Greed, Fear, infinite loop & Real Estate

The stock market prices are ruled by Greed and Fear. Prices go up when the market sentiment is predominantly that of GREED while it falls when the market sentiment is predominantly that of FEAR. CNN has FEAR and GREED barometer on its website http://money.cnn.com/data/fear-and-greed/ to gauge the emotion that is ruling the market at a particular given point.

However, there is an asset class where both the emotions leads to increase in prices and due to this it is only going up and up for the last decade. The asset class is Real estate.

There is a class of investors who believe this is the best asset class due to following reasons:

1.       Leveraging opportunities are very high in this sector as government and banks provide incentives to people to borrow 5-6 times of their annual income

2.       This is one of the only asset class (distant second might be gold) where parking of black money is very easy and considering the size of India’s black economy, there is substantial amount available to be deployed

3.       There is tax incentive on investment in real estate and also on capital gains (with a requirement of further investment into property)

4.       Real estate is one of the best bet against inflation and devaluation of currency

5.       The sector provides opportunity to make big ticket investments

There are equally compelling logic which suggests real estate is not a good investment:

1.       Rent realization to property prices ratio is as low as around 2%. Additional 0.5% is spent on property taxes, security, insurance etc. Comparing this with around 10.5% interest rate, there is a net loss of 9% which need to be earned by increase in property prices before any actual gain can be made. Considering tax saving of 3% (generally actual tax saving is much lower), still 6% year on year growth is required to ensure break even. For a 3bhk of carpet area 1250 sqft being sold in Mumbai suburbs at Rs. 5 crore, to give a 9% return it need to be worth Rs. 43 crores post tax in 2039 when your 25 year loan would be completely paid off. Which mean per sqft carpet area cost need to increase from Rs. 40,000 per sqft to Rs. 3,45,000 per sqft!!!

2.       There is a transaction cost of around 8% every time you buy or sell property in form of government taxes, brokerage etc.

3.       Property is generally illiquid and when you actually want to sell it takes 6 to 12 months to actually do the deal

4.       Property prices in secondary market are at a discount of around 20% then what a builder is quoting. (If you don’t believe me get a quote from builder and then compare the price on websites like magic bricks, 99 acres etc.)

5.       Property depreciates over time. People end up taking 25 year loans on property; however nobody wants to buy a property more than 15 year old. Over time apart from depreciation in form of water leakages etc., the technology and trends also change. 15 years back very few properties used to have club house, swimming pool and similar facilities. 15 years back power cuts were so prevalent that very few people would go for higher floor. 15 years back people used to prefer individual units over apartments. Today we can find in the same locality old property selling at Rs. 7000 per sqft (carpet) while new property selling at Rs. 15,000 per sqft (carpet).

That was the calculated analysis of pros and cons of real estate investments. But as we all know investments are made on animal instincts, based on emotions of Greed and Fear and not based on such calculations alone.

So what is the current mood of market – Greed or fear?

Well, in real estate market unlike stock market Greed means buy at the same time fear means buy. There is a class of investors who believe that post tax return offered by real estate would beat all other form of investments including equity and hence are investing in real estate. There is another class of investor who has need or perceived need of property in form of place to stay for the family today or in future. He is scared that if they didn’t buy today the prices would keep multiplying while his income would not keep pace and it would become impossible for him to buy property in future. Hence he is willing to leverage himself to the hilt to make sure that he buys it now rather than at a much higher price later. Of course, once he has met his requirement he need a bigger house, then a second home and then a home for his kids and one for his parents…..

In the real estate market there is a faith that property prices never fall. It going through a phase of self-fulfilling prophecy and today if there is one person desperate to sell there are enough buyers who would lap it up for fear or greed. The market has 70% pure investor, 20% investors who have perceived future use, and 10% real user demand. And there is enough cash being printed in the world to fund these investors. These investors have holding power, but how long. Unlike other asset class, real estate is a depreciating asset.

One day people would be more fearful that prices may fall than being fearful that it would become unaffordable. Till the day Bull and bear are dancing in a tango music would continue to play for real estate. The day bear starts fighting with bull the scene would become really interesting.

The faith/bubble that property prices never fall has seeds of its own destruction. Till the time people have this faith people will keep on buying real estate at higher and higher price. Longer this last the stronger faith people will have that prices can never fall and that would drive the prices higher even faster. It’s like a driver who would keep on increasing his speed because he knows that he will never crash. He would be right most of the time and which will give him more confidence to keep increase the speed. Can a driver endlessly increase speed of the car? How will this infinite loop end?

1.       The car would reach its maximum speed and then it will have to run at a constant speed

2.       The car would break down and it would need some time for repair

3.       The car would hit a bad patch, slow down for a while and hit the purple patch again

4.       The car would crash

Your guess is as good as mineJ. The fourth option looks scary at the same time 1 to 3 are not that bad. Isn’t it? But is he aware that the vehicle he is driving is similar to the bus Keanu Reeves was driving in the movie Speed. If he lets the car go down below a particular speed it will blew off!

Real estate is funded by 4 different sources:

1.       The banks funding the property buyer: The rate of interest is around 10.5%. Banks fund only 75% of the cost of the property and maximum up to 6 times of the annual salary. As there is enough margins and in India people rarely loose job, chances of default in these loans are very low. In worst case scenario if the prices increase too much very few property buyers’ salary would be high enough to meet the criteria of banks and hence the number of transactions would substantially come down.

2.       Banks fund the real estate companies: The real estate companies are funded by banks at the rate of interest ranging from 13% to 18% for meeting the cost of construction. Banks get land as security and if the projects keep getting completed in time and buyers keep buying at higher and higher prices the sector can afford this rate of interest. Only issue is when the sale quantity falls substantially and banks and real estate companies are stuck with illiquid assets.

3.       Private equity funds the real estate companies: The private equity guys investing in real estate expect a return of 18% to 24%. They do a structured deal with the promoters where it looks like equity contribution, however actually it is a high cost debt. Generally investors of this class have a time horizon of 5 to 7 years. As this Bull Run started around 2004, since 2009 onwards few exits have happen, mostly at loss. To continue to attract this kind of money, the sector needs to live up to its promise.

4.       Debt from unorganized market: Builders also raise debt from unorganized market at the rate of 18% to 36% and then put into the business as equity. This money is raised as a desperate measure and is done only on faith without any security or against the security of promoter’s shares.

Now the driver has to ensure that he is continuously increasing speed at a rate higher than the debtors car speed. If the average cost of fund is 15%, his property price increase should be more than 15% to ensure he does not default. Which means maintaining constant speed is also not an option. Can a car keep on increasing speed indefinitely? When & how will this infinite loop stop?