In the post on pharma sector (click here) we noted that companies can be classified as cyclical and non-cyclical companies. Cyclical companies are those companies whose growth is dependents on the overall state of the economy. When the economy is booming these industries do well. When there is a down-turn these companies show lackadaisical performance. Some of the sectors like steel, cement, real-estate, auto, travel and tourism etc, show cyclical nature. Non-cyclical companies or industries show a growth process that is independent of the overall state of the economy. These industries could be catering to needs of people that are inherently non-critical. Hence, irrespective of the current economic conditions, these companies keep their sales counter ringing. In India 4 major sectors are usually treated as non-cyclical (i.e. defensive) sectors. They are:

  1. Information technology sector
  2. Financial Sector
  3. Pharmaceutical and healthcare sector
  4. Consumer goods sector.

Out of these four, the sector that is of interest in this article is the Financial sector. The word “Financial Sector” is a generic term. It includes public and private sector bank, Non-banking financial companies (NBFC) etc.

Banks:

We are well aware of the banking sector. It comprises multitude of banks both in public sector and private sectors. These cater to a plethora of customers in rural, semi-urban and urban areas. Banks provide range of facilities to customers ranging from CASA accounts to investment options to various loans (Personal loan, Car loan, Housing loan, Student loan, Loan against property, gold loans etc). They cater to corporate sectors as well and extend credit to cottage industries, SMEs, large corporations. Banks also have various mandates like mandatory priority sector lending (ex: Banks have to lend certain portion of their loans to priority sector like agriculture). Banks also need to maintain a portion of their money with Reserve bank of India. The portion of money that needs to be kept with RBI is governed by the Cash Reserve Ratio (CRR) rate. In short, a bank is a complicated business.

Non-Banking Financial Companies (NBFC):

As per Wikipedia [1], an NBFC is and I quote:

“A Non Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 of India, engaged in the business of loans and advances, acquisition of shares, stock, bonds hire-purchase, insurance business or chit business but does not include any institution whose principal business is that includes agriculture or industrial activity or the sale, purchase or construction of immovable property”

There are different types of NBFCs, for example Asset finance companies help people in buying assets like tractors, automobiles, generator sets, lathe machines etc. Investment companies deal with buying securities. Loan companies deal with providing loans (other than those listed for Asset finance companies). Infrastructure companies provide loans for infrastructure projects and so on.

One set of NBFCs cater to the needs of consumers interested in buying residential dwelligs. There housing finance NBFCs are the main object of interest for us.

Housing Finance Companies:

As a prospective home buyer, if I am searching for housing finance then there are two types of companies that I can approach to:

  • Banks: Almost all public sector and private sector banks provide housing loans
  • NBFC: There are a set of NBFCs that are dedicated to housing finance.

The main aim of NBFCs catering to housing finance sector is to provide housing loans to retail customers. Sometimes they also provide loan against properties for customers who are short of money and want to mortgage their existing home. Sometimes they also finance builders to construct houses. If an NBFC wants to call itself a housing finance company, it has to register itself with National Housing Bank (NHB). Currently there are 72 housing finance companies registered with NHB (note that most of these companies are not public listed companies) [2]. NHB divides the housing finance companies into 3 categories. Category 1 companies are those that can accept deposits from public. Category 2 companies can take deposits from public, but they need prior approval. Category 3 companies cannot accept deposits from public.

However there is a different ways in which the housing finance companies can be segregated. Some of the methods of slicing them are given below:

Demography: India is a huge landscape and covering the entire country is not a feasible option for the housing finance companies. Hence the companies have limited their scope to niche areas.  Some companies have limited themselves to Tier 1 areas (i.e. urban areas. Ex: HDFC, Indiabulls housing finance etc) while others have limited themselves to Tier II and Tier III areas (i.e. semi urban and rural areas. Ex: Gruh Finance, Repco Home finance etc).

Loan Amounts: Some companies provide loans that are above a minimum threshold. As a customer you can approach these companies only when your loan requests are above the limit. Most of the banks and large housing finance NBFCs fall into this category. Some housing finance companies cater specifically to small loans. Some of them have an upper limit of Rs 5 lakhs while others have a cap of Rs 10 lakhs. Some of them do not have an upper cap but their approval process is tilted towards lower cap (say 10 lakhs), so a look at their loan book will show most of their loans to be less than this value.

Salaried and Non-Salaried Segments: Most of the housing finance companies cater to the salaried segments. Reason being that a steady income provides a visibility of future payment capability of the customer. All banks prefer to cater to the salaried segment. However, few of the NBFCs cater to the non-salaried class.

The housing finance companies fall in one of the categories for all these slicing. For example Indiabulls housing finance caters to Tier 1 areas, provides larger home loans and limits itself to salaried class. Whereas Mahindra home finance is predominantly in rural areas, provides smaller home loans and caters to non-salaried households.

How does the entire process work?

It seems to be a very straight forward process. The housing finance companies borrow money from various sources like banks, NHB, deposits etc at a specific rate (let us say 9%). They lend this money at a higher rate (say 12%) to borrowers who wish to take loan to build (or buy) houses/flats. The difference amount is their profit. When you deduct other expenses like employee salaries, infrastructure costs, taxes to the govt etc, whatever is leftover is the net profit for the NBFCs. NBFCs choose either to keep this profit with the company as shareholder capital or partially disburse it to its shareholders as dividend.

The process appears simple, but housing finance has its own complications, what if borrower fails to pay his EMI resulting in non-performing asset (NPA), what if the bank’s borrowing costs increase (should the NBFC pass through the costs), how do the NBFCs handle acts of god (natural disasters like floods, earthquakes can destroy/damage the property of the borrower should they reduce the rate of interest, waiver the loans, increase the repayment period…) and so on.

Moat for housing finance companies:

Warren Buffett popularized the concept of economic moat. According to Mr. Buffett an economic moat is like the moat round a castle that protects the castle for outside attack. An industry/sector that has an economic moat has the capability to generate higher profits leading to satisfied shareholders. So does the housing finance company have a moat? I believe the following can be treated as a moat:

  • For any company to generate revenue, it needs repeat customers. Be it automobile industry, airline industry, consumer goods industry pharmaceutical industry etc, if the customer who buys your product comes back to buy more, you are doing something good and hence you deserve higher revenue. However for industries like automobile, real estate etc, the chances of repeat customers are rare. People who buy a car do not generally look for a new car for some time in future.

Lending companies inherently have a moat of returning customers. Once a customer takes a home loan, month-after-month he comes to you and pays the EMI. So if you have “X” number of home loan borrowers then for the next, say 10 years you have assured source of revenue. If you need to increase your revenue by say 20%, all you need to do is to find only the delta customers who can generate this additional revenue. Compare this to an automobile company. If the company makes Rs 100 crore revenue this year, to maintain this revenue it needs to find same number of NEW customers next year. Additionally, to improve its revenue it has to find extra customers as well.

Housing Finance Sector Overview:

The figure below [3] shows the Indian households and their income levels (as per census of 2011). Close to 80% of the households has income level of less than 15,000. Most of the real estate boom has catered to the top 8% of the population that has income more than 25,000. So the households at the bottom of the pyramid have been left untouched by the housing boom that was witnessed in the past decade.

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Source: Axis Capital

The above information reflects in the demand-supply gap for house at different price points as well. Since 80% of the households have less than 15,000 salary, they would not be in a position to buy a relatively expensive house. Their desire would be to buy a house that costs less than 5 lakhs. Which reflects in the demand-supply gap shown in the figure below [3]. Households with salaries more than 25,000 can afford housing loans that the banks supply. Moreover they are generally salaried people who have regular income. Hence they are capable of getting home loans. Such households buy houses that cost upwards of Rs 7 lakhs. The population of such households is less and hence the demand is less whereas the supply is more than the demand for such houses.

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Source: Jones Lang Lasalle (JLL)

The table below shows the status of demand-supply in terms of number of houses. There is an existing shortage of 59 million units and most of it (40 million units) is in rural areas. New dwellings required is about 51 million units with an almost equal division between urban and rural areas.

Million Units Urban Rural Total
Existing shortage 19 40 59
Vacant house 9 10 19
New dwelling units required 28 23 51
Total 38 (i.e. 19 – 9 + 28) 53 (i.e. 40 – 10 +23) 91 (i.e. 59 – 19 + 51)

Source: Census 2011, Ministry of housing

Let us look at the occupation of these households. The figure below clearly shows that majority of the households are in the unsalaried segment. Rural households are predominantly self-employed. They could be in agriculture or they could have their own setup. Urban workforce consists of salaried class predominantly government employees and people working in private sector. There is an equally thriving self-employed section of households in urban areas as well. In the Rural+Urban sector again the households are predominantly unsalaried. Hence, self-employed and casual section of the society dominates the Indian diaspora.

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Source: Labourbeareau.nic.in

Each of the house finance company is growing in its own niche. The figure below shows the focus area of few of the housing finance companies [3]. Companies like HDFC, Indiabulls home finance predominantly cater to salaried class which earns a higher income. On the other hand companies like Religare and Bajaj Finserve serve the non-salaried class that falls in the high-income group. Hence, the companies that are on the left side of the figure ensure that they give loans to people in the high-income group (salaried or otherwise). There are some companies that give loans to low-income households. All such companies are on the right side of the figure. Companies like Dewan housing finance and Gruh Finance provide loans to Low income group but they concentrate on salaried people to offset the risk of catering to people with less income.  On the other hand companies like Repco home finance and Mahindra home finance cater to low-income families that are non-salaried. Families of people owning petty shops, small farmers, hawkers, tea stall, dhaba owners etc may fall in this group.

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Inherent advantages for lending companies:

I always feel that lending companies are like magic companies. Be it the banks or the NBFCs. Some interesting points related to the housing finance companies are listed below:

  • They don’t have to setup factories to manufacture their finished goods. All that they need is NBFC branches located in specific areas and your customers come in to buy your goods.
  • They don’t need to be at the bleeding edge of technology to survive. For example a drug discovery pharma company has to constantly innovate new drugs to earn profits. A product manufacturing technology company (ex: mobile manufacturing companies) have to constantly innovate new things to stay afloat. Housing finance companies lend money period.
  • They don’t have to worry about inventory turnover, overstocking and worry about unsold inventories etc. They also don’t have to worry about rising commodity prices.
  • Employee costs do not form a major part of their expenses. They don’t have to worry about year on year salary increments of employees the way IT companies have to manage this expense. There are fixed rules for lending and the employees have to follow these rules while approving loans for the prospective customers. Modestly educated employees are sufficient to carry out these tasks (especially for Tier II and Tier III oriented housing finance companies).
  • Since they do not have to sell loads of new home loans to customers year after year, their sales expenses are generally less. Moreover, their sales are generally based on word of mouth or minimum advertisement. Hence, the marketing expenses are also on the lower side.

Performance of Housing Finance Companies:

The below graphs show the revenue growth for 7 out of the 9 listed housing finance companies. You can notice that year-on-year all these housing finance companies have been able to increase their revenue. Indiabulls housing finance has seen the fastest growth over the years. The slowest being LIC housing Finance.

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Data Source: moneycontrol.com

The below graphs show the growth in net-profit for these 7 housing finance companies. Again from the graphs it is clear that each of these 7 housing finance companies have been able to grow their net profit year-on-year for the past 5 years.

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Data Source: moneycontrol.com

Now the above graphs are an indicator of a sector tailwind. It is rather a textbook example for a sector tailwind with each and every company showing an increase in their revenues. Also a consistent growth in net-profit clearly indicates that each of these companies has grown on their own without competitive price cutting, excessive sales and marketing expenses etc. Hence it appears to be a secular growth industry.

Risks:

The tier II and tier III market potential is pulling many more companies to start housing finance arm in their respective companies. Companies like Reliance Capital are drawing up huge plans to grow in this space. You can read the details here (http://articles.economictimes.indiatimes.com/2015-12-15/news/69062093_1_reliance-capital-reliance-commercial-crore). With housing for all by 2022 scheme being pushed by the government, housing finance has become a hot area. This will lead to competitors trying to gain market share, akin to what was seen around 2006-08 timeframe when banks started aggressively lending home loans at teaser rates that led to a huge drop in housing loan rates. I believe this is a major risk to the existing listed housing finance companies.

Acts of god (like floods, earth quakes) can act as black swan and destroy the dwellings of lot of customers. Companies like Gruh, Repco, Dewan housing have concentrated focus in Western and Southern states. Hence, a natural calamity can be a major setback to these housing finance companies.

Other than these risk, non-payment of EMI could lead to increase in NPAs for these companies. This is a crippling factor for these companies.

Summary:

From the points listed above we can note that housing finance seems to have a decent moat, interesting inherent advantage and they have shown fairly decent performance over the years. The sector as a whole seems to have a tailwind (considering the ambitious goal of home for all by 2022). Companies in housing finance sector merit a detailed look.

References:

[1] https://en.wikipedia.org/wiki/NBFC_%26_MFI_in_India

[2] http://www.nhb.org.in/List-of-HFCs-Registered-with-NHB-29-01-2015.pdf

[3] Axis Bank Capital Sector reports – 2 Dark Horses (30th March 2015)

Disclaimer:

I am not a SEBI registered research analyst. The information provided above is my subjective view based on what I have read on different websites, annual reports, and quarterly reports of various companies which I assume to be accurate. The above information should not be treated as an offer/advise to purchase a specific stock/investment instrument. Since these are my subjective opinions, I could be wrong in my understanding or presentation of information. I do not claim that the above information is complete or can be relied upon as such. We cannot be held responsible for any loss or damage caused due to any inadvertent error in the above information. We will not liable for investment decisions made by readers of this article based on the above information. I am not an investment advisor. Please consult your investment advisor for all your investment needs.