India Real Estate. Entering crash zone?

Have you read this interesting article in First Post? It says that real estate prices are about to crash across India.

I have been maintaining for some time that Real Estate Prices are very high in India and are due for a correction sooner or later. It looks to me that this correction is sooner rather than later.

Consider this. There are less than 30 Lakh people in India who has a taxable income more than Rupees 10 Lakhs per year. On the other hand, an average 2 BHK room in the outskirts of Mumbai costs over 1.25 Crores. Who can afford this? 

Answer? Speculators. Those with black money. DINKS and DIOKS (may be).

An average middle class person cannot afford this price. So what do they do? They stay in rented apartments. It works out cheaper. As per this article, the rental yield is about 3% which is much lower than a Bank FD. Which effectively means that it is much more lucrative to stay in rented apartment than buy a house.

Check out my article about Kambles in this blog to understand the details.

Signs of an impending correction is all around us. 10-10-80 Schemes, 20-80 Schemes, Developer paying Pre-EMI interest, pay  10% down and nothing till possession, Online sales of houses, Real Estate fairs offering huge discounts, seller paying the stamp duty, home augmentation offers (free furnishing, free modular kitchen etc) and even a 'Get one room free' offer (remember seeing this somewhere)....

Real estate inventory with the builders are piling up. It is currently about 77000 in Mumbai, which will take 30 months to clear !!.

Following are the seven reasons why I think that the real estate prices in India are about to correct.

1. Investor Expectations: News and signs of impending correction are all around us. The article in First Post is the latest sign that the prices are about to fall. As the expectations about a fall increase, investors will delay their purchases. This have a domino effect and will lead to further fall in real estate prices.

2. Working capital pressure: Builders normally manage the working capital requirements by rolling over the cash flow from apartment sales. As the sales of new homes fall, the builders will be under working capital pressure. Since other avenues of availing working capital are drying out, they, especially the small builders, will enter into a 'desperate sales' zone and lower their prices and sell the apartments at a loss. This in turn will add to pressure on the big builders to lower their prices.

3. Tightening of Bank Lending norms to Real Estate Sector: Earlier, banks could lend a significant percentage of their capital to the real estate sector. Two years ago, it reached an alarming rate of about 52% across the banking sector, while the norm is less than 10-15%. Seeing the risk to the banking sector, RBI intervened and tightened the norms and the oversight leading to banks cutting down on their lending to real estate sector. This in turn is putting pressure on the Working Capital situation of the sector as mentioned in point 2 above.

4. Strong black money legislation: The latest black money legislation introduced by the BJP government aims to crack down on the black money in this country. Traditionally black money was a major driver for escalating real estate prices in our country. Focus by government on black money has led to that moving out of the sector. This in turn is adding pressure on the working capital situation of the sector. 

5. Global economy is down: Many of the new home buyers are IT professionals. As we know, Europe is in recession, China market is tanking and globally economy is down except in the US. IT sector is expected to create 15% less jobs this year according to NASSCOM. IT companies may not pay the kind of salary hikes which are the historical norm and also there is a lot of focus on cost cutting in IT companies. The recent earnings downgrade of KPIT and Tech Mahindra portent not so rosy scenario for IT sector. So the Indian investors are becoming cautious and keeping their money in cash rather than investing in real estate.

6. Investible surplus moving to stock market: Currently Indian stock market is one of the few in the world, along with Japan, US and may be Iran going forward, that is doing well. It is expected to do even better in the coming years. Many investors are selling their real estate and investing the same in stock market with the eye on better returns. And this adds to pressure on real estate prices. 

7. Finally, Increasing real estate inventory: This will keep the prices down for some time till they get cleared. 

So my suggestion to those who want to buy an apartment. Wait. For all you know, you might end up with a villa for the same price.

Why real estate my friend, why not stocks?

(Warning: 
The article below is intended to educate the investors on the option of Equity Investing. This do not make any investment recommendations. There are many options for investing your funds. Equity investment is only one of the options. Equity investment is risky. Pl. discuss with your investment adviser before investing in equity market)

Notes:
1. It is recommended that if you are venturing into equity markets, you do it through Mutual Funds
2. Unless specified otherwise, all the references to the markets relates to Indian Equity Markets.

Now to the article....

I overheard my friend Raj talking to a friend about potential investments

Raj: I have some money to invest in. Where should I invest?

Friend: Why don't you invest in Real Estate?

Raj: That's what I have also been thinking.

This kind of discussion is all too common among middle class in India who has an investible surplus.

This always puzzles me, this fascination for real estate. Being a hardcore follower of equity market, and knowing that any day equity will outperform real estate, it is very hard to curtail the impulse to butt in when I listen to similar conversations.

On one level I can understand this fixation with real estate. I can think of the following reasons why people find it comfortable when investing in real estate.

They are in control of the transaction: When it comes to real estate, most of us are dealing with a tangible item. There is a parcel of land, or a block of apartment, you can touch, you can feel, you can meet up with others who have purchased similar property, you can meet up with and negotiate with the seller regarding price....

You are investing a large amount of money and you feel that you are in control, that you are taking charge of your investments. You have an emotional connect with the purchase process.

Buying a stock is just an unemotional transaction. You are dealing with an invisible entity, the stock exchange. In these years of Demat, you are buying something which you don't see and feel (earlier, you used to get a physical share certificate for your investments), price is given to you, you are a price taker. There is no scope for negotiations. None of your traditional purchase habits work when buying stocks.

Tangible vs. Intangible: As mentioned before, real estate is a tangible asset which you can see and feel. Stocks on the other hand is intangible. You can feel its presence only by the upward or downward movement in its price.

Parents have set example: Most of the people who buy property have seen their parents or some significant elders in their life go through the process of buying real estate. That is not the case when it comes to investing in Stocks. Despite phenomenal, mind-boggling returns from equity, many people of the previous generation were afraid of investing in stocks.  Culture of equity investing is a recent phenomenon in India. This has started only in the 90s with the advent of the new middle class. The first stock exchange was set up in India only in the late 70's. So for many people, buying stocks is a new experience and they have no one to look up to.

Friends have made money: Everyone out there has a friend who bought a house at 1500 per square feet, which is trading at 3000 (or 6000, whatever number) per square feet. It creates a visibility and removes the aura surrounding real estate investing. It is also possible that all their friends also invest in real estate and are not aware of equity investing (remember that birds of the same 'Investment Habits' flock together). Coupled with the fact that significant elders in their life had never invested in stock market, this leaves them with no examples of people having made money in any investment other than real estate.

Appreciation in real estate prices are highly visible: People can see and feel the appreciation in the price of real estate. Almost every real estate property advertisement presents the price information. This helps people to compare prices. Raj can say things like "Six months ago price was 1000, now it is 1250. It is a 25 percent appreciation in 6 months'. However, the price information on equity market is relegated to the pink papers and even here it is relegated to some esoteric language like '450, 475, 444, 453, 22'. One can't make a head or tail out of this information. (Information seen in Tickers in Financial Channels are only related to a few stocks and their prices are normally beyond the range of a retail investor)

Emotional value: This is a no-brainer. World over there is an emotional value attached with real estate. Having a home of one's own is considered a symbol of safety. Society (which mostly consist of people with similar aspirations) look up to people holding real estate. (It is a different matter that while doing the spring cleaning, you come across a share certificate of 100 Shares of Wipro bought in 1980 (purchased by your dad) at 10000 and see that the market value of that investment is currently 440 Crores (44000000000) and you have unclaimed dividends of about 118 Crores!!!!)

However there are some obvious disadvantages to buying real estate.

Your returns are not what they are: There are lots of taxes and duties associated with the purchase of real estate. Assume that you buy a 1500 square feet of house at Rs.1000 per square feet  and sell it at Rs.2000 per square feet. At the time of purchase you have to pay an overall tax of about 5% which inflates your purchase cost to 1050. At the time of selling, again you have to pay a tax of (let's say, 2.5%) which decreases your sales price to 1950. So your net return will be 900 per square feet, 100 (10%) lower than what is visible. Remember that I have not considered the time element here. If you had kept your house for 10 years before selling, that is a measly return of about 6% per year, lower than the inflation rate, which means that you have lost money in the transaction. (You could argue that you would have got rental returns, see my point below about rental returns)

Additional charges that lower your returns: Real Estate calls for two additional annual charges, vis. Maintenance charges and Property taxes. Those will further lower your returns. No such charges exist in case of Equity Investing.

The profit on your first house is always notional: One may pride himself saying that the house that you had purchased 10 years ago has quadrupled in value. But my question is, are you going to sell the house? Most of the time, your answer is no. This means that the returns are only notional.

Rental incomes are meagre: As I had mentioned in this post about Kambles the rental returns are measly. For instance, if you purchase a house for about 60 lakhs, which gives you a rent of 25000 per month (3 lakhs per year), the annualized return is only 5% which do not beat the inflation. Which means, as I mentioned in this post about Two Thieves, is a net annual loss for you. A bank deposit at 10% interest rate would have given you 6 Lakhs on the above.

You are not the real owner: Till you pay off the final installment of your EMIs (Mortgages), you are not the real owner of your property. The lender, usually the bank, is the real owner of your property. This was amply demonstrated by the recent housing bubble in US where the banks had to resort to distress sale of many properties where the owners could not pay back the mortgage.

Now let us talk about Equity Investing. It is a known fact that only about 3% of the annual savings in India are invested in equity markets. While there are many aspect as to why this rate is very low, including regulatory aspects, there is no question that attitude and perceptions of the people with respect to equity investments has got a lot to do with such minimal savings rates in equity in India.

The basic perception is that the Stock investing is esoteric and that it needs some expertise which many of us do not have. There is talk of PE, PB, Cash Flow, Balance Sheet...Not all people have the requisite knowledge to handle stock investing and hence are discouraged to invest in equity markets. However, expertise is required for any kind of investment, not just for investments in equities. If you don't have the requisite knowledge, you could either make sub-optimal investment decisions or worse, you could lose a lot of money. I remember once standing in a 'Tanishq' shop. One lady brought her gold jewelry to check it Caratage (Gold Content). When told that it was 18, she was inconsolable. The vendor who sold it to her had told that it contained 22 Carats and was charged her accordingly. How many of us know of people who purchased real estate and found that it was not what was promised? It is important to do due diligence no matter whatever the investment.

Despite above drawback, even when someone invests in equity markets, the make the following mistakes. 

They enter the market late in the cycle: This is the first mistake that most people make. Before a stock comes into the public domain, it would have already run up quite a lot. This means that an average investor is purchasing an expensive stock and as anyone know, an expensive item can only come down in value. This leads to investors losing money which reinforces their perception that equity investing is only for experts. (Read my post on 'Chaiwalla (Tea Vendor) Threshold')

Sell winners and keep losers: This is a peculiar habit of retail investors. They invariably sell the winners at the earliest opportunity and keep the losers all the way down to significant loss. Since the profit is limited and loss is unlimited, the investor ultimately lose money. Some time they compound the loss by buying more of the losing stock in the name of 'Cost Averaging'.

(I can go on. I have made more equity investment mistakes than I care to remember). 

If you put the effort to learn the basics, equity investing is much more lucrative (and intellectually satisfying) than any other form of investing. Following are some of the benefits of Investing in Stocks over Real Estate:

Easier Purchase and Disposal: Equity investment is very easy to enter and exit. You can get into the market for amount as low as 1000 rupees. Also it is very easy to exit from your investment. This provides easy liquidity. So if you have a requirement for liquidity, it is better to have some investments in equity markets 

Zero tax on long-term capital gains: This is the most important benefit of investing in equity markets. Long-term capital gains taxes are zero. This means that if you keep your stocks for more than 365 days and then sell, the profits are totally tax free. Compare this with investing in real estate where short-term capital gains tax is applicable if it is sold within 36 months and long-term capital gains tax applicable thereafter, unless you buy another property within a year of disposing off your previous property.

Much faster appreciation: Invested properly, Equity Markets can provide significant returns if an investor identifies and invests in the correct stock at the correct time. Just an example, a stock like 'Avanti Feeds' has quadrupled over the last one year.

Cycle turnarounds are much faster: This is another major advantage of investing in equity markets. Even when they fall, they recoup their losses very quickly, much more quickly than real estate. For example, in 2008, the market fell from 21000 to 8000 and in the last 6 years, it has recouped all those losses and then some. 

With all these benefits of investing in equity markets, my question to friend Raj is, 

Why real estate my friend, why not stocks?

How Sunder made a deal....

I was recently reading the book 'Rich Dad, Poor Dad' by Robert Kiyosaki. (My Review). In that book Mr.Kiyosaki posits that many rich people are deal makers.

What is a deal?

A deal is when you assemble multiples of investment options and sells the same as a deal where everyone involved gets a 'deal'. He shares the example of how he once made 40000 dollars in 5 hours by creating a deal. 

While reading this, I was reminded of my friend Sunder who made one such deal.

The year was 2000. The real estate market in Bangalore was slowly picking up. Mantri Group came up with an apartment complex named 'Mantri Paradise'. At that time a two bedroom apartment was being sold for about 13 lakhs. 

Sunder booked one apartment in the complex. He took a bank loan of about 11 lakhs. Mantri was ready to pay the 'Pre EMI' annuity payments to the bank. In fact Mantri facilitated the deal. 

By 2003 when the apartment was ready, the block which Sunder bought was being sold for about 25 lakhs. Sunder promptly sold off the house and paid off his bank loan and was left with a profit of about 12 lakhs. 

He did not rest with it. He used 3 Lakhs to buy a 3000 Square feet of land in Rajarajeswari Nagar, one the outskirts of Bangalore. He paid 100 per square feet. 

With the remaining 9 lakhs, he constructed 5 houses in the land. Fortuitously, Bangalore was starting to expand and Mind Tree set up their campus and office in Rajarajeswari Nagar, almost next door to Sunder's housing complex. 

Sunder saw an opportunity and promptly negotiated with Mindtree and leased out 5 apartments to the company at a tidy three year lease of about 10 Lakhs per house. 

Sunder's total out of pocket expense? About 2 lakhs

Sunder's cashflow from the 5 buildings? About 50 Lakhs

You do the math...

Why in the world should Kambles buy a house in Mumbai?

I was talking to my friend Vinod Kamble today. Vinod and his wife Amrita (hereinafter called 'Kambles') recently signed on the mortgage deal to buy a house in Mumbai.

Vinod works in a multinational with an monthly salary of about one Lakhs on hand. Amrita works in an IT company at a monthly salary of Rs.50000 on hand. 

This is a house in the newly developing area near Mumbai. The cost of the house is about 1.5 Crores. The Kambles have taken a twenty year loan of about a Crore from a bank on which they pay an EMI of about a lakh per month.

I asked Vinod how they are managing to pay such high EMIs.

'My monthly salary goes directly to the Bank', he replied, 'we manage our monthly expenses through Amrita's salary'.

'What about savings? Any?', I queried

'No savings. We hardly are able to manage the monthly expenses', he replied.

'Why buy a costly house? Were there no better offers?', I asked.

'There was some available at a cheaper rate little farther away, but we wanted to live in this locality', he responded. 

'Have you taken possession of the house?'. I enquired

'No, currently I am living in a rented apartment in the same complex. We will get possession next year', came the reply

'How much are you paying as rent?', I asked

'Rs.25000 per month', he responded.

I did some math. Kambles are paying about 1.5 Crores for an apartment from which he can expect a rental income of about 3 Lakhs per year. That is a measly return of 2% per year. If they stay in a rented apartment and invest amount of 1.5 Crores in an FD paying about 9% (6.5% post tax), still he will be getting a post tax return of about 4.5% after paying rent on his house. 

Assume that Kambles want to have an investment that will pay their rent, at the above rate, they need to invest a principal amount of 47 Lakhs in an FD at 9% interest to get an annual income of 3 Lakhs which will pay off their house rent. It is still one third of the investment required to buy a house. 

In addition they will have a surplus income of almost 10 Lakhs in a year which they can invest in Wealth building investments. Rs.10 Lakhs a year at an interest of 10% will grow to about 1.75 Crores in 10 years. 

If you show the math to Vinod, he will tell me that the value of the house will appreciate in future and hence it is an investment worth making. But for people like Vinod, this is his home. He is buying this house to live there. This house is not an investment which he plans to sell off at a later point in time. Since he is planning to live here and is not planning to sell the house, any appreciation in value of the property is going to be only notional profit. 

But, does he see how this purchase is impacting his long term future? Currently he is left with no surplus investment income. Kambles have no savings. They are not planning for the long term. They don't even have sufficient contingency funds. How will they manage 10 years down the line when they have kids and expenses shoot up? 

So what is better? Is it better for Kambles to buy a house in a less expensive locality? Is it better for them to stay in a rented apartment and invest the surplus income in wealth growing investment opportunities? Anyway you look at it, staying in a rented apartment is better. You also get tax benefits if you stay in a rented apartment.  

Considering that a home purchase can wreck havoc with the finances, why in the world should Kambles buy a house in Mumbai?