I will go out on a limb here and make a prediction regarding home and land prices in India.
Take prices when this boom started (say 2001/2002). Add inflation plus maybe 0.5% or 1% on an annual basis to it. Thats where the prices will eventually revert to. It might not happen this year or in the next 5 years, but it will some day (more likely sooner than later).
Folks may disagree sharply with this, but I stand by it. Time and again history has shown this to happen. Time and again people get caught up in the mania and say this time is different.
The question then arises as to what should one consider as inflation. Should we take commodity inflation (running in double digits over the last few years) or a broader inflation measure. I think can use the equity markets as a reference.
Historically, across the world, equities have returned around 5% above inflation in the long term. Indian equities since 1991 have returned about 12% nominally. Which seems to be roughly inline with what history predicts (ie. 5% real + 7 or 8% indian inflation).
We can use the same for housing. No reason for housing to to track higher inflation when equities (which also track consumption and inflation ) are indicating an inflation of 8%. This might come as a shocker for those who have bought homes and seen 20%+ annual appreciation over the last few years, but the truth is often bitter.
Ok. Lets say prices revert to mean. How long should I wait? What if it takes decades?
By all means, buy the house that you can afford. A house is a place to protect, to grow a family, build ties with the community around you, to live a life. Treat it like that. It is not some magical wealth multiplier. Never has, never will be. The whole of India was caught up in this party over the last few years, and now I suspect all of us will suffer the hangover.
Do not treat real estate as a passport to wealth. It is at best a store of value. It will keep pace with inflation and leave you with zero real gains. That too is difficult if you get the timing wrong. Ask the Japanese who bought in between 1986 and 1990. Home prices there are nowhere hear their peak values for almost 20 years now. Unlike equity (where you can have a SIP), real estate investment is a single concentrated bet at one point in time. That's what makes timing important. But then no one can time the market :)
Thursday, 7 July 2011
An exercise in valuation of land.
I had posted this as a comment on another blog. Having started my own blog now, I think this would make a good starting post. Some basic investing knowledge is assumed.
Real estate and housing has made millionaires out of paupers over the last few years in India. In this mania, basic investment principles seem to have been forgotten. People assume that "this time is different" and continue to pay exorbitant sums not just for homes, but also for empty land simply in the hope that prices will continue to rise.
I stay in a nice residential area in Bangalore (wide roads, trees ,parks, etc). The land nearby is "worth" Rs 4500/sq ft today. No one knows why and how the valuation is arrived at. It simply is because people are willing to pay that much. So I decided to work backwards and apply some fundamental valuation principles. The results are surprising and would love to hear comments from others.
Basic finance tells us that the price of ANY asset is simply the net present value of the assets future income discounted appropriately. This much is indisputable fact. What makes this hard in practice is estimating future income and the discount rate. So as a proxy, people use earnings multiples. For stock markets it is around 15, lets say for RE (due to sentimental reasons, we indians are different , black money, fast rising rental income, etc) it is 20.
Now take a regular sized plot here (60*40ft = 2400sqft). Build a nice two storey house on it costing around 35 lakhs per floor and you can expect a rent of around 17K per floor after maintenance costs are excluded. For simplicity, let us ignore taxes. So total income that the asset generates is 17000*2(floors)*12(months) = 4,00,000. Therfore the asset (land + house) is worth 20(earnings multiple)*400,000 = 80,00,000.
Given that you invested 70,00,000 on the house, the land alone therefore is worth 80,00,000 - 70,00,000 = 10,00,000. This equates to only around about 400Rs/sqft. Why then are people willing to pay TEN times this amount?
Fundamentals always reassert themselves eventually. History clearly shows that. Irrational exuberance always ends. Real estate here will be no different.
Real estate and housing has made millionaires out of paupers over the last few years in India. In this mania, basic investment principles seem to have been forgotten. People assume that "this time is different" and continue to pay exorbitant sums not just for homes, but also for empty land simply in the hope that prices will continue to rise.
I stay in a nice residential area in Bangalore (wide roads, trees ,parks, etc). The land nearby is "worth" Rs 4500/sq ft today. No one knows why and how the valuation is arrived at. It simply is because people are willing to pay that much. So I decided to work backwards and apply some fundamental valuation principles. The results are surprising and would love to hear comments from others.
Basic finance tells us that the price of ANY asset is simply the net present value of the assets future income discounted appropriately. This much is indisputable fact. What makes this hard in practice is estimating future income and the discount rate. So as a proxy, people use earnings multiples. For stock markets it is around 15, lets say for RE (due to sentimental reasons, we indians are different , black money, fast rising rental income, etc) it is 20.
Now take a regular sized plot here (60*40ft = 2400sqft). Build a nice two storey house on it costing around 35 lakhs per floor and you can expect a rent of around 17K per floor after maintenance costs are excluded. For simplicity, let us ignore taxes. So total income that the asset generates is 17000*2(floors)*12(months) = 4,00,000. Therfore the asset (land + house) is worth 20(earnings multiple)*400,000 = 80,00,000.
Given that you invested 70,00,000 on the house, the land alone therefore is worth 80,00,000 - 70,00,000 = 10,00,000. This equates to only around about 400Rs/sqft. Why then are people willing to pay TEN times this amount?
Fundamentals always reassert themselves eventually. History clearly shows that. Irrational exuberance always ends. Real estate here will be no different.
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