What a fancy title. Well, that’s just about it. Fancy !! Please don’t take it too seriously. You have every right to think about real estate without reading this article. I am just dabbling around with some “how to make a sexy headline” articles and henceforth the dumb attempt. Please excuse me 🙂
Anyway, let me start this post with an honest confession. I am not an expert in real estate. Rather, I am your average 30 year old, just married, neighborhood guy who is currently going through the usual pressures of “Why haven’t you bought your own house yet?” from his lovable mom, grandpa, granny, aunties, uncles and every other human hierarchy in that order.
Since a real estate investment is generally one of the largest investments for most of us, a wrong decision can have a significant impact on our lives. Hence, it is extremely important to try and understand some underlying fundamentals of real estate investing. The article is my attempt at understanding real estate investing.
First things, first. Why do you want to buy real estate. Are you buying a home where you can live or are you investing for future returns and have no plans of staying at the place you are buying. Now if you are buying a home to stay, this article ends just here for all practical purposes. You cant put a price to the joy of owning an own house, the joy of watching your kid scribble across the walls..blah blah..and so on goes the argument. An own house is like an IPhone. While both definitely have some practical purpose, you never try justifying their price vis-a-vis the features !! An “own house” is not an investment , its a feeling 🙂
Now if you are not a part of the “it’s a feeling” gang, the rest of the article is for us.
Common belief : Real estate always provides you great returns. Prices never fall.
As always, we turn to evidence. Lets see how real estate prices across different cities have moved in the last 8 years.
NHB RESIDEX tracks the movement in prices of residential properties on a quarterly basis. This is being done since 2007
I have taken 2007 to be the starting date as NHB Residex data is only available from then and has been updated only till Mar-15 (courtesy, the lazy folks at NHB)
As seen above, Chennai has been the top performing Real state market with a whopping 17% annual returns. But if you look at other major cities, 7 out of 26 cities have had returns between 9 to 12% which while not very attractive has at least stayed ahead of Inflation (7-8%). But the shocker is that, 18 out of the 26 cities have had returns equal to or below 8% not even covering for inflation !!
Just to ensure, that the evidence is concrete, let’s confirm the pricing trend from another source – Magic Bricks National Property Index which again confirms the subdued returns from real estate in the last few years.
So going back to our first statement – “Real estate always provides you great returns”.
The evidence doesn’t support this as most of the cities have had dismal price appreciation in the last 8 years (the above lines at this juncture apply only to chennai folks like me 🙂
Now addressing the second part – Do real estate prices fall?
Rewind to year 1997..
Read this India Today Article Real estate business in india faces unprecedented crisis as prices plummets
Real estate price crashes are pretty common across the world – Japan in 1990, US in 2007 etc. As seen in the above article even Indian real estate saw a sharp price decline during the 1996-2002 period.
“No asset class or investment has the birthright of a high return. An asset is only attractive if it’s priced right.”
― Howard Marks
So lets get our basics right,
Real Estate does not provide high returns at all points in time and can go through periods of decline or long periods of stagnant prices (time correction) !!
Real Estate prices just like any other asset goes through cycles (historically around 14 years with 7 years of high returns + 7 years of low returns according to JP Morgan Research) – there are periods of high returns inevitably followed by low returns.
Source: JP Morgan
The timing of exact turn in the cycle is extremely difficult. However an approximate evaluation of whether we are near the peak or the bottom of the cycle should be possible. Given the fact that real estate investing involves a large capital and significant loan component (at least for most of us), we need to be extremely careful and it is important to ensure that we are buying at the right price (read as valuation).
So, how do we go about evaluating if the prices are right ??
I will be using the Chennai market as an example. Given that Real estate markets are highly localized, you may apply the same framework for your respective location.
The first task is to make sure we are not caught near the peak of the cycle. But, how??
Test 1: Invert !!
The great 19th century mathematician Carl Jacobi was fond of saying that when you encounter a tough problem, “Invert, always invert.” So let us invert our problem and start with asking a simple question “What returns do we expect from our real estate investment?”
Going by the last 8 years, a lot of us would expect Chennai real estate to repeat the same 17% annualised returns. Let us invert this and see if this is possible.
A decent 2 BHK, 1200 sq ft apartment within the city would easily cost anywhere between 1 to 2 cr based on the locality. Hypothetically assuming you get an 20 year EMI for the entire amount (generally loans are provided only for a portion – around 80% of the house cost), at the current rate of 9.6% (Source: Bank Bazaar Link) it works out to approximately 94,000 to 1,88,000 every month. Assuming you require a salary that is at least twice your EMI amount and thus you must be earning at least 1.8 lakhs to 3.7 lakhs per month to buy a decent house within the city !!
Now assuming we want our property to appreciate by 17% for the next 20 years, this implies the price should multiply by 23 times or in other words a house worth 1-2 cr should become 23-46 cr. And for someone to buy it after 20 years, the EMI at the current 9.6% would work out to be 21-43 lakhs per month. Thus the buyer’s salary must be around 43-86 lakhs per month after 20 years !!!
A similar calculation at:
- 15% return expectation, works to a monthly salary requirement of Rs 30 to 61 lakhs
- 12% return expectation, works to a monthly salary requirement of Rs 18 to 36 lakhs
- 10% return expectation, works to a monthly salary requirement of Rs 12 to 25 lakhs
- 8% return expectation, works to a monthly salary requirement of Rs 8 to 17 lakhs
My head is already spinning.. Now don’t ask me what is the right price. But one thing clearly stares at our face. Real Estate prices in the long run must be a reflection of aggregate salary growth. The future salaries required to justify current chennai real estate prices look a little too unrealistic in my opinion. The past glory days of 15% plus returns in Chennai real estate look highly unlikely unless there is a new industry like IT which can manage to employ a lot of us and pay exorbitant salaries !!
Test 2: Rental Yields vs Home Loan Rates
One of the simple ways to evaluate if the property you are buying is reasonable or expensive is to compare the rental yields with home loan interest rates. Rental yield refers to the annual rent received from a property as a % of the total price of the property. Property price market is an illiquid market where generally the sellers in case of correction do not sell and mostly postpone their selling decision. Further even the real estate builders tend to not reduce prices even if demand is weak and try to wait out the period by getting support from banks who lend to them. Add to it the component of black money involved, the prices in real estate in India do not exactly respond to the economics of demand and supply as seen in other asset classes. However the rental market in comparison, is a lot more dynamic as tenants can easily shift between houses and hence responds to the demand scenario in a much better manner. Generally, in a fairly priced real estate market, the rental yield tends to be somewhere close to the cost of borrowing. Thus comparing the gap between the rental yield and home loan rates provides a good way to evaluate if real estate is cheap or expensive
Now the above data is from a Jul-2015 report. Applying current home loan rates of 9.6% and rental yields of around 2.5 % (I am taking my current rented place yield. Generally the range is between 2-4%) the gap works out to be ~7% which is pretty expensive compared to other global markets where the range is around 2-3%. So either rental yields should go up or home loan rates should come down or a combination of both should happen for real estate prices to become attractive.
In India, we also enjoy tax benefits* on home loans and hence adjusting for them, a simple rule of thumb can be:
Buy: when home loan interest rate – rental yield < 4 to 5%
Sell: when home loan interest rate – rental yield > 7%
Thus applying this metric, again the verdict is – Real Estate in Chennai is expensive
*To understand in detail the tax benefits in a home loan read the following article http://emicalculator.net/understanding-tax-benefits-on-home-loan-updated
Test 3: If last 7-8 year returns are damn good then be cautious
Again, Chennai Real Estate has had phenomenal returns in the last 7-8 years . Caution !!
Test 4: If everyone says real estate will always go up and come up with their own stories of how they multiplied their money in the last few years – Your danger signalling siren should be at its loudest !!
In Chennai markets, the siren is still loud enough…
Phew a long post. But, nevertheless let me sum it up
- Real Estate Investing Returns = Rental Yield + Price Appreciation
- Real Estate Prices aren’t destined to go up always and can fall or go through long periods of time correction
- Real Estate just like any other asset class goes through cycles – periods of high returns followed by low returns
- When buying a property:
- Evaluate future affordability by applying “inversion”
- Evaluate “Rental Yield vs Home Loan Rates” – Buy when its less than 4-5% and sell when it is above 7%
- If past 7-8Y returns are very high, then be cautious
- Add to it, if everyone is gung ho on real estate, then be extra cautious
- Verdict on Chennai Real Estate – looks damn expensive – need to be extremely cautious
Being from the financial industry, there is a natural bias built within me against real estate.While I have tried to be as rational as possible, I may have missed out on some perspectives given my biases. If you think I have missed out something or don’t agree with my thoughts, please feel free to share your thoughts in the comment section. I am consciously on the lookout for contradicting evidence and would love to be wrong !! Thanks for dropping by and happy investing 🙂