real estate

Real Estate – How Real Are The Returns : Is It Really An Asset?



Previously, I argued that real estate ‘investing’ returns were simply the result of liquidity and savings flows, and were therefore ‘accidental’ and unpredictable. They did not represent any substantial (relative) wealth creation, because ‘all boats rise with the tide’.

Disclaimer: This article was originally published in Nov 2006, so some data points might be outdated.

Investing is a Skill and a Mindset

Puritanically speaking, such ‘skills’ cannot be called investing, which can be loosely defined as the tracking of ‘value’ across the economy. Investing is a part of the asset-allocation process; good investing is supposed to transfer money from where it is surplus, to where it is needed/ deficit. The metric used to track surplus/ deficit is the Cost of Capital (k). The Cost of Capital drops where money is in surplus, and rises where money is in deficit.

Very quickly, capital is of 2 kinds: debt (fixed-return, non-risk-seeking capital) and equity (also called risk-seeking capital). The cost of debt is fixed and measurable but the cost of equity is neither fixed nor perfectly measurable because it incorporates return expectations, which are perceptual in nature. I am ignoring quasi-equity as a category, just to keep things simple.

“Store of Value” Investments

This brings us back to “store of value” investments. As I mentioned before, “store of value” assets like gold, real estate, etc do not create value, hence investing in them should never be done with debt funds. Only savings (i.e. equity) that cannot find an economic use, should be used to park in “store of value” investments.

Real Estate is bought for 2 kinds of purposes: the first, honorable purpose is to live in the house. This kind of real estate is consumer durable, a little better than a car. It depreciates at a lower rate and has a longer life, typically longer than the loan tenure that funds it. So it leaves some “asset” (residual usage) in the hands of the investor, who has used debt to fund his purchase.

Arbitraging the flow of ‘need’

The second, less honorable purpose of buying real estate is to arbitrage the flow of ‘need’ (which has an economic ‘value’). People bought bungalows in Gurgaon, and have held on to them for 20 years. So, for 20 years, this “consumer durable” has been lying in disuse/ misuse…….in order to find a desperate buyer/ tenant who is actually willing to pay through his nose to stay in that bungalow.

So a person who bought a bungalow for Rs.2 lacs in 1985, now expects to get Rs.1 cr. The probability that he will find someone willing to pay him that kind of money, is directly dependent on 2 things: the income levels of people wanting to live in that area, or liquidity/ debt flows into real estate in that area. The final buyer will have to be a person who wants to live in that bungalow, right? And the price he can finally afford to pay will be dependent on his income and debt capacity, irrational exceptions apart.

Hence, what the real estate ‘investor’ actually arbitrages is economic growth in the area, which is represented by the wages prevailing in that area, which drives purchasing power. The supply of ‘home equity’ comes from savings flows, which are directly proportional to income levels. Areas with a higher “propensity to save” have higher levels of real estate prices, with greater stability of prices (I gave Jaipur as an example of this phenomenon).

The Reason for Volatility in Housing Prices

The other kind of capital, i.e., debt, is mostly composed of housing finance. In the short run, incomes, and savings are less volatile, but debt flows into a real estate market can be very volatile. That is why most of the volatility in house prices is provided by debt flows. A sudden increase in bank funding for say, Gurgaon, will spike prices. Other banks will follow and there is an explosion of credit into the local (real estate) market. Equally suddenly, a perception that prices have peaked will take over and fresh lending will disappear.

This is the key risk to a real estate market. It is very important to distinguish between the quality of various bubbles. An equity-financed bubble can hold out for very long as I mentioned in Jaipur and Abohar/ Fazilka in my last article. But a debt-financed bubble may be very volatile, e.g., the new urban agglomerations attached to major cities like Delhi, Bangalore, etc. Investors do not appreciate the qualitative difference between these 2 kinds of capital flows and the bubbles they create.

The only ‘fundamental’ that a real estate investor should arbitrage is the build-up of infrastructure. The investor who invested in village land in Gurgaon (at some Rs.250 per sq. yd in 1986) would have got real (inflation-adjusted) returns on his investment. The risk he took: was whether Gurgaon would turn out the way it did. Every buyer of village land around Delhi, will not find himself sitting on land that is attractive to the next BPO player entering the city.

If you have managed to anticipate that event, you deserve the money you made. When you know a way to do that repeatedly, then maybe real estate ‘investing’ is for you. And, if you know how to MAKE that happen, then maybe you should get into the real estate business.

So, Are Real Estate Investors Speculators?

On a tangential note, have you tried counting the number of unheard-of names of builders advertising on FM radio these days? In one stretch of 15 minutes, I counted 5 different ads from different builders. Reminded me of 1995, when all the stations from Bandra to Churchgate only had ads for Finance companies. A couple of years later, the whole thing blew up in a series of scams.

Compare this to the equity market, where you anticipate demand for a product, the change in margins, and the strategic position of a company that seeks to benefit from these economic trends. The wealth that such companies are real (i.e. relative to the rest of the economy) and predictable. If an investor learns how to track such ‘value’ across the various economic sectors (and companies), his returns and wealth creation are real.

Does that mean that I am suggesting that real estate ‘investors’ are mere speculators (defined as people who cannot control the investment returns that they get) as opposed to relatively scientific ‘investors’ in the equity markets?

Not really……remember the “random walk theory” in equity investing? If you believe that kind of stuff, maybe real estate investing is better for you. The tangible assets that you can see, give great comfort to most people. And it is, after all, a consumer durable, which you can ‘enjoy’ even if you don’t get a positive, inflation-adjusted return if you have bought at the top of a bubble. So your mind will not stew much over the (absence of) returns that you get from a bad investment.

What is the right time to sell real estate?

So how does one find out the right time to sell? Difficult to say, in a market where bid-ask spreads can rise to 30% in periods of illiquidity, rigging is rampant and most demand comes from new project launches. But try the following behavioral indicators:

  • Month-on-month returns (i.e. price spikes in general housing prices) are at rates similar to stock market returns
  • Rental yields have dropped below half the rate of bank interest.
  • Input supplies (cement, steel) are stretched, with runaway inflation
  • There is a drop in liquidity, with a sharp increase in prices
  • New project launches are at an all-time high
  • Land scams have started
  • Occupancy demand is crowded out by speculators and HNIs
  • With 80% of the market population at the bottom of the pyramid, 80% of the housing projects are for the ‘top of the pyramid’. 20% of the population buys 80% of the housing stock. Do a dipstick survey…..!
  • Industrial demand (for bank credit) starts to get crowded out, with retail asset books being built up in the banking system.



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