The Changed Model of Real Estate Returns
Common assumptions underlying real estate returns are no longer valid...
By Dhirendra Kumar | May 15, 2013
The recent fall (and subsequent minor recovery) in gold prices has drawn extensive commentary on whether Indians’ love for gold will ever moderate. If jewellers are to be believed, then the fall in prices has triggered a buying-frenzy among people who believe that the price fall is only temporary. The other half of this love for ‘traditional’ investment avenues is real estate. A lot of Indians firmly believe that the most sensible ways of investing are land and gold -- exactly what they were a thousand or two thousand years ago. That you can’t lose money in gold or real estate has been is believed axiomatically, to the considerable detriment of people’s finances.
Between the two, the need to wean people off gold has been talked about more, primarily because of gold’s role in India’s current account deficit. However, when one looks at people’s personal finances, the role of real estate is more of a problem. Ordinary middle-class people are taking large loans to buy second houses purely as investments. They have a deep-set belief that this is a much better investment than anything else. So they’ll take on 15-year EMI obligations that eat deeply into their income. Interest rates are high and rental yields are minimal to non-existent. There’s no equivalent of this kind of mis-investment in the case of gold. Why do people do this? Where does this belief come from? One major source of this belief is anecdotal evidence -- misleading evidence, as it happens -- of the fabulous returns that people have earned from real estate. There are a few reasons for this belief. One of the less understood ones is that historic examples of huge returns over long periods of time are unlikely to be repeated -- they took place under a very different model of real estate investments.
If you try to deconstruct where real estate returns came from historically, there are perhaps five sources of the changes in the price of a given property, with the final return being the product of all these. First, the original change in usage from agricultural or simple barren land to residential or commercial. Second, the coming up physical infrastructure which made this land usable for the new purpose. Third, the improvement in livability or commercial viability as the area got populated more and more heavily. Fourth, the periodic booms and busts that afflict real estate. And Fifth, the general inflation of the economy that becomes part of the visible change in the property’s price.
When earlier generations bought property, they often did so at an early stage with almost all the gains from the second to the fifth point above accruing to them over a prolonged period. Things are different now when you typically buy an apartment from a real estate developer. In this new model, all gains from stage one to three accrue completely to the developer and whoever came before the developer. Not just that -- and this is the worst part -- the developer also tries, and often succeeds in capturing much the value of the later stages in advance from the buyer.
The intense marketing hype around real estate developments are intended to convince you that one day in the imminent future, the property you are buying will be among the most desirable ones, in your part of country. Therefore, you must pay up for that future now. Basically, to put things in investment terms, your acquisition price is at a high multiple of a value that will supposedly be attained in the far future. It’s a con job, and nothing more, helped along by the artificial scarcity in urban land and the huge amounts of black money sloshing around in real estate. Everyone should buy one piece of property to live in and forget about real estate as an investment. Unless, of course you have huge amounts of black money. But then, you wouldn’t need investment advice from an investment column.