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.