My actions impact the equilibrium14 min read

The Prince of Kandy

In the study of certain subjects, there are certain universal truths that teachers try to instil in their students. In medicine there is ‘first do no harm’, in accounting there is the notion of double-entry, and in economics (and important to this piece) there is the concept of demand and supply.

Though we may all understand these things we at certain points tend to forget them in our actions and revert to our instinctive mindset. This manifests itself for instance in medicine where the treatment is worse than the diseases. These truths also help the weaker students direct their focus in a manner that makes them productive.

The point of the study of demand and supply and the various arduous graphing tasks children are put through in the field of economics is to instil in them the understanding that economic producers and consumers come together to create a price. Factors inducing higher demand and lower supply will increase the price while factors inducing lower demand and higher supply will reduce the price.

Context

This piece is written in contrast to the mass misinformation campaign being run on the state of the value of condominium apartments in Colombo. The Central Bank of Sri Lanka, which is not necessarily the bastion of trustworthiness over the decades, has come out with information suggesting that condominium prices in Colombo remain robust.

The recent Condominium Market Survey does little to showcase how much excess supply is about to hit the market. This alongside the large speculative holding which that very data show is going to cause huge impacts on the financial system. To put it simply no one seems to be calling out the widely advertised fact that the Colombo City Centre by Abans which has been completed is still offering prospective buyers the opportunity to purchase apartments with a 20% downpayment and the balance in 2 years. Even monthly maintenance costs have been foregone.

Analogous case

Wishes

To come back to the point underlying demand and supply let us return to the story of a farmer which illustrates the fundamental principle of demand and supply. There was once was a farmer who was barely making any profits on his hard labour.

This farmer though hard-working and diligent was plagued by external factors beyond his own control harming his payout. Over the years the farmer had faced issues like drought, disease, and a lack of fertilizer destroying his harvest.

The farmer was however was a religious man and the greater powers were for this season willing to lend a sympathetic ear. The farmer being the hard worker instead of praying directly for increased wealth asked that there be increased rainfall and sunshine for him to grow his crop. He prayed that borrowing costs be reduced and support services for his industry be extended. He further prayed for all the other factors to bring about a bountiful harvest and his wishes were granted.

The farmer was elated and with no uncertainty, he could bank on an exceptional harvest this season. On coming to market the farmer was warmed to see that all his colleagues (the farmer was obviously not based in Colombo) had also benefited from his prayers and received stellar harvests.

Market

As the market opened the farmer’s joyful mood was quickly turned sour as the Colombo based merchants who he actively mistrusted were even more joyful than he was. These were people who had monopsony power (like monopoly power but for a purchaser i.e.- a single purchaser and many suppliers) and had taken advantage of the farmer on previous occasions. Though the farmer thought that with such a bountiful harvest he may even be in a position to turn away the merchants he over time realized that his bountiful harvest was not moving.

The merchants hadn’t even bothered to approach most of the stalls to negotiate prices and were sitting by the food stalls. A few customers may have purchased more than they usually do at higher prices but this was not enough revenue to cover the costs of production. The farmer and his colleagues quickly began to panic. As the day ended the merchants came and offered below cost to buy out the entire harvest.

The merchant later on passed on his purchased produce to an export firm at a handsome profit. The farmer on being completely wiped out and with no financial prospects took his own life later that day.

Stating the obvious

You can not increase supply without impacting the price. From the increase in the amount of BOI agreements, to the number of projects being vested with the UDA, to the huge amount of land just recently added to the map of Colombo, a lot of our financial interests are more aligned to the side of the farmer than of the merchant.

Even if we are to take the wild assumption that hyper proximity to the entrance of the Colombo Port City is important, we are not acknowledging the fact that large amounts of buildable (yes brownfield) land exist in the vicinity as evidenced in the picture.
The assumption is also wild as distance in the local market is usually to a local amenity or service and not a postcode. 2 kilometres to Royal College has more meaning than 2 kilometres to Colombo 07.

The density of our built-up area does not warrant a changing of that metric. Any spot in Sri Lanka is less than a small radius from a region that is not so heavily built up.

Sri Lanka is not Dubai. We do not have rich friends to bail ourselves out and have a large population to think of. Affordable housing is increasingly becoming an issue and it can not succeed if this property development boom is to succeed.

Signs of a bubble

The most obvious and glaring sign of the bubble is the fact that the rental yield on these apartments is paying out a lower figure than the government securities that share a similar liquidity profile. Our government securities market is jealously guarded by a highly profitable and very poorly regulated primary dealer network but does have a shorter time span of convertibility into money than some of these apartments in the current market. Also, government securities tend not to have monthly maintenance charges.

The asking monthly rental (can be negotiated downwards in the current market) for a 3-bedroom 7th Sense apartment is Rs 710,000 quoted as US$ 3,500 a month. A similar apartment has an asking price of Rs 175,000,000 (again can be negotiated downwards). Even under the ridiculous assumption that apartments are always rented and there are no maintenance costs, this leaves the landlord with a rental yield of 4.86%. A treasury bond with a 1-year yield (basically a treasury bill) is yielding 7.49% as of 30.09.2021.

I don’t know what value one can place on the social status of owning a 7th Sense apartment brings in a venomous Colombo shindig but it sure as hell can’t be 263 basis points.

Replacement cost principle

The current marketing ploy by the increasingly desperate real estate developer is to offer these newly constructed apartments as a mechanism to shield your net worth from the impending currency depreciation.

Though this is a compelling sell and the vehicle market has surely seen great success with this line it is difficult to see why people with money who are more sophisticated should fall for the replacement cost fallacy.

People buying vehicles in a panic are doing so as they see themselves needing a vehicle in the future. People buying apartments, as many as 30% according to the Condominium Market Survey, are doing so for a secondary income stream. As I have argued before most of them do not need an apartment and as mentioned before would be better off renting and placing the saved funds in Treasury Bonds.

The value of these apartments

The value of these apartments is not in the quality of their finishing. Apartments in Cinnamon Grand which are now quite dated are still going at prices similar to the much newer apartments in Monarch. The value is tied to the location.

As evidenced in the picture even prime locations as close to Cinnamon Life are now opening up. Though there is a shortage of financially secure developers in the current marketplace, there isn’t a shortage of land.

The conspiracy behind the toppling of the building in the image is interesting as like the story of the farmer’s prayers it will backfire on the prospective sales on the newly constructed buildings. If Cinnamon Life was to position itself as a prime location instead of targeting a row of buildings with significant architectural value should have looked to prevent the Tata Housing complex that popped up a few hundred metres to the right which currently houses blue-collar Indian labour for the construction projects such as ITC.

That old building

This is an argument that should be screeched at anyone who suggests this speculative property boom is about tourism. That old building is something that over a long period of time would have garnered a premium in terms of rental. It does not take an international traveller to realize that sometimes the best parts of a city are the old parts. All tourists flock to the likes of the Dutch Hospital region to partake in the unique atmosphere that section of the city brings about.

Check your Instagram! The mosque in Pettah is a huge draw as evidenced by the many new social media posts in the region. Colombo City Centre on the other hand peaked a few years ago and is now of no interest except to the occasional moviegoer.
Further development can be made to the entire Fort region if the Central Bank stopped pushing its weight and allowed that section of road outside its building to open up. It doesn’t take a student of architecture to realize that the Stuart is supposed to open up facing the ocean and it is a crime to our battered tourist sector to maintain those horrid grills.

How we got here

Basically, greed and weird risk appetites. To recall something that I wrote in February 2020;

The Beira Lake Conspiracy
You and I do not have land around the Beira Lake. Some of you, if you are lucky, might have ownership of some apartment in the area. The land in that area is inherited and is artificially inflated in value due to the hoarding nature of the holders and the enabling tax structure.

John Keells and Browns Holdings, for instance, had so much land that it was weighing down on their financial performance. To rectify this corporate Colombo conspired with the authorities to spark a highly speculative property development boom with incredible concessions on tax.
Tax from actual work can be taxed as high as 24 per cent but when one of Mangala’s dimwit friends’ makes it through sitting on their ass with the property they inherited they pay capital gains at 10 per cent. Municipal tax is negligible and municipal works in the Beira area are anyway funded either centrally or through apparent aid .
The development of the area is being heavily pushed through the channelling of credit and tax concessions into the area. Given all of this how politically sustainable will the impending bailout be? Especially when the SMEs realize that they were left out of the recent SME bailout scheme.

Accounting fraud

As mentioned before the entire property sector is quite low yielding. The city hotels even before the pandemic were operating at a loss. This boom was made possible by the lax attitude of the Central Bank and more importantly the Insurance Regulatory Commission of Sri Lanka. The investment by Sri Lanka Insurance into the failed Ceylinco Celestial Tower (now the Grand Hyatt Regency) allowed the accounting standard to take into their books very high values for buildings. If that building had to be auctioned off instead of sitting on the balance sheet of Sri Lanka Insurance and consequently the Life Fund, we would have realigned our developments.

Currently, early withdrawals from the Life Fund would benefit more so than later withdrawals because at some point that investment will have to face market realities and be written off.

How many prospective buyers?

How many people in Sri Lanka can afford an apartment that costs in excess of Rs 25 million? Under the assumption that you can borrow at 7.5% that would mean an interest outflow of Rs 145,833 a month. As the Household Income and Expenditure Survey does not give a strong sense of the distribution at the end of the spectrum it is difficult to see how many people are there who have incomes that are 3X of the median.

Given that people do not intend to spend their entire income on housing let us assume as with Norway and Sweden Sri Lankans tend to spend 30% of their income on housing. That would mean that a person would need an income of about Rs 486,111 a month to have a lifestyle that fits into the lifestyle that goes with the apartment.
This makes our calculation easier as that income figure would have to cross the tax threshold. There are 292,712 individual tax files open in the country. Here if you are a taxpayer you should congratulate yourself as you are technically more or less in the 1%. As I have mentioned earlier these 292,712 people probably do have homes and are unlikely to purchase for their own consumption the rest of the housing stock. If it at all they will be purchasing to rent to foreigners who are currently in short supply.

Resorting to accounting fraud

Take the recent IPO that is going to happen for Expack Corrugated Cartons. The company is in a competitive business market and isn’t that highly profitable. The company as with many Colombo corporates is heavily geared probably as well at the level of the parent company.

They have been paying out the extra cashflows from their operations out of their business as dividends. The accounting standard allows them to do this as they have made book profits and probably not appropriately written down their property, plant, and machinery. As with many manufacturing industries, they have huge assets proportionate to their balance sheet in property, plant, and equipment.

As machines deteriorate over time they are now trying to keep their dividend machine flowing by raising public funds to replace their plant and equipment. Careful investors would note that they are not trying to grow their business substantially and intend to sell off the old plant. Don’t be fooled as if the returns from the venture were as high as the CAL report suggests they would use internally generated funds for investment.

Here it must be repeated time and time again that it is possible under Sri Lankan Accounting Standards to put in any damn figure in a valuation document. Many of the failed institutions on the CSE have done the same.

Conclusion

If companies like Ceylinco that have genuine long term investment needs entered the property sector and were honestly managed we would have a continuous stream of nice developments. No one would make a killing but at the same time, no one would make a loss.

However, if they get too risk-averse and instead let their historical turf get invaded by the likes of the Prime Group which notably have taken over failed Ceylinco institutions and are going on a rampant expansion, we will end up in a situation like this. If the farmer hadn’t prayed for mega-profits he wouldn’t have ended in that mess. If all you really want to do is save then a Treasury Bond performs better than the current condominium market.

Much like our currently overvalued stock exchange the saying ‘all fictitious value must be a loss to some person… the only way to prevent it is to sell out and so let the Devil take the hindmost,’ holds. Interests rates will have to rise over the medium term further hurting the discount rate on future cash flows which in the case of rental income have no prospect for an increase in terms of Rs per sqft.