Understanding Real Estate Market

Real Estate (RE) market has been one of the most talked about and widely covered by analysts. Also it is one of the sectors that has seen best booms and worst busts vis-a-vis other sectors. In fact, Asian crisis of 1997 and ongoing worldwide slowdown (the Sub-prime crisis) owe their losses to RE.

RE is part of a larger category of assets called Real Assets. Real assets are assets like real estate, gold, commodities, etc. which are tangible, unlike shares and bonds which are paper securities. Shares and bonds don't have any intrinsic value in themselves but these represent assets and hence hold values. RE is the oldest asset used by investors to park their surplus monies. In fact, it is believed that due to scarcity of land in historical periods, other securities like shares, bonds, etc. were developed. Even in today's times when investors are losing their risk appetite everyday and cost of capital is rising with each day passing, RE still happens to see major deals involving billions of rupees.

In India major players in this sector are:

Akruti City	DLF	Unitech
Indiabulls RE	Omaxe	HDIL
Peninsula Land	Sobha Developers	Parsavnath

Major Activities

As with any sector, RE also has a 'project life cycle' which can be broadly divided into following activities:

1. Land acquisition and conversion – This stage requires lots of approvals and permissions from various regulatory authorities. Apart from being the first, these activities are most risky ones. But following the fundamental principles of finance (for more risk, investors demand more return), this section of RE life cycle is most rewarding for investors.
   

   
   

2. Construction and development – Once the developer (one which undertakes the responsibility of placing a structure on a piece of land) has acquired the land and taken necessary approvals and permits, it starts the work of building structures. This can be done either through some third entity (construction contractors) or the developer can do this itself. Companies like DLF, Unitech, Sobha Developers are said to have strong execution skills.
   

   
   

3. Sales – This is the marketing section for developers. Here the industry gets exposed to retail investors who lured by discounts, easy loans, and so on. The credibility of Developer is what end-users/investors take very seriously for reasons like clean title. No one wants to put his/her money into some investment which tomorrow is claimed by many or is under litigation for some reason. A good developer is also believed to bring a quality product in the market.
   

   
   

With each section, some other attributes like type of investor, investment horizon, etc are related. Let us put these in form of a table :

Attribute ↓ Stage→	Land acquisition and conversion	Construction and development	Sales
Type of Investors	Private Equity, HNIs	SPVs, Retail	Corporates, Retail
Investment Horizon	Very small (months to 2 yrs)	Small – Medium (1 to 3 years)	Long*
Risk	High	Medium	Low
Return	High	Medium or Low	High, Medium, Low*

* Depend mainly on the market condition, whether boom or bust

Cash Flows of a RE company

Outflows
Cost of Land and related expenses	x x x
Construction and Development Costs	x x x
Interest	x x x
Admin and other costs	x x x
Inflows
Sales	x x x
Rentals/Leases	x x x

Valuation of RE assets

Some of the prominent methods of valuation are:

1. Build and Sell – Discounted Cash Flow (DCF) Method. In this method, we discount the prevailing actual sale prices at cost of capital.
   
2. Build and Lease – DCF method. Here we capitalise (divide) the prevailing rentals by the cost of capital.
   
3. Assets in construction stage – EBITDA (Earnings before interest, taxes, depreciation and amortisations) multiple. This method requires, first, estimating the sales price and then reducing from it the average direct expenses to arrive at EBITDA.
   

Why Boom!!!

Though it is not possible to list out the factors/reasons behind a boom in any industry, but with loads of research and analysis, experts say that the last rise in investments in RE was due to the following reasons:

1. High Liquidity in the market – Having a lot of investment in a particular sector, more so when it is not able to absorb so much lead to spiralling of prices. Any RE project can take 3-5 years from initiation to sale. It is not that with more demand, the supply will increase instantaneously. But why was there so much liquidity in the market? Reasons:
   
   1. Huge foreign inflows
      
   2. Low cost of capital
      
   3. Active retail investment, through easy loans and increasing affordability (specially the salaried class)
      

   
   

2. High Valuations – backed by high liquidity and churning of capital within project stages led to high valuations. Churning of capital is supposed to take place when investment horizons fall and still market rewards you with handsome returns. What is said to have happened was that investors were realising their investments pretty soon and were re-investing in other projects as there was huge demand (at least in reports and forecasts, if not in real life!). Mathematically, if you have increased cash flows in few years against smaller cash flows in a stretched period, you will have a better NPV or IRR. This churning of capital happened mostly in the first stage of 'land acquisition and development'.
   

   
   

3. Regulatory Support – Recent years have seen government encouraging this sector with passing of SEZ Act, fast clearing of projects (mainly SEZs), tax benefits, etc. Though one can argue that banks were asked to value their investments in RE sector with more risk-weightage.
   

Why Bust?

The reasons behind the crisis could be many. Some of them are:

1. Diminished affordability – With Central Bank's aim of taming inflation, we saw lot of pressure on interest and other statutory rates in 2008. The result was falling economic activity as the cost of debt rose to high levels and investment decisions became all the more difficult. Businesses, whether big or medium or small had to bear the increased cost and wherever possible the increase was transferred to consumers. However, RE was one of those which suffered the most. At the producers' end, high cost of debt made it difficult for developers to execute the existing projects and to go for new ones. Since RE is another capital intensive industry in which any typical project has more than 50% debt, things became all the more difficult. Developer's found it difficult to complete the financial closure of projects on time.
   

   On the consumers' side, rise in cost of loans and hence increased EMIs (Equated Monthly Instalments) reduced their appetite for making investment in the sector. In fact, many who had taken these loans for self-accommodation purposes also bore the brunt. Actually not only the rates were increased but also Loan-to-Value ratio (if value of property is Rs. 10 lacs and the loan that could be availed by mortgaging this property is Rs. 5 lacs, then L-t-V ratio is 50%) was reduced. Though now things are recovering with RBI bringing down the interest rates and issuing directives for encouraging banks to lend in this sector.
   

   
   

2. Faulty estimates – When oil was at $147 a barrel, analysts forecasted a price of $200. When Sensex was at 21k forecasts for 30k were not few. I think this is the way some analysts/experts use market scenario to make themselves famous. Nevertheless, year 2007 had many reports published that talked about acute shortage of land in India. I am not an expert to comment on the real demand/supply situation, but I am sure many of these reports exaggerated the real situation. The result, oversupply.
   

   
   

3. Exit by PE funds, foreign investors – PE funds, as said above, have been one of the main players in this rally. However with falling valuations and high cost of capital, it became difficult for them to invest. Moreover now they either had the choice to sell their investments at loss or wait for some more time. Whereas, foreign investors were busy withdrawing money from risky markets and refurbishing their domestic balance sheets. RE being one of the risky sectors, saw more redemptions. However, one can argue that the current mouth-watering valuations should bring more investments by strategic investors like PE funds, big developers.
   

   
   

4. Overall fear or recession – No economy I think has been able to save itself from deteriorating investor sentiments. All are worried about worldwide recessions, with exceptions being countries like India, China, Russia and other developing nations. But even economies like India saw losing investor appetite and more due-diligence. Investors' which are even more scared prefer to sit on cash or bank deposits rather investing in other assets. This further brought down the valuations.
   

   
   

What's next

With recent proactive actions from RBI and stable investor actions, one can expect that the market will not fall drastically, atleast from this level. But we may see some more declines as the 4^th quarter results are going to be worse than 3^rd quarter. As far as RE market is concerned we still may be able to see some downside because of cash-strapping of developers, decreasing profits of investors like Corporates, PE funds, HNIs, etc., increasing unemployment and some other reasons.

But if one was to forecast what one may see in coming times:

1. Lower real-market interest rates
   and L-T-V ratio – By interest rates, I don't mean to say only statutory rates (as I believe that a lot has been done by our Central Bank). Interest rates here refer to the market interest rates which are currently different from bank rates. Actually it is stated by many that banks have not passed on the reduction in cost of money done by RBI to the consumers. And one of the main reasons behind it is that banks are sitting on cash. More so for RE sector due to its riskiness. Lenders are discounting valuations to large extent.LTV ratio is also said to be higher compared to year 2007 levels.
   

   What we shall see in future times is lower real-market interest rates and lower LTV ratio.
   

   
   

2. More investments – With easier financing, one must see RE industry coming back on track with existing projects completing on time and new projects getting investors. But investors need to be more sceptical about the business model of the developers, contractors and other related businesses like facilities management, asset management, etc. This is because no one is sure of what will happen in future – whether Corporates (one of the major customer class for developers) will perform good or whether PE funds and foreign investors start pumping their investments in this sector.
   

   
   

3. More government support – As a sector RE is one of those which hires millions, has countless ancillary industries and brings much foreign investment. It is, I think, one of the agenda's of government to bring this sector on track. Already RBI has asked banks to go forward to in lending RE sector.
   

   
   

Let us all hope that we see more lucrative investments with robust markets in future times.

SUB-Prime Primer

We all, whether those who are part of financial markets or those who are not, have been hearing, reading and (now started) speaking about SUB-PRIME or U.S. financial crisis or credit crunch or financial market breakdown or … (the list goes on). No one has been fortunate enough to skip the aftermaths of inventions of complex financial products (CDO, CLO, CMO and alike) and have seen markets crumbling, whether developing or developed. In fact, this crisis has been hitting the hardest to the developed economies like world-power United States, U.K., etc. The question of how well regulators have been undertaking their responsibilities and how far can market-makers (big banks like erstwhile Merrill Lynch, erstwhile Bear Sterns, Goldman Sachs and counting) can go to innovate (without assessing the potential risks associated) has popped up.

For those, like me, who are still trying to understand the market, and need a primer on what is sub-prime, let us begin to explore the concept. First of all, as the classic definition goes, something which is not a PRIME is named as SUB-PRIME in the market (market in this article shall refer to financial markets). These refer to rates of interest or the credit-worthiness of the borrower. In clearer terms, a borrower who has a good credit history of honoring his/her obligations is said to be PRIME borrower and the one who has either defaulted or is expected to do so is called SUB-PRIME borrower. But how are these simple definitions responsible to collapse of such giants who have dozens of sophisticated investment analysts, economists and other experts? Also these institutions are not in retail lending / mortgaging, so how come these two are related?

Let’s first answer the second question. The story begins from a year 2000’s DOT COM bubble burst, when the markets crashed like pack of cards and there was an urgent need to revive the markets and boost confidence. For achieving the said goals, FED (Federal Reserve – US’ central bank) reduced interest rates to stimulate borrowing and kick-start business again. As expected, markets picked up and confidence was restored. There was a huge increase in amounts of loans granted by banks during this period.

In the real estate market, mortgagers (who get commission on the number of mortgages done) and bankers who wanted to increase their portfolio, went beyond and started serving those who did not deserved them (SUB PRIME borrowers). But since these borrowers gave more commission to the mortgager and more interest rates to these bankers, all were happy. Banks actually modified their lending criterion to book more profits without realizing the aftermaths of such loans which were slowly becoming a major chunk of their portfolio. Such borrowers kept their houses (which they bought with the money lent by banks) as collateral to banks for the funds borrowed, as a typical mortgage-backed transaction. And with easy and cheap money, it was not difficult to buy a home in US (the dream of – a house for each American – seemed to be becoming a reality). This led to surge in house prices, which further enabled SUB-PRIME borrowers to obtain more loan as their collateral value increased.

Securitisation is a form of off-balance sheet financing. (Now you must be wondering that why am I suddenly introducing you with another concept. This is because securitization is what brought our big I-Banks into picture.) Not all companies like to raise direct debt. Obviously there are reasons behind it. Firstly, more debt on my books will tarnish my ratios which are one of the primary tools used by market analysts to gauge a company’s worth and performance. Secondly, to comply with regulations (like in banking sector), I would be required to bring in more equity to balance capital structure. These and many other reasons, motivate firms to go for off-balance sheet debt. How they do this is by doing away with their illiquid assets like book debts, loans granted, etc?

Now this is the phase where I-banks play their pivotal role. Since huge amounts of loans given by (conventional/commercial) banks over-burden their balance sheets and restrict their ability to expand their portfolio. To overcome this, banks sell these loans to I-banks, through securitization, and get ready money for providing further loans. Now what these I-banks do with these loans/debts is that they sell these to investors (usually pension funds, endowment funds, high net-worth individuals). This is done by making packets (tranches) of such loans based on features like maturity, credit risk, etc. For e.g. making tranches of AA rated loans.

The story was going simple: Banks gave loans (since we are concerned with sub-prime crisis, so loans to sub-prime borrowers), then sold those loans to I-banks which further repackaged and sold these loans as credit products to investors. In this chain, a not-so-worthy man got a house, mortgager got his commission, bank got high interest rate and I-bank got commission to sell credit products. All are Happy!

The story was going fine until the something happened.

Fed and other Central banks (in countries like UK & Europe) realized that slowly and slowly asset prices went beyond their tolerance limit. To hold prices from surging further and to bring assets prices to their intrinsic (justifiable) value, Fed increased interest rates which actually increased the payments to be made by the ultimate sub-prime borrower. As a result, they started defaulting. This led to fall in the payments made by special purpose companies (those created to sell loans/debts). Since these companies were paying dividends to Institutional investors, defaults of borrowers affected them too. Gradually the defaults got the whole system infected and paralysed. Since now it was unaffordable to purchase property, the property prices started declining. Again one of the affects of this was that the margin of borrower (percentage of amount borrowed against property) declined.

So the outcome of this financial engineering was that all the systems in the financial markets started tumbling with banks (Commercial and Investment banks) facing billions of dollars of losses.

The moral of the story seems to be that innovation should be protected with adequate risk management, else it could be fatal.

What is a financial model?

One of the main tasks of an analyst is to prepare a robust and complete financial model for the investment for which he is doing analysis, which can be an existing business or a new project. In most simple terms, a financial model depicts the outgo (s) for investment and the revenues/cash flows from the investment. A financial model necessarily has to inculcate the business model of the investment - whether it is selling a product or a service.

typically a financial model should answer the following questions:

1. When and how much needs to be invested?
2. How the funds for investment will be raised (debt or equity or both)?
3. Life of project?
4. Major assumptions which will have a bearing on the numbers - like inflation rate, market interest rate, taxes, customers, etc.
   
5. What will be the recurring cash flows (due to various reasons including different accounting policies adopted by companies, artificial inflating of revenues, etc. cash flows are most preferred tool for an analyst for adjudging an investment)?
6. How much will be the cost of operations?
7. What will be the return to various stakeholders - debt providers, government (in form of taxes), shareholders?
   
8. What are the sensitive areas of which analyst has to take note?
9. What are risks which can affect the future cash flows?

The above list is not at all exhaustive. There can be countless variables which can be built in within the model.

Though, a financial model gives information only quantitative outcomes for an investment, it is the most pertinent task for an analyst in investment analysis. Once the model is complete, he should be able to know the NPV (the net of PV of Cash inflows and PV of investment (s) / IRR (annualized effective compounded return rate which can be earned on the invested capital) and other metrics for measurement of return from investment.

Scenario Analysis and Sensitivity Analysis are major tools for assessing the vunerability of investment. Former involves changing many variables (affecting the future cash flows) and then observing the outcome of these changes to the return on investment (or equity). In sensitivity analysis, analyst changes one variable at a time to know the result. For e.g. what will be the effect of a 1% rise in inflation rate or how much would the cash flows rise with 5% increase in number of customers. By these two excercises, one gets to know the trigger areas which could lead to fall of the project.

Some pointers I remember while preparing financial models:

• Put (or try to put) all assumptions on a single sheet
• Highlight the cells which have entered value (instead of calculations) - standard is to use blue color
• Separate sheets for tax calculations, revenue detail, cost detail and outcomes (with scenario category - worst, most likely or best)
• Focus on what the output should be and what the users of model like to see.
• Try to complete the revenues, costs, cash flows, etc for a year and then extend to future years based on the assumptions.
  
• Minimum number of sheets not only helps the analyst but the readers of the model too.
• Make use of comments feature to highlight important information.

Which is the Best Investment Destination?

After 2006-07 which saw enormous growth in Merger & Acquisition Deals (including LBOs) in ‘BRIC’ economies – Brazil, Russia, India & China- both quantitatively & in value, now the question which has gathered attention is that which is the most promising economy in terms of investment returns for 2007 or which market has become expensive or which country has better prospects taking into consideration its previous year’s performance.
Questions are many but answers not so simple. To begin with we can go through the some vital facts & figures as shown in the figure: -












Source: CIA Factbook 2007

After compiling the above data now its time for analysis.

• Starting with area, Russia has the largest area of around 17 million sq km which is more than half of the combined area of its peers. So it has huge geographical advantage in terms of land though the whole of it may not be usable for industrial purposes.



• In case of population, China takes the lead which is followed by India. But in terms of ‘density of population’, India stands first with 333 persons per km!!! Whereas Russia though boasting with largest surface area has meagre density of just 8. We all can understand how this is beneficial for Russia as now each resident in Russia has greater share in natural resources. India is many a time compared with China in respects of population, but a point to be brought to notice is that though India is second to China in population but China is around three times in area than India.
  As far as growth rate is concerned, India having 1.38% is followed by Brazil with 1.04%. It is appreciable the way China has controlled its growth rate which has become one more reason of its enormous economic development in a short span of time. Russia has a decreasing growth rate of 0.37%. A low growth rate can indicate greater standards of living of people, better quality of workforce, more education, less disparities among population & so on. This ultimately leads to reaching the grade of developed nations in lesser time.
  The unemployment rate depicts the quality of population. Not only should a population be proportionate to its area covered but also it should be skilled & put to use in economic development. Brazil suffers from huge unemployment rate of around 10%. This is terrible as the population which is already employed is paying for the living of the unemployed public too. Moreover such a group of residents is not contributing to the national development but is consuming the natural resources which will disturb the balance. Again China steals the show with least rate of 4.2%.



• In terms of GDP & its growth rate, China tops the chart followed by India. Former has whooping 10.5% as GDP growth rate while India is following it with 8.5%. Brazil lies at the bottom with 2.8%. Though Russia has only 1.7 trillion which is a little ahead of Brazil but it has growth rate which is more than double (6.6%) of latter’s (2.8%). GDP is regarded as the biggest indicator of economic health of a country. For understanding it is the gross market value of goods & services provided by a country during a particular period (usually a year). It reflects how the country’s corporates-both public & private- have put to use its resources. So the more the GDP & its growth rate, the better for the nation.



• Public Debt is the money owed by government. It can be internal (where govt owes money to public or financial institutions within the country) & external (where it owes to foreign public & institutions). More of public debt can be because of heavy investment by govt in nation’s development (infrastructure, education, subsidies, forex reserves, etc). But more public debt as a % of GDP reflects the imbalance between govt spending & value creation. If more investment by a firm is backed by increased sales, then it is said to be utilising its operations well & there seems more growth. Same is the case with nations. In this context, India & Brazil may face great impact of imbalance of investment & return in future as their debt as % of GDP is around 50%. While Russia has this ratio standing at only 8%.



• Inflation rate has been the most talked about matter in India recently where RBI is tweaking the monetary policy frequently to tackle inflation. Inflation, for laymen, is the rate at which commodities get dearer after a particular period (usually a year). It hits the poor & fixed income groups badly. From economic point of view, a little bit of inflation is always desired. But high inflation makes resources expensive which may affect the growth aspects of economy. China has been able to keep its inflation at 1.5% lowest among developing countries. While India has moderate inflation of around 5.3% (which crossed 6% in first quarter of 2007) but Russia has hyper-inflation of 9.8%. Even Brazil enjoys low inflation of 3%. How come China has greatest GDP growth rate but least inflation rate is a question which has not been answered yet.



• Industrial production growth rate shows the pace with which the secondary sector of the economy is producing output. A country with more rate is said to have greater efficiency with which it puts to use its resources. Here also China is numero uno with 22.9% which is 3 times the growth rate of the runner up India having 7.5%. Brazil & Russia are still to touch the 5% mark.



• Forex reserves are the amount of foreign exchange lying with the Central Bank. These though are not great investments as the monies raised here are invested in other countries or provided to government at very nominal rates. But these reserves come to rescue when there is huge volatility in the international market. The Central Bank of a country sells foreign reserves to prevent the home currency falling beyond the comfort level. China has accumulated reserves exceeding $ 1 trillion. All other participants lag far behind. Russia comes 2nd with $ 314 million followed by India & then Brazil.



• One more indicator of nations’ performance can be the major market index. Though it is not a consistent measure of economic development & is often affected mainly by emotions of investor but still it can be used as a scale to measure the current investment outlooks of people & future prospects of corporate sector. Russia’s RTS Index has provided a return of 800% from Jan 1997 to Jan 2007, highest among BRIC countries. Runner up is Brazil’s Bovespa with 436% followed by India having BSE Sensex which gave return of 217%. Here China has not been able to score & lies at bottom with SSE Composite Index providing 80% since Jan 2000.

Apart from the above metrics, Foreign Direct Investment (FDI) already made is another factor that can have impact on decisions of International Investors. China allowed FDI in 1978. Now it is the largest receipient of foreign investment among developing countries & second in the world. In 2006, China's overall FDI inflows totalled $69.5 billion, most of which was for financial service sector. But 2006 saw a drop of 4% in the FDI investment since 2005. India is becoming liberal about its FDI policy lately by removing or reducing the caps on Foreign investments. For e.g. the cap in Air Transport Services was raised from 25% to 49%. Still there are limits on foreign investments in Banking, Asset Reconstruction, Broadcasting, Insurance, Defence Production, Infrastructure, Telecommunication and Newspaper. Apart from these sectors 100% FDI is permitted in all sectors. India received approx $ 11 billion in 2006 while FDI totalled US$18.78 billion in Brazil, higher than for 2005 (US$15.19 billion). Total Foreign Direct Investment in Russia in 2006 is estimated at US$ 31 billion. Here also China is number one.

Conclusion: Which would be the final investment destination is a question will the time will answer but there seems to be a great fight between China, India & Russia. If figures are to be believed then China & India have highest GDP growth rate & industrial production growth rate. Brazil is still huge unemployment rate, heavy public debt & least rate of growth. Apart from above factors - Political stability, high productivity, low costs of labour and good infrastructure are some of the key metrics to be kept in mind while making a foreign investment.

Inflation, Monetary Policy & Investor

During last few months we all have seen lot of movements in the money market & also in the share market. A hike in CRR or REPO rate brought a lot of volatality in the markets. There is a sharp rise in the inflation rate which, as some say, made the FM bring structural changes in the budget because inflation in our India is not only a economic but a political subject too. No one knows where will it all land. But knowing the basics of these terms would enable us to decide our future course of action.

INFLATION: General rise in prices measured against a standard level of purchasing power.
Simply put it is the percentage of our current price that we will have to pay on the current price in order to buy a commodity after a particular period. For e.g. if price of an item is Rs 100 today & inflation rate is say 6%, then we will have to shed Rs 6 apart from the basic price of Rs 100.
Inflation is measured by comparing two sets of goods at different points of time & computing the increase in cost not affected by increase in quality and qauntity. For e.g. if cost of one two-litre Pepsi is Rs 50 as against the price 3 months before which was Rs 45 for 1.5 litre, then we will have to make adjustment for contents.

It is measured through various indices like Wholesale Price Index (WPI) or Consumer Price Index (CPI). Usually inflation shown by an index is different from inflation bear by an individual. It is because index covers several items which are given different weights & so the change in prices of these items is depicted by the index and the spending of a household will not be done in the same pattern (as of the index). Also the Education Cess is not considered by the index.
A rise in inflation rate raises the cost of production for the business people & cost of living for the common man. Corporates pass their burden of inflation on the latter by raising the prices of commodities. As far as we as ultimate consumers are concerned, we should plan our expenditure accordingly & also keep inflation in mind while making investments. It can be explained as follows. We should make our budget of household expenditure keeping in mind the average rate of inflation i.e. a reserve for it should be maintained to bear the rising prices.
As regards the investments, we have to put in our money in such places which can earn a good return over & above the inflation rate (called real rate of return). For e.g. if we invest Rs 10,000 in a Fixed Deposit at 8% p.a. & inflation rate is 5%, then we don’t get a return of Rs 800 but after providing for inflation we left with just Rs 300 i.e. a real return of 3%.
MONETARY POLICY: Policy of the Central Bank (Reserve Bank of India, in India) through which it keeps the supply of money in control thereby constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth.
Tools of Monetary Policy:-

$ Bank Rate: It is the rate at which RBI lends money to banks.
Increase in this raises the cost of funds obtained by banks from RBI & vice-versa, the burden of which is in-turn passed on to the consumer.

$ REPO (Repurchase Option) & REVERSE REPO Rates are the main players here. Former is the rate at which RBI lends money to banks against government securities & infuses liquidity into the system. Reverse Repo is the rate at which RBI sucks excess money supply from the system by selling government securities to banks. Recently RBI hiked the rates which positions them at REPO:7.5% & Rev Repo at 6%.
If REPO rate is hiked then it means that now banks will have to incur more cost to obtain funds from Central Bank & so they increase their PRIME LENDING RATE (PLR), this results in increase in the rate at which the bank lends money to consumers.
On the other hand if REVERSE REPO rate is hiked then it reduces the overall liquidity available for lending to borrowers as banks may find it more attractive to lend to RBI. As a result the lending rate of banks to consumers may rise as now they would expect a rate of interest above the REPO rate to forgo RBI i.e. opportunity cost is increased.

$ Cash Reverse Ratio (CRR): It is the percentage of deposits which banks are required to keep with RBI under RBI Act. This serves dual purpose – (1) RBI gets control over lending capacity of Banks (2) a portion of deposits of public is secured with RBI.
A increase in the CRR produces similar effect as is observed on hike in REPO rate. In such a situation, banks have to keep more funds with RBI & the balance loanble funds are chased by same number of borrower. This raises the interest rates of banks. But some analysts believe that a hike in CRR does not bring an immediate impact on interest rates as the demand for loans by consumers may not pick up along with a hike in CRR & banks may still witness surplus liquidity for a temporary period.

$ Statutory Liquidity Ratio (SLR) is the statutory reserve that is set aside by banks for investment in cash, gold or unencumbered approved securities valued at a price not exceeding the current market price. SLR should not be less than 25% and not exceeding 40%. Currently it is at 25%.
A rise in SLR has the same affect as CRR i.e. it reduces the funds at disposal of banks & brings a halt on rising liquidity.. As a result banks raise their lending rates to maintain their margins.

Usually it is seen that a hike in CRR %, SLR or REPO rate brings a sharp decline in the prices of bank stocks. The main reason as it seems is fear in profitabilty of banking companies due to higher costs of borrowing from RBI or their ploying of funds into less profitable investments (government securities). So any news of RBI changing the aforesaid tools shall warn us for a market reaction.

Apart from the above repurcussions, a rise in the interest rates forces some changes in the market some of which can be enumerated as follows:-
Increased interest rates affect the whole economy as it brings a rise in prices of commodities which pulls the demand down.

Direct result of rising rates is beared by corporates who now face additional financial costs. A hike in interest rates brings cost of bonds down.
The prices of stocks falls as now the investors expect a greator return from the market as compared to the yield generated by bonds as seen above.
Though the sudden fall in stock market as a whole or financial sector in particular may give us chill bites but they also bring an opportunity for the investors to enter the market at low prices (if only the companies are fundamentally strong).


Conclusion: After the above analysis we can say that Rates – inflation & Interest both – have a direct bearing on an investor’s decision. Though the market may not always behave in the aforesaid fashion but for conservative investors these are warning signals.