How do we know when a market is overvalued? The equity market looks at price: earning (P-E) ratios, book value, price earning to growth (PEG) ratios and valuations to see if stocks, or entire markets, are overpriced or underpriced. Is there a similar metric for real estate, a rule of thumb that tells you when a property, or the whole real estate market, is overpriced or underpriced? Mature markets use some rough rules of thumb to decide over- or under-pricing in real estate. The first is the ‘gross rent ratio’. Divide the sale price of a property with the gross annual rent it will get. Gross rent does not account for costs of the loan, maintenance or society fees. If a flat sells for Rs1 crore and can be rented for Rs50,000 a month, or Rs6 lakh a year, the gross rent ratio is 16.6. Real estate investors use a rough rule of thumb that says: buy at 10 and sell at 20. Buy when the rent ratio is 10 and sell when it touches 20 because the property is overvalued. The second metric is the yield which just switches the two numbers. Divide the gross annual rent by the sale value of the property. The annual rent of Rs6 lakh divided by a capital value of Rs1 crore gives a yield of 6%. Mature market thumb rules say buy at a yield of 5% and sell at 10%.
I used both the metrics and tried to see how buying or selling price and rents behave in Delhi. I picked a B category location in South Delhi (SD) and an old middle-class hub in East Delhi (ED) and looked on a property search site to look at the prices and rents for similar properties. The SD flat has a sale tag of Rs3.5 crore and is rented out for Rs65,000 a month. This gives a gross rental ratio of almost 45 and a yield of 2.23%. The ED flat has a sale price of Rs1.8 crore and rents at Rs30,000 a month. This gives a rent ratio of 50 and a yield of 2%. If the real estate mature market rules were to work in India, then either the house prices will fall or rents will rise, or both.
Click here for enlarge
The valuations are way off the charts, but it is unfair to use the mature market rules in India. Mature markets have a much lower cost of capital and don’t suffer the price escalations due to black money. One handle that could be used is the yield on commercial real estate in India. A few real estate experts I spoke to said that a 7% yield is ‘good’ and the property is ‘investment worthy’. Why can’t we apply that yield metric to residential? No, say property experts. Residential real estate is different. You can’t look at residential real estate like other assets—it is different. How’s that? People buy for themselves, they buy for the long term, they can hold for a long time, people don’t buy for yield, they buy for capital appreciation. But, we’ve not seen much of capital appreciation in residential real estate for a few years now. In fact, some of the overpriced Gurgaon condos are down to half price with no buyers, what appreciation?
Why are people going to keep investing in real estate if there is no capital appreciation in the near term? This gets another line of argument—because they look at the EMI like an SIP. It’s a strange argument because in one you borrow to invest and in the other you invest out of your savings. An SIP allows you to buy a rising and falling market in little pieces over a long period of time with your own money. An EMI allows you to pay borrowed money over 15 years for a decision you took at a point in time. An EMI does not allow you to buy cheaper when real estate markets crash. Borrowing to market time is a poor investment strategy whatever may be the asset class you are targeting.
Remove all the noise around residential real estate and what remains is this: other than the fact that the steady supply of black money has raised residential real estate prices in the Indian metros, especially Delhi, there seems to be no other reason for the current property valuations in an oversupplied market. Real estate has been a traditional sump of black money in India, but if the Modi government crackdown on corruption and black money makes a dent in this, we should expect the depression in real estate prices to continue.
We clearly need to shift our mindset from believing that real estate is a one way ride which will throw off profits sooner or later. The thousands of people stuck in delayed projects in the NCR have found out the hard way that real estate is not a sure-bet. Rents and EMIs converge in mature markets, but not in a market like India. But how big should that difference be? If you want to buy a house to live in today, do the math. Does it make more sense to rent right now or buy? Suppose the difference between the rent you need to pay and the EMI for the house you want to live in is very large, would it make more sense to start an SIP with the money you save on the EMI or you see yourself living in that house of 20-30 years ahead? For investors into residential real estate – you have to be really brave to step into this market today, or you have cash that needs a sump.
To those who still persist in saying that over the very long term real estate is a sure win, I can only point you to this paper (bit.ly/2wzlLyG) by Piet MA Eichholtz, that looks at real estate prices of a Dutch condo from 1628 to 1973. This well cited paper finds that prices only doubled over that period and grew just 3.2% a year from World War 1 to 1973. There are periods of very high growth between these two time points, you need to know how to time the market in real estate to make supernormal profits. Not that different as in the equity market timing approach.