Thursday, February 07, 2008

Real estate - an asset class?

Many people are increasingly comfortable treating real estate as `an asset class'. It is argued that land isn't being produced, that as the population grows, demand for real estate only goes up. Astronomical prices of real estate in India encourage holding real estate assets in the hope of obtaining high profits in the future.

This proposition is debatable. There is actually ample land out there. A calculation shows that even if all of India's population had a dwelling of 1000 square feet per family of 4, this requires only 0.76% of India's land area, assuming a low FSI of 1.

In the case of equities, we know that in all countries, a diversified portfolio of equities earns a few percent per year in real terms over long time periods. Some papers show that this is not the case with real estate (!).

If land isn't scarce, then the cost of built-up housing isn't much, it's just the cost of steel and bricks. To think of it as an asset class is as odd as treating (say) a car as a financial asset. The only challenge is one of overcoming government zoning restrictions, and building enough property, so that prices can then crash.

This is part of the story of the US housing market in recent years. Thanks to sound urban policies, there are no real entry barriers to building houses in the US. Zoning rules are sensible, and the policy framework supports easy extension of urban areas into outlying barren land. When houses could be sold for more than the price of cement and steel required to make them, this kicked off a massive supply response. This kicked up GDP growth for a few years. It took a little time, but this killed off the phase of rising prices. For some time now, house prices in the US will be low because of this overhang of supply.

There are legitimate concerns about bank exposures to real estate, since the market is non-transparent and marking to market is difficult. I think it is easy to build a risk management system governing loans against shares or bonds, but I'd worry about loans against houses or cars.

There are strong concerns about foreign capital coming into the real estate sector of a country like India. It is claimed that foreign speculators will drive up prices and thus make housing unaffordable. This needs to be questioned, for foreign capital that goes into development (directly or indirectly) ultimately drives up supply and thus solves the problem (see above link).

Transforming the real estate sector requires a sustained push in terms of financial capital in development, professional management teams that will build millions of square feet instead of thousands of square feet, and a big jump in the FSI. Once these initiatives are in place, real estate prices will drop, households and businesses will find space to be much more affordable, and it will not look so good as an asset class.

Some of these pieces are now coming together. A new breed of firms are now accessing public markets to obtain capital on a scale that was previously unimaginable, and bringing modern professional organisations to bear on the task of rapidly building properties. Foreign capital and foreign firms are increasingly coming into this area, though much slower than would be the case thanks to capital controls.

The CMIE executive summary for this sector shows a growth in total assets from Rs.22,156 crore in 2004-05 to Rs.53,522 crore in 2006-07. The market capitalisation of listed firms on NSE in this sector is Rs.3,13,981 crore, and the P/E of 37.3 will attract entry. Of the 80 firms in this sector, CMIE finds that 54 have adequate liquidity to make it into the price index for this sector. These are all still small numbers compared with the size of India, but it looks like serious firms are finally coming together, that might ultimately be able to pull off a massive supply response.

In this context, I was intruiged by this story by Raghavendra Kamath in Business Standard, describing incremental supply of ~ 15 million square feet in Bombay in a year. That sounds nice, it represents the kind of dent that is required on the part of supply to make a serious difference to prices.


  1. Excellent points. I made a very similar argument on my blog after discovering that land in Haryana and Himachal is more expensive than land in Florida and California. Given the 10 to 100X income in US, this is hard to sustain. Even if Indian incomes catch up in next decade or two, the present value is hard to justify.

  2. Very true indeed and given the unabated price rise, housing in India seems like a bubble waiting to burst similar to what just happened in the USA.
    Much is said about the rising incomes driving up the asset values in the housing market. However we have completely lost touch with the reality that buying a house today entails a payment of 10 odd times this generations' annual earnings as opposed to a 3-4 times annual earnings paid by the previous generation.
    Apart from facilitating more investments in the real estate sector, the government should also look at promoting satellite towns or upgrading the housing infrastructure in Tier-II and III cities by effective policy framework.

  3. I am not sure I agree with the argument that because there can be huge supply and the hence possibility of real estate value falling (from the apparent bubble right now), real estate cannot be an asset class. I may be miss reading the whole post.

    Aren't you confusing the supply/demand market dynamics with a financial/investment definition. Should commodities not be an asset class because their supply/demand is heavy controlled by babucracy?

    Real estate would be asset class if it behaves differently from other economic entities during a business cycle and if it's investable. (I am sure there is a standard definition for defining an asset class in portfolio theory.) The answer to the first is clearly yes - housing/office space do behave differently, and the latter increasingly so - with more and more real assets equity available. Pricing bubble/zoning issues, while important, are not relevant to defining an asset class, I think.

  4. I agree, it's confusing vocabulary. Anything that's investible is an asset class.

    What I meant was: Is there a good argument why you expect a risk premium on long positions? I fear this isn't the case with real estate.

  5. Truly, when you hold a hammer, the world looks like a nail. There's tons of "natural" supply of land, if only the "unnatural" force of government would stand down and allow the "natural" force of the market to make life better for everyone.

    Malarky. Like many other things having to do with human provisioning, real estate development involves externalities, in spades. Yes there is lots of land, but are private companies going to put up all the public infrastructure and then meter it? Are we going to have a patchwork of parallel roads and sewage lines that then compete for customers?

    Come on man, at least give people the full story if you're going to pose as an economist. Market failures, people!

    Yes the Indian government is rubbish at a lot of things, but this doesn't make government per se dispensable. Have you any policies for making the government better other than making it smaller? Deal with democracy man, it ain't going anywhere. Stop wishing it away.

  6. yes at present a normal middle class person cann't afford to buy the land because the land and the residential flats are very-2 costly in india at every where which is not be possible to be buy easily.

  7. Real estate in small pockets like Mumbai city is controlled by one section which dictates the policies of the government to a great extent. The amount of money spent on the new sea bridge could have been well spent on the suburban rail network where inadequacy cost 4000 people to die every year due to overcrowding like falling off trains and accidents.

  8. how would you explain the high cost of land? even in villages prices have been growing by leaps and bounds.

  9. The influence of black money in driving prices up is something that must be taken into consideration, IMO. Even newly developed apartment complexes have 'investors' buying flats in bulk (and paying a significant proportion of it in black). The US housing bubble was fueled by cheap credit and low interest rates, and it took a massive pop. That's not the case here, and the perception of real estate being a good investment attracts a lot of black money. Yes, theoretically, it might not obtain a risk premium, but the real world dynamics seem to be a little different, establishing a sort of a price floor.

  10. Land is HIGH in cost because Indian governments do NOT do ANY greenfield development. THey develop in dribbles and drabbles off of existing creaky roads and just lump "extensions" to existing city areas.

    It is typical madness called "india". Every city in india is growing it's RADIUS in ad-hoc third world fashion unevenly across all compass points from the historical "city center". It is the maximum ROI for city administrators: Max stamp revenue and kick backs from developers for new developments with minimal investment in water, power, sanitation and (crucially) roads from City administrators side. Result: the sh*t you see in India today.

    Let me remind you when you do this type of "radius" enlargement, what happens to the AREA of the city? Yes, geniuses, IT GROWS AS THE SQUARE OF THE RADIUS. Grease money to the BBMP, DDA, or other city body GROWS AS SQUARE OF RADIUS. But these outer areas are IMPOVERISHED in sorely needed infrastructure by the INVERSE OF THE SQUARE OF THE RADIUS. ONly in India. How many IIT engineers do you think it will be before some dim wit figures this out? Still waiting for "the one". Till then, EMIGRATE.

    Evidence of decrepit radius enlargement is visible in ALL Indian cities from British times: there is an OLD BRITISH CORE called "town" in all indian cities. In "town", all the roads have proportion, there is flow, and there is charm. THen there is what india has built in the "suburbs": traffic hell, near poisonous borewell water supply, mish mash electric connections etc. But you already know all this.


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