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Unreasonable Reality

The new real estate life cycle has seen developers charge for a future rise in value, thereby depriving buyers

I wrote about real estate investing (Realty on Razor's Edge) and how it must be evaluated according to the same basic criteria as any other investment. In response, I have received a large number of rejoinders, many from people who made money in real estate till about 2005 and lost a lot after that.

These letters made me think about how a piece of real estate gains value and how that value can be captured by people who own it at various stages in its life cycle. Broadly, here are the six sources of real estate value creation:

One: the legal ‘state-change’ from agricultural or unused land to residential or commercial;

Two: the creation of a physical environment which makes the real estate usable. This consists of construction and infrastructure;

Three: the improvement in actual livability (or commercial viability) as an area becomes fully populated and eventually comes into the mainstream;

Four: Inflation and general economic growth over a period of time;

Five: The periodic booms and manias that inflict real estate;

Six: the periodic slumps that occur.

Of these, one, two and three occur sequentially during the life of a real estate asset. Number four overlays all the others and goes on continuously while numbers five or six could happen at any time.

In the old way of investing in real estate, one bought a plot of land in an area which was substantially underdeveloped. Typically, one would buy it from a government agency which had acquired it and changed the land use, or a private entity which had done the same. In that model, you would capture all the sources of value creation except some part of stage one. All the price increases that would happen because of the other five factors would add to your returns.

Things are very different now when real estate investors buy apartments constructed by a developer. Obviously, in this new model, stage one and two are completely taken over by the land acquisition agency and the developer between them.

However, what has been happening is actually far worse for the buyer. The general hype around real estate, the massive price inflation and the high-pitched marketing around specific projects means that the developer has already tried to capture a lot of the future value accretion that would have happened in stages three and four. As a buyer, you are told that one day the area in question would be the next central Delhi or south Mumbai and therefore, you should pony up a future price right now.

From an investment perspective, this basically means that your acquisition price has factored in a high valuation for future earnings. All that is left to you as an investor is numbers five and six in the list above, provided you are lucky enough to buy into six and sell out of five. And that’s doesn’t always work out, as real estate investors have found out in the last year or so.