I had written about real estate and its valuation a year back. I would suggest reading the earlier post before proceeding on this one.

The usual approach to valuing real estate is to look at the rental yields.

Rental yield = net rental after all expenses / capital value.

Investors expect yields to be in the range of 4-6%. This equates the capital value to around 16-25 times the rentals being received on a property.

Ancedotal evidence
I have a few friends who have trying to rent out their apartments in bangalore. They are finding it diffcult to get a rent of 11000 per month on a 2 bedroom, 1200 sqft apartment. Supposedly the apartment is worth between 40-45 lacs (atleast, depending on who you ask).

So based on the valuation thumb rule, either they should get a gross rental (excluding expenses) of around 16000-20000 at a minimum or the property value should be around 25-30 lacs.

Now I can consider my 2 bedroom dinghy, a tajmahal and value it at 50 lacs, but the value has to be backed by rentals. I personally think the litmus test of property values is the rentals one can receive on it. Property values are like stock prices. They have an element of underlying value (cash flows in stocks and rentals in case of property), but at the same time there is a speculative element too. The speculative element appears as a part of the quoted price – stock price or property value.

When investors are optimistic, stock prices are bid up and when they are pessimistic they bid them down. Simple isnt it ? well almost everyone forgot this basic idea for real estate. Property prices rose 2-10 times across the country depending on the location and type of property

Is the valuation approach correct ?
Now you can say that this valuation approach is incorrect. Consider this – if I have to invest in an illiquid asset, will it not expect 14-15% returns over the long term ? So if I am getting 2-2.5% via rentals, then my property should appreciate by 12-13% p.a over the long term to get decent returns.

Well, globally over a range of markets, real estate is known to return 2-3% returns over inflation ( so around 7-8 % in case on india) over the long run.

You may argue, as several of my friends have – this time it is different. India is doing well, incomes are rising, there is limited land and huge demand etc etc. Well, to that I can say, please read the history of the real estate boom and bust in japan in late 90s, in california and florida in 80s and check what is happening in the US, dubai and other markets. Similar faulty logic was given to justify the inflated prices, till the bubble burst and prices returned to reality.

Hope and belief does not count
Investing in any asset, stock or real estate cannot be based on borrowed wisdom. If you want to make money, use common sense and read about it before taking a plunge.

Unfortunately a lot investors in the US and maybe in india got greedy and speculated in stocks, real estate and other assets in the last 2-3 years.

Real estate like any other asset is known to get overpriced from time to time. I strongly felt that the huge surge in global liquidity from 2003 drove the interest rates down in india and pushed the stock and real estate prices up.

All talk ?
You may be thinking – everyone is smart after the fact. If you were so smart, what did you do about it ?
For starters, I was not smart about it. I avoided being greedy and tried to use common sense. I personally like to run my finanical affairs with a margin of safety. For example, when buying an apartment, my primary considerations were the following

– can I afford the EMI – I tried to keep the EMI at 40% of my current gross income (not future income)
– would I be able to keep the house if the worst case scenario happened, such losing my job or loss of income.
– What would my debt equity ratio after buying the property (see this post for more details of my logic)

2003-2004 was a great time to take housing loan. Banks and HFC were giving variable rate loans at around 7.5% and fixed term loans at 7.75%. I had no idea whether the real estate prices would boom or go down. However what was obvious then, was that banks were underpricing debt. Let me explain my logic for the same

A loan by a bank is basically a product which has a cost and a profit margin for the bank.

So interest charged = bank’s profit margin + cost

Cost = interest paid by the bank + loan losses due to bad loans (typically around 1-1.2 %) + overheads (typically around 0.5%)

The interest rates paid by the bank is dependent on the inflation.

So for a 7.75% charge, the bank was assuming a cost of fund of 6% (7.75 – 1.2-0.5 %). This was too low. This is the cost at which the Indian government is barely able to borrow, much less the banks.

The subsequent events have borne out the above logic. The loan losses were underestimated by the banks and the cost of funds was underestimated too. As a result, bank have now repriced their loans and are not likely to underprice them as low as 2003-2004 time frame.

During the 2003-2004 time frame, I strongly felt that the loan rates were too low. In response to that, I refinanced my loans and increased the duration from 15 to 20 years (see an earlier post on the same). The key was to focus on what I know (loan rates were low) and avoid speculating on what I could not know (real estate prices would rise or fall)

Have I gloated enough?
The above thought process turned out to be too conservative. Others who took higher risks in 2003-2004, were rewarded handsomely. So, my decision was not some unqualified success. However I am still very happy with decision as my conservative approach has helped me in avoiding losses in the past.

Being rational and avoiding greed is like virginity. Either you have it or you don’t.

Collateral damage
Not everyone who is suffering in the US or india was greedy or speculated in real estate. Some of the buyers in the US were first time buyers who bought property as their first home at speculative prices. These people are now facing ruin due to drop in home prices. One feels sorry for them.

What does the future hold ?
I don’t know 🙂 ..what one can do is to look at history and try to learn from it. History does not always repeat, but it is good starting point. In most of the real estate bubbles, the market takes upto a decade to recover the earlier peaks.

One should also remember that real estate typically gives a few percentage points over inflation. If you speculate in an illiquid asset, by buying it on debt, you are asking for trouble.