December 16, 2008

Real estate – current reality and some thoughts

I had written about real estate and its valuation a year back. I would suggest reading the earlier post before proceeding on this one.

The usual approach to valuing real estate is to look at the rental yields.

Rental yield = net rental after all expenses / capital value.

Investors expect yields to be in the range of 4-6%. This equates the capital value to around 16-25 times the rentals being received on a property.

Ancedotal evidence
I have a few friends who have trying to rent out their apartments in bangalore. They are finding it diffcult to get a rent of 11000 per month on a 2 bedroom, 1200 sqft apartment. Supposedly the apartment is worth between 40-45 lacs (atleast, depending on who you ask).

So based on the valuation thumb rule, either they should get a gross rental (excluding expenses) of around 16000-20000 at a minimum or the property value should be around 25-30 lacs.

Now I can consider my 2 bedroom dinghy, a tajmahal and value it at 50 lacs, but the value has to be backed by rentals. I personally think the litmus test of property values is the rentals one can receive on it. Property values are like stock prices. They have an element of underlying value (cash flows in stocks and rentals in case of property), but at the same time there is a speculative element too. The speculative element appears as a part of the quoted price – stock price or property value.

When investors are optimistic, stock prices are bid up and when they are pessimistic they bid them down. Simple isnt it ? well almost everyone forgot this basic idea for real estate. Property prices rose 2-10 times across the country depending on the location and type of property

Is the valuation approach correct ?
Now you can say that this valuation approach is incorrect. Consider this – if I have to invest in an illiquid asset, will it not expect 14-15% returns over the long term ? So if I am getting 2-2.5% via rentals, then my property should appreciate by 12-13% p.a over the long term to get decent returns.

Well, globally over a range of markets, real estate is known to return 2-3% returns over inflation ( so around 7-8 % in case on india) over the long run.

You may argue, as several of my friends have – this time it is different. India is doing well, incomes are rising, there is limited land and huge demand etc etc. Well, to that I can say, please read the history of the real estate boom and bust in japan in late 90s, in california and florida in 80s and check what is happening in the US, dubai and other markets. Similar faulty logic was given to justify the inflated prices, till the bubble burst and prices returned to reality.

Hope and belief does not count
Investing in any asset, stock or real estate cannot be based on borrowed wisdom. If you want to make money, use common sense and read about it before taking a plunge.

Unfortunately a lot investors in the US and maybe in india got greedy and speculated in stocks, real estate and other assets in the last 2-3 years.

Real estate like any other asset is known to get overpriced from time to time. I strongly felt that the huge surge in global liquidity from 2003 drove the interest rates down in india and pushed the stock and real estate prices up.

All talk ?
You may be thinking – everyone is smart after the fact. If you were so smart, what did you do about it ?
For starters, I was not smart about it. I avoided being greedy and tried to use common sense. I personally like to run my finanical affairs with a margin of safety. For example, when buying an apartment, my primary considerations were the following

- can I afford the EMI – I tried to keep the EMI at 40% of my current gross income (not future income)
- would I be able to keep the house if the worst case scenario happened, such losing my job or loss of income.
- What would my debt equity ratio after buying the property (see this
post for more details of my logic)

2003-2004 was a great time to take housing loan. Banks and HFC were giving variable rate loans at around 7.5% and fixed term loans at 7.75%. I had no idea whether the real estate prices would boom or go down. However what was obvious then, was that banks were underpricing debt. Let me explain my logic for the same

A loan by a bank is basically a product which has a cost and a profit margin for the bank.

So interest charged = bank’s profit margin + cost

Cost = interest paid by the bank + loan losses due to bad loans (typically around 1-1.2 %) + overheads (typically around 0.5%)

The interest rates paid by the bank is dependent on the inflation.

So for a 7.75% charge, the bank was assuming a cost of fund of 6% (7.75 – 1.2-0.5 %). This was too low. This is the cost at which the Indian government is barely able to borrow, much less the banks.

The subsequent events have borne out the above logic. The loan losses were underestimated by the banks and the cost of funds was underestimated too. As a result, bank have now repriced their loans and are not likely to underprice them as low as 2003-2004 time frame.

During the 2003-2004 time frame, I strongly felt that the loan rates were too low. In response to that, I refinanced my loans and increased the duration from 15 to 20 years (see an earlier
post on the same). The key was to focus on what I know (loan rates were low) and avoid speculating on what I could not know (real estate prices would rise or fall)

Have I gloated enough?
The above thought process turned out to be too conservative. Others who took higher risks in 2003-2004, were rewarded handsomely. So, my decision was not some unqualified success. However I am still very happy with decision as my conservative approach has helped me in avoiding losses in the past.

Being rational and avoiding greed is like virginity. Either you have it or you don’t.

Collateral damage
Not everyone who is suffering in the US or india was greedy or speculated in real estate. Some of the buyers in the US were first time buyers who bought property as their first home at speculative prices. These people are now facing ruin due to drop in home prices. One feels sorry for them.

What does the future hold ?
I don’t know :) ..what one can do is to look at history and try to learn from it. History does not always repeat, but it is good starting point. In most of the real estate bubbles, the market takes upto a decade to recover the earlier peaks.

One should also remember that real estate typically gives a few percentage points over inflation. If you speculate in an illiquid asset, by buying it on debt, you are asking for trouble.

18 comments:

Prasanth said...

Rohit,

There has always been a mismatch between the rentals and the "assessed" value of a property in India. As an example, I can supposedly sell my apartment in Chennai for around 35 lakhs (price my next door apartment was sold a week back). However, maximum rent I can get (or the offers that I get) is in the region of only Rs 6000 to 7000.

Real estate as an "investment" worked as long as the bubble was still growing and there were people to buy the property off you at a much higher price than what you paid for it. However, it does not work if you planned to hold on to the property and tried to rely on rental income.

Rohit Chauhan said...

Hi prashant
that is precisely my point. rentals and property values have become disconnected in a lot of places.
we can argue that the yields should 2% (as it is in most places), but rental yields across markets and across various times show that yields below 2% are low and investors demand more.
either the rentals rise , which may happen in india or the property values drop or both

regards
rohit

Vic said...

Rohit,

Your analysis seem to focus on residential apts.
I invested heavily in RE during last 3-5 years. In my experience, most of the folks buying the apts, don't really go into rental/yield aspect much. The big chunk of the returns are expected from appreciation..which is all speculation.
But for commercial properties, rentals are much higher. For example, a good A grade office space can yield 8-9% and retail 11-12% which can come under pressure at times..but stay stable for the most part. Plus you can add some appreciation. So I think this is a decent asset in one's portfolio.

Vikas

Rohit Chauhan said...

hi vikas
yes you are right ..i am speaking in terms of residential property.
if the numbers you mention are representative, then the gap in yields is still fairly high.
some part of the higher yields can be explained by the higher cylicality of the rentals as commerical property is more influenced by business cycle, but still the difference is quite high.
i agree it is a decent addition to the portfolio ..the negative is see is the amount of money needed to invest and i assume it also requires more skill to invest in commercial property than residential.

btw - vic ..do you have an evil twin by the name rana:) ? this dude keeps flaming me and seems to dislike what i have to say .. ..just joking

regards
rohit

Vic said...

Hi Rohit,

I agree with your comments.

I was also shocked when I first saw a post from Rana few months back. I thought somebody was imitating me as it is not usual to spot Rana(s). My guess is Some Hot Blooded Rajput..:-)

On a different note, I'm almost done with reading your 2005 posts (quiet a few you had that year). It is part of my daily activity, like it very much.

Thanks,

Vikas

Rohit Chauhan said...

hi vikas
thats make it three of us ( you me and the hot blooded evil twin) i am a rajput too :)

2005 i had more time and less work :)

also back then i used to write about current events. i have stopped doing that since then. hopefully one of these days i should be able to consolidate some my posts in an ebook

regards
rohit

Anonymous said...

Hi Rohit,

Good post!

Like Vikas mentioned, rentals from commercial properties are much higher than residential.

I am getting one proposal of commercial property - price 30 lacs, current rental 30,000 / month. This way yield is 12%. However after tax it will be 8% only. Not sure about rentals in future - most likely going down.

I still feel investment in equity is much better - in term of liquidity, tax, etc.

Thanks
Prashant

Vic said...

Hi Prashant,

I agree with you that equity investment is better.

But for large portfolios i.e. Over 1 Cr, it is good to have 20-25% in a good commercial..just to own different asset class. You can reduce the tax bite by deducting some expenses.

The financial markets are not very transparent and developed in India. Also majority of ppl still tend to invest more in RE.

Vikas

Vic said...

Prahshant,

I forgot to mention: the proposal you talked about sounds an attractive one. If you don't mind, can you share the details?
Keep in mind that the commercial leases are usually 3-5 years plus annual increase.
So If one does his homework and buys it at an attractive location @ cheap price, can work out good. Same thing goes with selecting a tenant which can weather the storm.

Vikas

Rohit Chauhan said...

hi vic / prashant
what kind property do you consider as commerical property - shops , industrial plots etc ?

also if i am not mistaken, commercial property management requires more time and involvement ..any views on that ?

what kind of legal and procerdural safeguards do you have for commercial property?

although not discussed openely , residential property especially in places such as mumbai have high risk if you rent it out. tenancy laws are so bad and anti owner that if the tenant refuses to vacate , the owners is in trouble

what has been your experience on this count with commerical property ?

i personally think equity is more transparent and convenient for me ..with a job and other time constraints i would not have the time and energy to manage a commerical property. but those who can , it can be a good source of income

regards
rohit

Vic said...

Rohit,

There are two types of commercial properties:
1) Office Space
2) Retail store in a mall
I would prefer investing in Grade A Office space which is usually rented to MNCs..not corrupt.

If you take up a space in new mall or building, the management is minimal. I have bought OFfice space which is under construction so don't have any rental experience in the same category.
But I have/had residential apts in Gurgaon, Noida and Pune which I have been renting for last 3-4 years..that too primarily from the US.
First of all, I buy a property in Modern India spots which obviously attract good crowd. These ppl have least interest in acquiring your apt. So it is not all that difficult but appears to be.

For example, learning to invest (Not trade) in stocks is not difficult or extremely time consuming but most of the ppl find it so. Same thing goes with property acquisition/ongoing mgmt.

There will always be work involved regardless of what type of investment it is. For example, my broker went belly up which was never expected. I just found out that the assets are only covered upto 1 lac by NSE. Luckily, I had invested less than one lac, I could have easily invested much more.
During my research in hunt for a new brokerage, I found out all kind of issues with top brokerage firms in India. I'm just speaking of the middle man here, not even the companies that I would invest in. Such basic issues don't exist in the US.
But this won't stop me from investing. Just keep on learning the lessons..more you learn..better one becomes.

Vikas

Rohit Chauhan said...

Hi vic
you seem to have a experience/ knowledge of real estate / commercial property management ..do you mind making a write up ..would like to share with other readers on this blog ..i think it will help everyone

also i thought brokers - such as icici direct only act an intermediary ..the stock is held by nsdl ..is your understanding different ..can you clarify what you mean by assets covered upto 1 lac only ?

regards
rohit

Vic said...

Hi Rohit,

I've lot of experience in Residential arena and some exposure to commercial. I can write on my learnings if you like.

Yes, you 're right that the brokers act as an intermediary only But there can be lot of issues in my experience. For example:
Whatever the trade you execute, it takes some time to settle/reflect in your DEMAT a/c. In my case: Many stocks that I had already paid for were still sitting in Broker's pool, they never made it to DEMAT

You can find all sort of issues with the Top brokerages such as ICICI direct, HDFC, Motilal, sharekhan etc. in Mouthshut, e.g.:

www.mouthshut.com/product-reviews/IciciDirect.com-925042891.html - 341k -

I totally believe in such issues as I'm going through the same. though many might never come across any.

Vikas

Vic said...

Rohit,

I was told by my contact about 1 lac limit, not exactly sure of this but there's one for sure.

It relates to the shares/money that hasn't hit DEMAT yet.

Vikas

karthik said...

Hi Rohit, Just getting off track for a bit.. Wanted ur view on Satyam drama...

Even after the promotors showed that they cannot be trusted the script went up again yesterday.. How can people buy this script after all this?..How do they know that promotors wont try this stunt again?

Rohit Chauhan said...

hi karthik
nothing new actually. satyam is known for poor governance. what is new that the market gave a good wacking to the promoters and they were not able to get away with their games. main reason was due to the presence of foriegn investors and the co. being listed in US
MNCs, and other indian companies continue to behave equally badly. however indian investors including the big ones never assert their rights.

In india it is easier to steal 100 crs via stock market than 100 Rs.

i dont know why people are still buying the stock. i would personally never touch such a company.

regards
rohit

Anonymous said...

Hi Vikas,

Sorry for late reply.

I think you would not be interested in this property for the following reasons:

1. It is not from reputed builder.
2. It is located in Meerut (UP)
3. You will not get MNC renting it.

This property came to me through my father but I decided to let it go.

Apparently property price has gone down to 28 lacs. Actual rental is 25,000 / month with 5% yearly increment for 3 years.

Rohit,

Main reason for my interest in commercial properties (primarily office space) is more appreciation of commercial properties than residential in the past plus higher rental yield.

Thanks
Prashant

Vic said...

Thanks Prashant,

You're right about that:-) i.e. the reasons listed by you.

Vikas