Whose dream does realty boom destroy?

If you suddenly get a real estate boom with foreign capital flowing in and also get a wage price spiral, it will make India's task of continuing to have a significant cost advantage over the rest of the world very difficult."

Not our words. Neither those of a conservative central banker nor a self-absorbed academic. Anshuman Jain, one of the most powerful bankers in Europe, had once said this in an interview to ET. It's another story that a year later Deutsche Bank, where Mr Jain heads the global markets division, emerged as the most aggressive investor in the Indian property market.

As a banker he could do no less, as a professional he could say no more. But as India allowed foreign investment in real estate, banks and bond houses from New York to Jerusalem found the opportunity irresistible. With investors across markets snooping around for new assets, Indian properties became the red hot blue chips.

While it's too early to say whether spiralling property prices, fuelled by a rush of overseas money, has taken away some of our competitive advantage; it has certainly priced out genuine home buyers from the market.

The argument that foreign funds in real estate is confined to FDI-compliant projects and thus don't affect smaller residential projects is simplistic. As foreign money-be it in the form of FDI or FII subscription in an equity offering by a developer-flows in, it pushes up valuation of all projects, even those properties which are not FDI complaint but coming up in the same region. Besides, several projects are above five lakh sq feet-the basic condition for an FDI.

Things would have been less alarming if the story ended here. What has complicated the situation is the nature of money. Most of the money that is being shown as FDI is not equity but pure loan.

There is a reason behind the financial engineering-the conditions for foreign loan (or external commercial borrowing) in real estate are extremely stringent. So, the financial products that are being sold to foreign investors are preference shares and optionally convertible debentures, which technically qualify as equity but are foreign loans in reality. It's a win-win situation for the Indian real estate firms as well as the foreign investor since RBI has made it difficult for local developers to borrow from banks; they are willing to pay a higher interest (linked to instruments like preference shares) to foreign investors; the latter does not bring in risk or equity capital to buy the preference shares but simply borrow at a much cheaper rate in the international market to lend it to local developers. (In banking parlance, they use the debt side of their balance sheet to invest in India.)

The foreign investor often borrows at 5% and earn 12-13% as interest on preference shares. As long as they can borrow and earn a fantastic spread, money will flow in unrestricted through the automatic FDI route to chase Indian properties.

What then are we doing to correct the bubble? Raising interest rates, tightening money and making life difficult for local borrower. If interest does go up beyond a level, investment demand for properties may slow down and this could bring about some correction in the market.

After a point it may (or may not) translate into lower monthly outgo for borrower. But such corrections are often long and painful. The actual home buyer will continue to borrow and pay an exorbitant rate of 13-14%. But if properties are considered as an asset class by overseas investors, money will again rush in after a brief correction.

Chances of a dramatic fall in property prices are slim. Even in other markets like Japan, the market ballooned for a decade and took yet another decade to lose steam. Interest rate is too weak a tool for this to happen. It may be more crucial to address the real supply side concerns.

Besides scrapping archaic legislation on urban land ceiling in markets like Mumbai, it's perhaps high time to do a comprehensive revision in FDI regulations. For instance, the two page document-Press Note 2-Foreign Direct Investment in townships, housing, built-up infrastructure and construction-development projects-states that 'the investment would be subject to a minimum capitalisation of $5 million for joint ventures...' and `original investment cannot be repatriated before a period of three years from completion of minimum capitalitalisation'.

So, the interpretation could be that if a foreign investor pumps in $5 million today and then $15 million in the next tranche three months later, the first tranche of $5 million is identified as "original investment"; the investor can, after the property is developed and sold, take $15m out of India, while the three-year lock-in would apply only to the initial investment of $5 million.

Not only is there a need to plug these loopholes, the conditions for FDI should be made more stringent. It is equally important to ban hybrid financial products like preference shares and optionally convertible bonds which today masquerade as equity for FDI in real estate. It's not enough to make foreign venture capital funds give an undertaking that they will not fund real estate.

They will simply come in as FDI through Mauritius. Any attempt (like rate hike) to correct the property bubble without cutting the flow of leveraged foreign funds could be excruciating. It's like shutting the door only to keep the window open.