Mumbai
The skewed property market in India should be a warning to households wanting to acquire real estate
It is tough to talk a household out of buying more property . Even my bet ter-informed friends and colleagues are unable to resist the lure of real estate. For households, this asset is the largest and most expensive one they hold on their portfolio. But then, columnists like yours truly are very determined to point out again and again that one shouldn't overdo this. Why is real estate harmful to a household's portfolio?
The chunky asset cannot be utilised in small portions. Prices vary by unit, making it a market whose goods are not uniform and therefore, expensive to find, evaluate, buy or sell. Transacting costs are high. Yields are low since the future cash flows in the form of rent extend to perpetuity . To a normal household, buying a house is risky as they operate with limited information and expertise.
We will discuss the economics of the real estate market this time. What determines supply and demand, and therefore, prices, and how the market adjusts these variables to move towards equilibrium.Modelling the real estate market is some what complex due to the presence of two distinct segments of buyers. One set is looking at houses as the space in which they would live in. The other is buying houses as a capital asset or an investment opportunity . The interplay between these segments complicates the market.
If buyers of space dominate the markets, the economics is straightforward.Seekers of living space have the choice of paying rent or buying a house. Demand for property will go up as more households need space; earn incomes that enable them to pay sustained rents; access affordable credit to buy rather than rent; and use tax concessions to make a large purchase that is otherwise expensive. In this market for living spaces, supply will tune itself to the same factors that influence demand. Since houses are durable, existing stocks will get re-priced, and new stocks will be added based on demand. Valuation and pricing will be the discounted value of future rents.
Now durability of the housing unit, the high unit cost and the availability of credit and tax concessions creates an opportunity for investors. Even households that set out to own a space to live in become investors in the property. The changes in the supply of houses and the expected changes in future rent, can modify the valuation of houses, creating a large set of investors and speculators whose actions influence the prices.
In a simple user-driven market, demand and supply will determine prices.In a market dominated by investors, cost of funds and supply of property will determine prices. The most important problem in the real estate market in India is that it is dominated by investors who access money lying outside the system.This is why we have the ironical situation of a large number of unoccupied houses on the one hand and a housing problem for the common household on the other.A dysfunctional market where the supply of houses is tuned to the investor, rather than those that seek spaces to live in.
This brings us to the optimists who continue to believe that property is the “best“ investment. What are the risks?
First, the demand is driven by valuation myths (for example, real estate prices in Mumbai can only go up, since it is a tiny island). If renters or buyers of space are only marginal participants, prices no longer reflect this constraint. If more than 50% of Mumbai's population lives in slums, it is a reflection of this imbalance where seekers of space are not buying it, and those that are buying property are simply assuming that someone else will buy at a higher price. Valuation is not based on future cash flows, but on vague assumptions about future price.
Second, demand for property is fuelled by cash, equity and borrowings.The “black“ component in real estate purchases makes this market very murky. Property is the preferred place for ill-gotten money to hide. When dominant buyers are also able to meddle with government policy that influences the market, it gets murkier. Large stretches of agricultural land have become hugely expensive in the last 25 years, simply because the government bought land on behalf of private entities. When “investors“ are insiders who are loaded with cash, or are willing to put in their funds or access borrowed funds at low costs, prices respond to the bottomless pot of money that backs up the demand. Investors then see opportunity instead of risk.
Third, supply responds to investment demand, by focusing on building units that appeal to investors. The time lag in the response of supply to demand can be a killer in housing markets. The large backlog of unsold houses tells the story of oversupply . Bank credit to housing has since slowed down to single digits; and new investors are tough to find. Measures to tackle the black money are inadequate, but some chipping at the block has begun.It does not take a class in microeconomics to figure what happens to an oversupplied market that is unable to find buyers.
The primary reason why property should not figure as an investment option is this disequilibrium in the property market. The only way it can return to normal is through a deep correction in prices. Investors who brush aside this view are assuming that property markets in India will remain skewed forever.Brave stance, indeed.
The author is MD, Centre for Investment Education and Learning
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