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The past and future of real estate as an investment

It's time to permanently abandon the myths that surround real estate investments

A couple of weeks ago, while I writing about the success of the black money declaration scheme, I referred to the collapse of real estate as a viable investment option. As expected, this brought a flurry of protesting emails from a lot of people who seem deeply committed--not just financially but also emotionally--to the idea of real estate being not just a great investment but the only viable investment option.

As it happened, I also happened to run into a prominent Delhi-based real estate developer who made the claim that every wealthy person in the city had become rich through real estate. While such a claim is unverifiable and basically rhetorical, I guess it can be argued that rich people buy a lot of property and eventually the price of that property increases. But to say, based on this, that all rich people became rich because they invested in property is hyperbole. It could also be availability bias of who you know. I mean a narcotics smuggler would probably think that everyone who’s rich became so out of the drug trade.

Around the same time, I hosted Value Research’s inaugural ‘Money Hangout’ on Youtube, where participants asked questions about their investment problems. The typical real estate question arose out of the same problem. A lot of people have second apartments, bought as an investment on a loan that is being repaid with some difficulty out of a salary. Now, the apartment is worth some theoretical number of crores but is practically unsellable and the rental yield is a ridiculous one per cent or so a year if one can find a tenant. Obviously, real estate ‘investors’ of this category are asking themselves some uncomfortable questions, even though they are not yet prepared to accept the obvious answer.

The problem here, which is blinding everyone, is that there are plenty of anecdotes of people of earlier generations doing very well out of real estate. Everyone knows some families who owned a house bought 30 or 40 or 50 years ago which, when sold after decades, made them rich.

The problem with getting inspired by this is that the entire model of real estate value creation has changed. Broadly, there are five 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 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 and slumps that inflict real estate.

In the old way of investing in real estate, one bought a plot of land in an area which was substantially underdeveloped and over the next two or three decades one could capture all the value created under numbers 2 to 5 above.

Things have been very different in the last decade when real estate investors have bought apartments. In this new model, stage one and two are completely taken over by the land acquisition agency and the developer between them. However, by creating tremendous hype around real estate, engineering massive price inflation and high-pitched marketing, developers have also captured a lot of the future value accretion that would happen in stage 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. Many did so, and find that they now have a long and uncertain wait. Maybe their descendants will get something, maybe they won’t.

Of course, some of this excitement about the fabulous long-term returns of real estate arises purely from mathematical illiteracy. One of the people I spoke to breathlessly told me about a piece of property in Mumbai that became 100x since the mid-60s. Did that person realised that this was a rate of return of barely 9.7% a year? Probably not.