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By commonsensical valuation methods followed globally, Indian real estate sports nosebleed valuations. It is important to be aware of this if you want to ‘invest’ in real estate
Property prices across India have run up a lot between 2003 to 2008, appreciating as much as even 400%+ during the said period.
Some places have now cooled down, like Hyderabad due to the Telangana agitation and Bengaluru. Meaningful correction is yet to be seen in metros like Mumbai and Chennai, etc.
Recently, a prospective buyer wanted to purchase a second-hand flat in Chennai for Rs1.2 crore. This flat was purchased for Rs30 lakh by the original buyer in 2005.
The buyer's line of thinking is as the value has multiplied by 4 times in the past 5 years, he would buy now and sell it in 2016 for Rs4.8 crore! He is assuming an absolute return of 400% in the next five years, a CAGR (compounded annual growth rate) of around 32%.
The annual rental yield for his Rs1.2 crore investment is only Rs.2.4 lakh or a mere 2% per annum.
Recently, a client of mine wanted to purchase a property she is residing at for Rs65 lakh. The rent she is paying is only Rs9,000 a month. Even by investing in fixed deposits, she may get around 9.5% p.a. whereas by investing in this
20-year-old flat, her yield (or saving) would only be 1.67% p.a.
The 'House price to (annual) Rent' ratio in her case works out to 60 times. Going by international standards, if this ratio is above 20, then the cost of owning is considered higher than cost of renting.
The generally accepted range is around 15. This was the ratio prevalent in the US, before the great housing bubble began. Considering the crash in the US housing market during the last three years, this ratio may even be lower now.
This means, the rental yield in case of the above client should be at least 5% p.a and preferably 6.7% p.a. Again, this implies that the Rs65 lakh flat's fair price is actually between Rs16.2 lakh and Rs21.6 lakh.
You can use this back-of-the-envelope calculation for arriving at the fair value of the property you are looking at.
Though no ratio can be blindly applied, this is a good point to start with.
Another pointer worth looking at is that the value of the property you are planning to buy on a loan should not be more than 3 years of your annual income.
I feel that your home loan EMI as a part of your income (debt to income ratio) should not exceed 35% to 40% (maximum). Anything beyond this may put a huge strain on you especially in a rising interest rate scenario or any other contingency in life.
Teaser loan rates at lower EMIs in initial years would do more harm than good. The debt to income ratio would get skewed after the euphoria of owning the house has evaporated.
Applying the above three-rental yield, loan to annual income and debt to income ratio, the current real estate market looks very unreal to me.
Home ownership is becoming beyond a dream of the common man. I'm not even referring to the poor or lower middle class. Even for the middle class or higher middle class, it is not about a dream home but dreaming about a home.
The strange thing about the real estate market is that many a times the prices do not come down but markets simply become illiquid. No transaction happens but still the price on paper remains high.
I can only hope that the real estate prices correct significantly. I believe that there is a powerful vested interest lobby which keeps the price artificially high.
Robert Shiller, by tracking the US home prices data from 1890, has mentioned that in the longer run, property prices grew at an annualised return of around 3%, just keeping pace with inflation.
This means the real rate of return in real estate, after adjusting for inflation, is nothing.
Out of curiosity, I browsed to find out how much the S&P 500 index (equity) has given since 1890. It works out to 9.24%.
This again means the real rate of return in stocks, after adjusting for inflation, is 6%+.
This further strengthens my conviction; in the long run (even after I'm dead and gone) equities are capable of providing superior return than any other asset class and investing in equity is the best way to beat inflation.
In India there are no broadly accepted transparent indices across various locations for real estate. The real estate market is not well regulated, like, say, the securities market.
Black money, goondas and political clout play a significant role in this market.
Maybe that's why the regulator has not so far allowed REITS (Real Estate Investment Trusts) in India, which would make it easier for even a common man to participate in the real estate market.
You may not be able to buy a house but at least be able to own a portion of it, doors or roof or wall through REITS!
In the current scenario, the only way to bring down the abnormal real estate prices is to opt for renting rather than owning a house.
Though this idea may not sound pleasant to your ears, try giving it a serious thought.
Maybe you can consider starting a movement against ownership. I would be glad to join the same, if you don't disqualify me for already owning a house!
In a poorer country like Bangladesh, 90% of the houses are owner occupied. Whereas in a richer country like Switzerland, only 33% of the houses are owner occupied. This is not the latest data but at least should serve as a good pointer.
Follow the Swiss!
As I'm in the profession of reviewing people's financial health, I find that once I remove the value of self-occupied property, which is usually a loan under 20 years, loan, and gold jewellery, the net worth is very meagre even for high income people.
People who talk about appreciation in property over a 20-year period do not take into account the interest they are paying on their long-term housing loan and other costs like taxes, periodical maintenance and repairs etc.
Also the focus is on absolute returns and there is no clue about annualised returns.
Once these are pointed out, I'm able to see a surprise on their face.
As leverage (borrowing) is freely available, the next move is to start planning to buy another house!
Housing bursts always lead to banking bursts, who are the providers of the much required leverage, both to home builders and buyers, which is also responsible for keeping the home prices high.
Bankers are one tribe who can actually help in bringing down home prices.
Is it in their interest to do it?