction material, the price for an 'affordable house' costs over seven to eight times of annual income.

Role of housing finance

Faced with such a challenging background, owning a decent house with basic facilities and adequate space becomes a dream for the majority of Lankan families.

Those with housing needs look for financial support which could be paid off in affordable instalments within a reasonable period. The housing industry considers a housing loan to be affordable if the monthly instalment is less than 40 percent of the household's monthly income.

While there are many other aspects that contribute to the housing industry, an integrated housing finance system will play a vital role in the growth and expansion of the housing sector. Similarly, the housing finance business itself, has a vast potential to grow as a profitable industry with the expansion of the housing sector.

Housing finance needs do not only involve financing of new construction or purchase of property. Substantial funds are also needed for housing rehabilitation, repairs, furnishing, appliances and utilities and also for real estate development.

Housing finance industry in Sri Lanka

Over the past two to three decades the industry has embarked on a gradual transition towards an integrated market-driven housing finance system which is highly segmented on the level of income. The mortgage market has grown by leaps and bounds, recording a growth rate of 30 percent over the past decade.

The market value has been estimated at Rs. 231 b as at end 2011. The commercial banking sector which caters to a wider income group accounts for 69 percent of the market, while Licensed Specialised Banks (LSB) hold 31 percent of market share. Low and middle income segments are mainly catered to by the LSB sector.

Growth potential

The size of this market as a percentage of GDP is only eight percent which is much lower than the world average of 30 percent (World Bank statistics). In India, the mortgage to the GDP ratio which is currently nine percent, is projected to grow up to 20 percent by 2020 (National Housing Bank of India statistics). The ratio is 29 percent in Malaysia, 32 percent in Singapore and 81 percent in the US. These statistics showcase the growth potential in Sri Lanka.

Central Bank statistics show that 5.2 million households have spent Rs 681 b in 2011, on housing and housing-related consumption. This represents 15 percent of the households' consumption expenditure. Meanwhile, gross domestic capital formation on residential buildings is Rs 433 b as at end 2011. Nevertheless, the total housing finance outstanding is only Rs 231 b.

Wider income housing finance

The commercial banking sector has served the effective demand of the population in the high-end segment of the income pyramid recording a market value of Rs 159 b as at end 2011. This wider income market representing approximately 25 percent of the potential housing finance market in the country, has been substantially sluggish over the past five years with slow growth prospects being forecast.

Emerging opportunity

The expansion in the country's mortgage market has swelled from the demand generated by the low and middle income housing finance that is mainly driven by the LSB sector.

This market has widened from approximately Rs 52 b to Rs 72 b showcasing an annual average growth rate of seven percent over the past five years and can be projected to reach over Rs 100 b by 2020.

According to World Bank estimates, this market constitutes the second tier of the income pyramid and represents approximately 35 percent of the potential housing finance market.

A potential housing finance market has a mortgage value of approximately Rs. 1,000 b, with an average loan size of Rs 500,000. The approximate number of customers is two million households, of which only seven percent of which has been penetrated by the banking system. With the current growth trends, the middle income population segment is expected to boost growth in the housing finance market. As per the Central Bank estimates on domestic capital formation, this segment of the population spends around Rs 240 b annually on housing which is 103 percent higher than the total mortgage outstanding .

Who constitutes this market

The middle and low income segment and informal sector as a whole represent this market. Wider income and upper middle class segments of the population are well served by the formal financial system, with various financial products tailored to suit them, nevertheless there is little or no finance available to the emerging section of the population.

Middle and low income families can be divided into two categories. The first being, people who are formally employed and who have formal documentation in terms of pay slips or bank accounts.

And, the second being the informal category such as daily wage workers, shop-keepers, pavement hawkers and farmers. They lack formal documentation of their income or assets to provide as security. The formal financial industry has little or no focus on this category of customers.

In my experience, the majority in this segment have the capacity and willingness to pay for affordable housing, if finance is accessible and affordable. They are also not reluctant to pay a reasonable risk premium for a hassle free facility.

Sharing experience

Low and middle income housing finance, particularly in the informal sector, is a highly fragmented market. Strategies and business models differ based on whether the customers are rural or urban, from low income or lower middle income groups, self-employed or daily wage, engaging in agriculture or fisheries.

For any financial institution to be successful in doing home financing with this sector, their preferences, needs, income pattern, ability to pay, needs to be studied first.

An organised and regular method of customer engagement and captivation are rewarding strategies. Staff training and immersion are equally important.

Reaching this market often requires radical dynamism with changing approaches. Standard credit evaluation practices used in commercial lending are less practical.

Instead of evaluating income cash flow, assessing households' expenditure cash flow is a more practical method of determining repayment capacity. Knowledge of family size, lifestyle, future expectation, and distance to workplace would be important, in assessing the cash flow.

In the low-income sector, women play a key role in managing family finances.

Often engagement to an equity building savings plan is either made or influenced by the housewife, who ultimately takes care of timely repayment. Customer education has shown to be one of the most effective tools of loan default management.

Another key to success in servicing this sector is maintaining a long-term commitment which paves the way to build a savings buffer, cash flow and credit worthiness. Customer handling has to be futuristic while short-term commercial profit should not be expected.

Engagement in community works could be a good strategy of gathering information and getting better acquainted with the target audience. Application of the personal banking approach applied by banks to high-end customers would be an effective strategy in penetrating this market.

Think out of the box, be flexible and be open to new ideas.

Addressing the housing finance needs of the informal sector requires an inclusive approach which links their environment, neighbourhood and economy.

Historically, large businesses have focused on the medium to high income population segment. However, businesses across the world are increasingly giving serious thought to the low-income market given its sheer size and dynamism. Innovative methods of engagement have opened lucrative avenues of revenue generation for these businesses. The same holds true for the housing finance market in Sri Lanka as well.

The writer, a BSc Special Graduate, has an MBA, and is a Fellow of the Institute of Chartered Accountants of Sri Lanka and the Institute of Certified Management Accountants of Sri Lanka.