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.
This is very good analysis. The primary macroeconomic element that is driving this madness is excess money supply:
ReplyDelete- Banks giving away cheap loans (sometimes multiple loans on the same asset)
- Expats investing back in India
- Safe haven for Black money (a rogue element with black money will buy even at ridiculous prices; Will get the land registered at much lesser value; Then will get it appraised by a *private evaluator*; And mortgage the asset with a bank to raise money for another venture)
As long as this mass Ponzi scheme (with a positive feedback loop) runs, land prices will keep shooting up. And, only when the music stops on money supply will the market correct to the true value of the underlying assets.
Cheers,
PA
Very nice analysis. In fact, if you drive outwards from the center of Bangalore (MG Road) in either direction for about an hour, you will see that land prices are in that range (400-500 psf). So, your analysis is right on the money!
ReplyDeleteThat said, "downtown" real estate is always priced quite high --everywhere in the world. But, do places that are only 15-20 minutes away from the periphery of the city deserve land rates of 4500 psf? Of course not. They will eventually correct, the wisdom is in waiting.
Does not take 5 key things into consideration:
ReplyDelete1. Rental growth
2. Scarce or prime land
3. Zoning changes
4. Developments around the land in the locality
5. Return of PE 20 does not take capital appreciation into consideration (which Indians are sharp enough to do) that could be a result of monetary expansions or points 1, 2, 3 and 4.