## November 19, 2007

### Real estate valuation - Inverting the problem

As Charlie munger says, it is useful to invert a problem and think through. So let me try that and please bear with me on the mental acrobatics.

In the last post, I developed the basic logic that real estate valuation depends on the rentals. Lets say you are looking at a property valued at say 50 lacs (5 million) . Now the reason to invest in this property is that you expect to make more than fixed income. Lets say you expect 15% p.a.

So the property should be worth 1 Cr (10 million) in the next five years. Such a property to sell at 10 Million, should atleast yield a rent of 40000 Rs/ month (assuming a P/R of 20). For some one to pay a rent of 40000/month, that individual should be earning atleast 170000 rs / month pre-tax.

How did I come up with number? assume a 30% tax rate and that a person would not prefer to spend more than 30% of his net income on rent in the long run. So we are talking of a person making 20-22 lacs per annum.

I agree salaries in india are rising and will continue to do so, but think of it this way - How many people can earn 20-22 lacs per annum (or 50000 usd ). To give a comparison, 50000 usd income is around the median income in the US too. On the flip side, with dollar depreciation and margins of IT/BPO companies getting squezed do you think it is feasible for indian companies to keep increasing salaries at 15% for the next 5-6 years and still be competitive?
Going one step further, if the investor thinks he can sell the property for 10 million , the person buying it will have to do a similar math. If the next investor expects 15% p.a , then he may agree to buy the property for 10 Million at a P/R of 20. However the property should then be 20 million, 10 years from now and needs a tenant making 40 lacs p.a (100000 dollars) to support the rents.
At any point during the next 10 years, if the above assumptions break, due to drop in salaries or recesion, the P/R (like P/E of a stock) could fall and returns could drop. I would agree that in the above scenario there are a lot of assumptions and ifs and buts. However one should think hard before going ahead with a big investment decision.

Please note that I am not talking of local knowledge of real estate. If someone has special knowledge of an area and knows that the area would develop in the next few years, then that person has an information edge and can make high returns. My example is of a general case of an apartment in a city which is what most of the investors put their money in.