George Akerlof, noted Nobel Prize winning economist wrote a paper titled The Market for Lemons: Quality Uncertainty and the Market Mechanism, which was published in 1970. It talked of a simple theory of information asymmetry, a situation where the seller knows more about a product than the buyer which can lead to market failure. The industry of study was used cars. ‘Lemon’ is an American slang for cars which are found defective after having been bought. The premise further was that, if valuation information was an endemic concern in a market susceptible to asymmetries, it will lead to higher value products being driven out by the lower value products as consumers will not be able to utilize any viable mechanism to discern the value of a specific product.

This theory finds resonance in the Indian real estate markets. The theory of lemons can be applied to not only development formats and developers but also to the broker community and the wide encompassing Foreign Direct Investment market in real estate.

More often than not, the buyers are unable to ascertain the full extent of information for a particular project. Though, this concern besets all development formats, this is a major flaw in the Indian residential market. Commercial office occupiers have recourse to a battery of lawyers for due diligence, a team of experts to gauge and evaluate the technical specifications of a project and an iron clad lease agreement which is well negotiated by its consultants and legal advisers to protect its interests by ensuring a consistently high degree of transparency In its real estate dealings. It is the bane of the individual buyers in the residential housing domain to face a situation where complete information is not forthcoming. A common grouse for such transactions in India are one sided, unilateral sale contracts, lack of public information and disclosures on land acquisition, status of planning approvals and an innate inability to read the fine print. This coupled with a lack of a consistent and transparent definition of carpet/super/super built-up area and well defined apartment owners’ rights leads to the information asymmetry in the market. It becomes the classic case of lemons where due to information failing the CATA (Complete, Accurate, Timely, Adequate) Test, buyers end up gravitating towards a sub-standard project and in the short to medium term leads to an overcrowding of such projects.

The importance of the organised consultancy domain which adheres to the highest standards of financial accountability and transparency is in contrast to the community of unorganized brokers which will pass the lemon test with flying colours. Lack of a regulatory body fails to keep in check unfair and unethical trade practices by the latter segment, which is usually at the expense of the buyers. All the above factors combine to create an inadequate consumer protection ecosystem. Another fallout is imperfect pricing as information asymmetry leads to imperfect price elasticity based on supply, even though a state of perfect competition exists in the housing sector.

Real estate investment, particularly FDI inflows are also adversely impacted by the asymmetries in the market. The investor is non-local and hence more susceptible to a lack of information. This can be easily measured by the FDI inflows in real estate and stock in real estate to the total FDI inflows. A look at the Transparency Index 2010 by JLL (Read the whitepaper – Global Real Estate Transparency Index 2010 released by Jones Lang LaSalle.), shows that India Tier I cities are ranked semi-transparent there is still scope for the level of FDI inflows to improve further as information asymmetries are countered by greater levels of transparency and availability of information in the public domain.

The way forward is towards the ‘Lemon Laws’- the way various US states have adopted laws which act as a counteracting institution of sorts. These laws do not eliminate the potentialities of asymmetric information, but, rather, provide recourse to a buyer if he happens to buy a “lemon” rather than a good car. In India the need of the time is palliative counteracting institutions which will counter and attempt to remove the asymmetry prevalent in the market. Greater reporting and accountability practices coupled with an effective and swift redressal mechanism, guarantees, which shift the risk on to the sellers and certification and licencing requirements to ensure a minimum level of proficiency and competence along with a proactive state backed reform system will go a long way in helping the Indian home buyers to make a much more informed decision and have a recourse in adverse situations.

About the author
Rohan Sharma is the Research Manager for Jones Lang LaSalle in India, based in Gurgaon.