real estate

Riding On A Hope & A Prayer : The Drivers of Real Estate Returns



I would like to restate the real estate investment debate. It isn’t really about whether the land has suddenly become an ‘el dorado’ for investors. It is about understanding the difference between “store of value” investments (that are secondary derivatives of economic activity). And those investments that create value by generating economic activity, like equities and debt.

Disclaimer: This article was originally published in Oct 2006, so some data points may be outdated.

The ‘store of value’ argument…. again!

Let me explain. Land, (or gold, for that matter), does not create wealth. It is only worth what someone else (perhaps a bigger fool) will pay for them. It does not generate value. And it is actually sometimes cash-negative. The cost of maintaining a store of gold (security, transportation, insurance, etc) is to be deducted from the Capital Gains earned from gold. And in case gold prices are stagnant or declining (1981- 2001), investors suffer losses even in nominal terms. In the case of land, you might get rent, but after deducting costs, the effective yield is marginal. Mostly, the land is held for the Capital Gains it yields.

In parts of Delhi/ Gurgaon, where the Rental Yield (i.e. the Annual Rent divided by the Market Value of the property)  is down to 1-2%. There is nothing left for the landlord investor after maintenance, repairs, security, municipal charges, insurance, rates, and taxes. The net cash flow from holding property in Delhi may actually be negative. Investors find it worthwhile to hold land ONLY because of the Capital appreciation that accrues from selling it to the bigger fool.

The Flow of Money

Theoretically, economists would argue that normal returns would accrue to investors in the long run. In Gurgaon, for example, the landlord investor who chooses to hold on to his property at these rates is giving up the option of selling his property and parking his funds in the bank at 8%, or getting a post-tax return of 6.5% from Mutual Funds. He is expecting a Capital appreciation of at least 7%, otherwise, this is not a rational choice.

There are other factors at play, however. For example, the flow of black money into real estate ensures that the “opportunity cost” of the capital flowing in has to be adjusted downward. Black money carries a storage cost, and security risk (of being found out by the CBI, Income Tax, etc). This drives down the return expectation from real estate, ensuring that even after the above obvious calculation, there is no capital flight from this sector.

The physics of bubbles

Just like you fill up a balloon only when you pump in the air at a pressure higher than the atmospheric pressure prevailing outside, a bubble (in asset markets) blows up ONLY when the cost of capital (i.e. the return expectation) drops below the levels prevailing in the outside economy.

This can happen for structural reasons (like the flow of black money, Japanese funds flowing to stock and bond markets, etc) or for sentimental reasons (like the mindless manner in which people bought IT shares in 2000), or even technical reasons (like farmers in Punjab not knowing where to put their cash surpluses, leading to a steep hike in the prices of agricultural land).

Sometimes, regulations can create such bubbles (like capital convertibility restrictions in Forex markets). The drivers may be different, but the fundamental phenomenon is the same: the cost of capital drops.

To understand what happens next, let us go back to the balloon example. To hold up the balloon’s shape, you need to close off the vent. If you leave a small hole, the balloon starts to deflate. The bigger the hole, the steeper the rate of deflation, till at one tipping point, it can be called a full-scale collapse. But in every case, the pattern is the same……different words are used to describe different rates of deflation.

Now let us look at what it takes to hold up the balloon. There is a certain amount of air that needs to be pumped in, without which the bubble would move from inflationary mode to deflationary mode. This certain amount of air would be directly dependent on the size of the balloon/ bubble and the size of the vent. A small balloon with a small vent can be held up by a child’s mouth.

But a large (hot-air) balloon with a big vent needs a pump machine to hold up the balloon (like those gas balloons we see on buildings). The bigger the balloon, the bigger the vent………the bigger the incremental flow of air needed to keep up the balloon/ bubble from inflating.

The physics of financial markets’ bubble

Now let’s get back to financial markets‘ bubbles/ balloons. The incremental flow of funds that is needed to hold up an ever-larger bubble, will keep growing. When Gurgaon was just a village outside Delhi, prices could be kept up by the small amounts of funds (including black money) that flowed from real estate speculators.

As it grew bigger, the number of segments that needed to join in, also increased. First, the BPO segments, then the affluent middle class from Delhi, then the NRIs, and finally, the big Housing Finance banks with their mortgage finance. In short, you needed ever larger amounts of ‘incremental flows’ to hold up the bubble.

Momentum ensures that the number of segments that follows quickly on the heels of its predecessors is an ever-proliferating phenomenon. The Gurgaon bubble has created interest in the big real estate companies, who were pre-May favorites on the stock markets (Unitech, DLF, Ansals, et al) and would have raised large sums on the stock markets, effectively involving the man in the street finally. Lastly, the big overseas flows would have started, creating a full-fledged ‘hot-air’ balloon.

Now the balloon would have got unstable. If even one segment withdrew (like the RBI-mandated exit of the banks from realty sector lending), it would have led to slow deflation. Thereafter, the build-up of momentum would depend on the interplay between 2 factors: the continuous, steady inflow of black money and increased savings (from all that wage inflation that Sudhendu Bali talks about in his article) would trade-off against the downward pressure exerted by all the earlier segments wanting to make a slow exit. Any sudden change in the balance of power (the interplay referred to above) would create a disorderly exit, leading to a sharp dip in prices.

An example of bubble and bust

Have I explained the sequence of events? To repeat, let me give you my famous Jaipur example again. The city has no industry and lives on just 3 businesses: tourism, gemstones, and garments. Why do people buy real estate there? Because outsiders (Jaipur supplies Indian industry with its entrepreneurs and senior managers, who send back their savings to the city, buying their post-retirement real estate) keep buying real estate, which is funded with equity, NOT debt. These properties never come on the market, even if vacancy levels exceed 50%. That explains why Jaipur has had a perpetual real estate bubble for the last 30 years.

As the city has got larger, newer segments have had to come in. BPO players and the banks bought some real estate in Jaipur, then the big Industrial Houses moved in. Now this size bubble cannot be held up with the flows coming from Jaipur’s traditional sources: their domestic industry (tourism, gemstones, and garments) and their diaspora (Jaipurians who send back their savings from outside the city).

The short point: anybody who puts his money behind such a phenomenon, is not really investing. He is putting his money onto a momentum-driven rally, hoping to find a bigger fool. The supply of bigger fools does not seem like drying up any time soon. But this can hardly be called investing.

So, can you beat the market at all?

Is there any sensible way you can beat the market in a steady, non-random fashion? Can you really hold on to your gains? You keep rolling over your gains, till you reach one steep, Japan-style deflation in asset values that will take away the wealth accumulated by generations. What did you say? It hasn’t happened in India?……….in inflation-adjusted terms, look at real estate in Kolkata over the period 1971-1990.

Hence, real estate investment returns are the mere product of liquidity and savings flows, NOT their fundamental cashflow generation capability. Investors can be good at predicting the latter, but there is simply no way of predicting accurately the former. If you REALLY want to get rich in a sustainable, non-random fashion, equities are better.




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