Saturday, December 23, 2006

Worldwide Real Estate Bubbles & Dumb Investors

Abstract: In this post, we will try to look at the general housing bubbles, their causes, how to invest in houses & price them, and Indian house bubble
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If you are in any part of the world, by now you should have know what a housing bubble is. A housing bubble is one, where the prices are artificially inflated over a course of time due to business cycles/low interest rates and when they reach a tipping point, dumb investors keep jumping in thereby increasing demand and the price, and even more dumber people join the bandwagon stating that the past few years returned astronomical returns. This process of dumb investing has been goin all around the world for the last 10-15 years, as more and more dumb people have both resources and basic information to buy them.

Economist describes some of the bubbles http://www.economist.com/finance/PrinterFriendly.cfm?story_id=5283797

The biggest current bubble, one that scares people around the world is the US one -
http://en.wikipedia.org/wiki/United_States_housing_bubble,
where a lot of stupid Americans paid millions for not-so-great properties in California, Florida etc and are now facing trillions of dollars of combined debt. Now, properties in Naples, San Diego... are available at less than a half of the price and many studies indicate majority of US cities would have a housing price drop.

Let us look at a fundamental of investing. P/E ratio that is a basic armor for any investor, including real estate buyer. Let me explain in simple terms and you could get a ton of further infrmation in the net.

A company is priced by the amount of stocks. For example, Microsoft has around 12 billion shares each priced at $30. So, the total worth (called, Market Capitalization) of the company is $360 billion and so if you have that much money, you could buy the entire thing (theroatically). Now, we have an annual profit (Earning) of around $12 billion, so we have a P/E (Price/Earning) of around 25. This is a very important ratio. This means that for every $100, the company gives around $4 or it earns 4% interest per year. If you totally discount growth, you could directly compare this amount to other investing options (say, 5% in bank deposits, 6% in bonds, etc) and based on this, the stock would come to an equilibrium when the price would reflect how much interest you want to earn every year. Stock markets is as simple as this.

However, we totally forgot about growth. If Microsoft grows at 50% per year, then next year we would have an earning of $18b (your return will be 6%), and so on. Thus, we have to factor a reasonable future growth expectation and have to put that in the price. Thus, though 4% returns are lesser, since it could grow more people still put money in it. This is how stocks are priced. The only unknown here is the growth and people try to take various factors in estimating the growth for the next few years, and since the predictions are always varying you see small variations int eh stock prics. More the uncertainity, more the volatility.

Now, come back to house pricing. Here, the earning is the rent - property tax - depreciation - maintainence costs + tax sops (if any)

You can generlly assume the rent to grow with inflation, and other factors can be precomputed. Thus, you can roughly predict how much you will earn in the next 10-15 years with the house. Now, you want the returns to be atleast 1-2% more than secured things like banks & fixed deposits as you are taking a small risk here and so there must be a reward. Thus, you should be able to earn around 8% (for US) from your house per year. A right house is one that reflects this. How about your house? If the returns are significantly lower, then your house is overpriced and it would fall, as rents for residential property generally dont match up the bubble. Thus, if your house rent is $1000/month then your house is reasonable priced around $150K and anything over that is considered a bubble. But, a lot of people have paid more than doubel for such properties!

Coming to India, we see a lot more crazy thing. I see the rent for an apartment next to my house is Rs.5000/month and so valued it around Rs.750K(as the interest rates are high around 11%, while the high rent growth would partially offset this), but the house is priced around Rs.3million. Thus, we are facing a very serious bubble to the tune of around 400% and this seems to be the case around the country. For residential property, the rent always grows with inflation, and if the P/E is more than 11 (for India) or 13 (for US), then there is a serious trouble of a bubble.

Second, affordability. That 3million rupee house is an average apartment suitable for lower-middle class & middle class families only and their annual salaries less than 150K/year. So, the house is around 20 years of their yearly salary, which means that if a middle class has to buy they will forever be paying mortage. Thus, the house prices should reflect the salary levels of the potential buyers and if not, they run the risk of not finding buyers at all (the upper class will go for more expensive tastes, and might not bother about such a shabby house). My family is an upper-middle class family and we ourselves find it unaffordable to buy that house, which is not even a shade closer to my dream house. But, I routinely find such properties sold for over 5million and surely people must be nuts.

Third, economic growth. There is a general misunderstanding that as economy grows people wont have a place to stay and hence prices will skyrocket. They generally quote the first law of economics: demand-supply relationship. What they dont understand is economics has other laws too. In certain markets as demand increases prices will go down (any industry that is scalable like electronics or service industries) due to greater spread. But, wait a minute, is not land scare, limited and constant? Let us learn statistics.

India has a land surface of nearly 800 million acres of which atleast 150 million acres are considered waste land. In fact, as agricultural productivity increases we can also move a part of unproductive agricultural lands for commerical purposes as the farming supply could increase by a factor of more than 3 times, if Indian lands can get to international standards in productivity. So along with the waste land and unproductive agricultural lands, we have over 200 million acres for commerical use. Even if we could utilize 10% of this space, we could build a 5000sq ft bunglow for every single Indian family and dont even need high rises and no land shortage whatsover!!! But, we are unable to utilize because there is not enough growth in economy, infrastructure and technolgy. However, a lot of developments are occuring as we speak. Hundreds of SEZs are coming in these waste lands and real estate developers are scourging for such lands, along with unproductive agricultural lands. IT companies are trying to move towards Tier-II & Tier-III cities, Organized retail is trying to push into more of suburban culture and Infrastructural growth would connect these remote regions with economic powerhouses. Thus, as economy grows we could utlize greater and greater of these waste lands, and in the long run there wont be any shortage as there is enough of supply. So, even if every Indian dreams to live in a sprawling estate, the wishes could be accomodated. We just need more growth in infrastructure and technolgy and that is what happening now.

Thus, in the next decade the prices could plunge once it crosses a tipping point, and greater economic growth will lead to lower housing prices as we saw above. However, till that time housing prices in cities would be high enough as sub-urbian infrastructure has not developed enough. But, when you buy houses you have to have a long-term (10-20 years) in mind, and plan for that, and by that Indian growth would have achieved better utilization.

Once, the bubble bursts, there will be a spiral and I hope people use their brain and do calculations before getting caught in neck deep loans.

2 comments:

ORYX said...

Balaji,

I believed in the same theory mentioned by you and thus did not invest in property here in Mumbai. But now the rates have gone so high in the last 2 years that even if they come down by 25-30% it would not help. The prices have shot up by almost 100% to what they were then.
In this scenario what do you think should have been an ideal buying period?

Balaji said...

This was an interesting question. The way in which the prices have gone up is fascinating. But, while the market is pretty much overheated, I dont call for a blanket ban on real-estate investments, but invest appropriately.

Also remember, it just takes just a 50% drop to square a 100% gain and this asymmetry must always be kept in mind. A lot of people buy property just in the hope of capital appreciation, and if it fails to appreciate, leave alone go down in price, a lot of people will be fried in oil.