After the Stock Market, is Real Estate next?

After the collapse of the Indian stock market, is real estate next in line for a fall?

Some people say yes, others vehemently deny such a possibility. Let us try to analyse the situation in residential real estate. Now, any analysis of an asset market is always based on given information and logical, validated assumptions. Our information could be incomplete and our logical constructs limited by the unknown. Hence our conclusions could be wrong. But that does not stop us from analysing.

But before all, let us recall that real estate is local. So it is possible that prices fall in one part of the country but are rising in other parts. Our analysis would be general in nature.

There is a community of people who believe that the price of Indian real estate does not go down. They agree that prices in developed markets such as USA, UK, etc can and do go down, but not in India. I think that is a dangerous belief.

The price of any asset is governed by the laws of demand and supply, real estate included. When quantity demanded outstrips quantity supplied, prices rise. When quantity supplied is greater, prices fall. That is what happens in a free market. Empirically evidence suggests the same. There was a real estate boom in the mid 1990's in India. If one would recall, it did not end too well. Prices did come off 40% in some areas in Delhi and 35-40% even in land starved Mumbai.

Detractors agree, but contend that the real estate market, at least the residential market, is not a free market. Large developers 'hold' prices artificially even if demand slackens relative to supply. When demand rises again, they are able to sell at high prices. Hence prices don't fall. We shall look at this argument later in this post.

But first, let us get a sense of the actual demand for housing in our country. It is estimated that there is a demand of 2 crore homes in India. That seems like a big number, big enough to sustain any boom in residential real estate. Some of this would be for apartments, some for bunglows, etc. For the sake of ease in calculations, let us assume that this is to be met by multi-story apartments. Most of the demand would be from middle to low income group. Assume a liberal average area of 1200 sq feet per apartment. This translates into an area of 2400 crore square feet of construction. Seems huge! Again, assume and an average of 10 floors per building. Thus the total construction area required will be 2400/10 = 240 crore sq feet of land.

Assume that as per the norm being followed, 30% of land is used for construction while 70% is left open. So the land required for housing would be 240/0.3 = 800 crore sq ft.

If this looks like a mind-boggling number, think again. One sq kilometer has 1.0763 crore sq feet. So 800 crore sq feet land is about 744 sq. km of land. To meet the housing needs of the entire country, we need 744 sq km of land!

Delhi has an area of 1483 sq km.(Source:Wikipedia). Thus the entire housing need of the country can be met within half of Delhi's land area!! That is all the land required! India is not Japan where land is short. The total land area in India is approximately 32.88 lakh sq km. India can satisfy the housing needs of its population in 0.02% of its land!!

Is buying a house affordable now? It depends upon which city/area you are talking about. In general however, one measure of whether buying a house is affordable is to look at whether the current owner-residents can buy their own house. Anecdotal evidence suggests that such cases are few and between and in many areas prices are way beyond the reach of current owners. At least I can vouch for the area I stay in, and in the area my parents stay (different city). In such scenarios, only fresh demand from richer/high income people can cause prices to rise further. True, incomes have risen over the last 4-5 years. But so have expenses, fresh expense heads do come up and housing prices have risen faster than rise in incomes. Prices in many areas quote at crazy levels. Make no mistake, India needs property, lots of it. But at much lower prices.

What about buying on borrowed money? For borrowers, a rising interest rate regime is a bad sign. Rising interest rates make EMI payments go up, buying a house, especially at elevated prices becomes unaffordable and buyers refrain. Prices do not go up when demand slumps. Interest rates are rising and threatening to go higher, which is not good news for demand.

And then there is the supply side. A capitalistic economy follows a typical boom-bust cycle, called the business cycle. Demand rises compared to supply. Since additional supply usually takes time to come through, rising demand causes prices to rise. Rising prices increase the profitablity of existing suppliers. The lure of easy money entices more suppliers to enter the industry, each hoping to make supernormal profits. At the same time, rising prices curbs demand. As more suppliers enter the industry, at some point, supply exceeds demand, inventories pile up, prices eventually fall to levels where the market clears and demand and supply are in equilibrium. It happens all the time!

And that is almost sure to happen. Take an example of Gurgaon, Haryana. The existing supply of ready-to-live apartments is about 8000-9000 units. Prices have risen over the last few years in Gurgaon on the back of higher demand over existing supply. Higher prices have lured developers to increase supply. Over the next 3-4 years, a projected 20000-25000 (my conservative count) new apartments will come in the market. This is over 2-3 times the current supply. Sure, some demand will exist, but will it be enough to take care of such a supply - I am not sure of that!

Developers have a vested interest in being bullish about real estate prices. Some developers claim that demand is robust. Others reluctantly admit that while demand has gone down, prices have not. I can't understand how a fall in demand cannot not lead to a fall in prices. Unless the developers themselves are 'holding' prices and not allowing them to collapse. Maybe they can do so in the short run. Some are deep pocketed and might be willing to sustain losses for a while. But many others are facing a serious cash crunch. And there is a limit to which prices can be artificially supported, if such is the case. There are reports that many developers have borrowed money from the market at high interest rates. If new housing does not sell, how will profits look like? The stock markets are anticipating trouble for housing companies. Have a look at the table below to see the serious damage in the share prices of prominant developers (30 June 08):

Stock.....%Fall from highs
DLF.....68%
Unitech....69%
Parsvnath....80%
Ansal....86%
Omaxe....79%
HDIL....73%
Sobha....74%

The previous boom (mid 1990's) in real estate in India started to go bust on the back of rising interest rates in 1994-95 and on oversupply. The impact was felt with a lag. The current boom is now facing headwinds on interest rates, not dis-similar to the one felt back then. Will there be a bust again? It seems possible though no one can be sure. Maybe prices will fall. Maybe there would be a time-wise correction with prices going nowhere for extended periods. I dont know for sure what would happen. But looking at the scenario the risks to housing seems to be on the downside.

Do SIPs really work?

A Systematic Investment Plan (SIP) is an investment plan that allocates a fixed sum of money (usually the same amount) at a regular frequency (month/quarter/etc) to an asset class (like stocks/bonds/gold/etc). For example, every month you invest, say, Rs. 25000 in a mutual fund and keep doing this month after month.

SIP is an idea that the professional investment community loves to push. Every day we read so called experts advising people to go in for SIPs. Mutual funds come out with advertisements urging investors to buy a SIP in their companies. It is common wisdom that SIP is a good way to make money over the long term.

SIPs look like a great idea. It is convinient and affordable for the average investor. All you have to do is to simply put away a small sum into the markets - the same amount every month. When prices are low, you get a higher number of shares or mutual fund units. When prices are high, you get a smaller number of shares/units. A classic case of rupee cost averaging, which essentially is the foundation of a SIP! It seems like a great way to take market exposure and a great way to make money.

There is just one little thing. It doesn't work!!

Have a look at empirical evidence. If you had invested Rs. 10000 in the BSE Sensex on the first trading day of every month from January 1992 till April 2003 (more than 11 years) your total investment of Rs. 13.6 lakhs would have become 12.33 lakhs giving you a -1.8% return compounded annually over the period. You would have actually lost money. Compare this with a one-time investment in the Sensex in January 1992, which would have given you a 4% (positive) annual return. Add transaction costs and the performance of the SIP would look worse.

How about the period in the current bull run? From May 2003 till date (27 June 2008), the Sensex has gone up at the rate of 34.6% compounded annually. In contrast, the same SIP would have invested Rs. 6.2 lakhs and would have made Rs. 11.17 lakhs at an annual compounded growth rate of 23.7%. Not bad, but still lower than the return on a lump sum investment!

One instance where rupee cost averaging (and hence a SIP) can work in the long run is, if for the first 7-8 years prices keep falling and take off steeply in the latter part of the investing period.

Rupee cost averaging - like diversification- does not make you more money. It prevents you from losing more money in certain market conditions (like a falling market) than you would have lost otherwise. If that's good enough for you, fine. But if you are convinced that a market or asset will go up over time, rupee cost averaging does not make sense. In short, if you like an investment, simply go for it.

Fundamentals or Funnymentals?

The Indian stock markets crashed in January this year from their highs to a level corresponding to 5000 on the Nifty.
"Buy", said the analysts on the fundamental side. "Stocks have become cheap and India's fundamentals are strong", they said.

The markets crashed further In March to levels corresponding to 4500 on the Nifty.
"Terrific opportunity to buy", said the same guys. "Stocks have become dirt cheap compared to fundamentals. Things would get ok in 6 months time", they argued.

The Nifty rallied to 5300 in a month after that. Some fundamental analysts proclaimed that the bull market had resumed.

The Nifty todays stands close to 4100 levels, more than 20% lower from the highs seen in April/May, and looks like going down further. Supposedly good stocks are down 60-70% from their highs. Some are down even 80-85%.
When would the pain end? Fundamental analysts claim that the pain could last another 12-18 months.

This post is not a criticism of fundamental analysts. It is meant to highlight how no one really understands how the economic scenario would pan out. The subject is far too complex for any one of us to comprehend. Most of us do not have the ability to comprehend and anticipate how the world would look in the future.

A mere 6 months ago, few anticipated how bad the world would look today. Fundamentals of the Indian economy never seemed better in January 2008. Suddenly, they no longer look good. A spate of bad news has hit the world economy and the Indian economy too. Crude oil keeps hitting record highs, inflation is in double digits, interest rates are in the rise, economic growth seems to be slowing down, the country's fiscal situation seems to be detoriating, corporate earnings which were assumed to remain good, now are under threat, across the globe the housing crisis and its fallout does not seem to have played out completely...there is a lot of anxiety and gloom in financial markets. Who had thought we would be in such a position?

Stock prices are supposed to reflect the fundamentals of companies. When we say that stocks have become cheap, there is an underlying assumption that fundamentals are better compared to the decline in stock prices. However if fundamentals detoriate faster than the decline in stock prices, stocks could in fact become more expensive even with a fall in their prices. How do we say how bad fundamentals have become? How do we say how worse they will get? How do we say when would things look better? Since most of us don't understand completely how economic change will happen, we cannot answer such questions.

Fundamentals then are hazy, perhaps we should call them fuzzy-mentals. But it is funny to note how prices move ahead of the news and ahead of fundamentals, that price moves first and then the news follows. Perhaps we should call fundamentals as funny-mentals.

The key thing is to understand the perils of trading/investing on the basis of something we dont understand; and to stick to something we understand. Blind faith in fundamental reasoning is not a smart thing to do. Have blind faith that your mother would always love you. In all other matters, it is wise to keep an open mind.

PS: While the PE ratio may not mean much in isolation, especially for an index whose composition changes across time, here is some data for the PE of the Nifty over the previous lows since 2002. In a ballpark sense, you can establish yourself whether the Nifty (current PE = 17.67) is cheap.

Date --- Nifty PE
25-Oct-02 --- 13.83
17-May-04 --- 12.87
14-Jun-06 --- 14.92
27-Jun-08 --- 17.67