The UnReal State of India’s Real Estate

India-Real-Estate-Market

Over the weekend a friend called and we talked about an interesting conversation he had had with his landlord.

My friend’s landlord is a successful corporate executive and doesn’t live in the same city as my friend does. The landlord had bought the flat that my friend currently lives in, sometime in late 2004.

At that point of time he had paid around Rs 18 lakhs for it. This is what my friend could gather from the conversation with his landlord. The flat is currently worth close to Rs 1.3 crore.

In a period of close to 12 years, the market value of the flat has gone up more than seven times. And this is where things get interesting.

My friend currently pays a rent of around Rs 27,000 per month or Rs 3.24 lakh per year for this flat. The rental yield works out to around 2.5%. Rental yield is obtained by dividing the annual rent by the current market price of the flat.

The question is why would someone want to continue owning an asset which generates a return of 2.5% per year. The interest rate offered on money kept in savings bank account is at least 4%.

So the point is when you can earn a minimum 4% fixed return with none of the headaches that come with owning real estate, why would you choose to earn 2.5%? Also, the actual rental yield is lower than 2.5%, given that a certain amount of maintenance has to be paid to the building society every month.

Then there is the cost of maintaining the flat. Further, property tax also needs to be paid every year. In this scenario it makes perfect sense to sell the flat and invest the money in bank fixed deposits, which currently pay around 7-8% per year.

I put this thought across to my friend and who in turn spoke to his landlord. And the answer he got was very interesting.

The landlord told my friend that his rental yield was 18%. It took me a while to understand how he came around to this number. He was calculating the rental yield on the original price that he had paid for the flat.

A rent of Rs 3.24 lakh on a purchase price of Rs 18 lakh works out to a yield of 18%. While, this is totally wrong, but this is the way my friend’s landlord is currently thinking. He thinks he is earning 18% from his flat and won’t sell.

But he can sell the flat, pay tax on the indexed capital gains and invest the remaining amount in a fixed deposit and earn much more than Rs 3.24 lakh he is currently earning. Over and above this, this investment comes with none of the headaches of owning real estate.

This is not exactly rocket science. It is simple mathematics. So what exactly is preventing my friend’s landlord from selling out? One answer could be tax deduction on the interest payment of the home loan that he had taken in order to buy the house.

But given that the loan is in its twelfth year of repayment, the interest component will be quite small in comparison to the landlord’s current income and really not worth the trouble.

So what gives? The landlord is totally anchored into the price appreciation that has happened till date. His investment has increased in value from Rs 18 lakh to Rs 1.3 crore in a period of over 11 years.

And this is something that is stuck in the landlord’s mind. Before I go any further, it is important that I explain the term anchoring here. As Garly Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them: “Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you.”

This applies in case of my friend’s landlord. He has seen the price of the appreciate from Rs 18 lakh to Rs 1.3 crore and has a strong belief that the appreciation will continue. In the process he has held on to this flat. He is anchored into that belief.

Is a similar sort of increase possible? It would mean that the price of the flat would be more than Rs 9 crore (Rs 1.3 crore x seven times) eleven years from now. That is totally unbelievable.

Also, the real estate prices haven’t gone anywhere over the last few years. Most people don’t take that into account. The money illusion is at work. As Belsky and Gilovich write: “This involves a confusion between “nominal” changes in money and “real” changes that reflect inflation.”

Real estate prices have remained flat across large parts of the country over the last few years. The average rate of inflation between 2012 and now has been around 7-8%. Once we factor this into account, the real estate prices have actually come down by a reasonable amount in real terms.

Again, this is something that my friend’s landlord in particular and most other real estate owners in general don’t seem to understand. It will take some time for these people to realise this. Plus, there is always the bit about owning something you can see and feel, which always works with owning real estate. This obviously does not apply to financial investments.

Further, with a huge amount of unsold inventory of real estate companies, as well as homes that have been built and bought as an investment, in the market, real estate is not going to match the returns that it gave between 2002 and 2012. Those days are long gone. Also, it has just become way too expensive.

Of course, people take years to come around to realising that they have been wrong for a long time. Mistakes are not easy to admit and this time will be no different. Until then, the stagnation in the real estate sector will continue.

The column originally appeared on Vivek Kaul’s Diary on April 11, 2016

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About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

4 Responses to The UnReal State of India’s Real Estate

  1. Raj says:

    Sorry, couldn’t understand your argument. Just for understanding purpose let us compare it. Correct me if I am wrong. The rental income from house is equal to dividend income from equity. Equity price appreciation equal to house price appreciation. Incase of equity the dividend income is going to be 2-3% same as rental yield(you have mentioned in the article). Equity price appreciation may or may not be equal to 18%. As per your article the house price has appreciated by 18%(CAGR). The return from equity and house are two component(price appreciation and dividend/rent). Why are you telling the landlord should sell the house and put it into some other investment. We don’t usually sell the equity just because the dividend is 2-3%.

    • AP says:

      Nowhere has he talked about investing in equity rather than real estate in the above case. He has compared returns in this situation with a simple FD, which to most Indians is the first and most preferred step as far as investing is concerned.

      With that kind of money, the owner can also bargain for himself a favorable of interest compared to the kind currently offered on FDs (6-8%).

  2. MyInsignia says:

    In my understanding the difference in very simple.

    (1) Profit Sharing
    (a) In case of FD and savings account – The profit is only the interest. The principle amount
    remains the same.
    (b) In case of real estate – The rental income (which usually increases YOY) plus the cost of the house (principle in this case) also increase YOY. So isn’t real estate double beneficial.

    (2) Ease of holding

    (a) Even an illiterate person can buy/sell/own property
    (b) same is not true in case of owning equities.

    (3) Sense of owning

    (a) Real estate is not gonna die instantly.
    (b) Investing in equities can wipe away your capital if not invested in good stocks.

  3. AP says:

    My case is a bit similar as in I’m living in a house that is fetching its owner an annual rent yield of just 2.3%. That is the figure if we go by the market price of the property. Owner has a different figure in her mind altogether in case she wants to sell, which is almost 50% more than the home’s current market value. Reason being ample availability of new homes, something which I believe has definitely hit the resale market, unless the location comes into play. Clearly, that decade-long boom has deeply influenced her a lot.

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