In simple terms real estate means and includes bungalows, apartments,
commercial spaces like shopping malls, individual shops, offices, etc. It is a
dream of many to own them, whether for living in them or for “security” when
they grow old as they can sell them. However, the question that haunts people
is whether they are paying the correct price for it? Furthermore, real estate
investments take up a huge chunk (almost whole) of the investible portfolio of
a common man in India which makes the decision even tougher. However, we also hear
of people boasting of the money they have made “investing” in real estate. We
hear of people selling lands at prices which are enough to feed generations.
These stories which everyone has heard, especially in the last 10 years are
enough to lure any individual to buy real estate.
In this article, I would not give any current data points as to the
prices of real estate and how they have risen from the 1980s till 1990s and
fallen a bit to only resume their even fiercer uptrend through the 2000s and in
the last 2-3 years have depressed drastically. Due to the fact that real estate
prices are not quoted anywhere publically and are different for different
localities, it becomes virtually impossible to get exact data. The more you
read into valuation of real estate, the more you feel that real estate is nothing
more than a typical asset class with the only difference that emotions get
connected to it due to high level of investment required and the fact that you
can visually see, touch and feel the investment made.
Now for valuation purposes, let me take a very irrational assumption at
first. I consider man/ woman as being rational human beings who are willing to
take the estate on rent rather than invest in a highly priced place even if
they wish to stay or use the place for own purpose. This gives a third party
angle to the whole transaction. You are assuming that you are an investor and
the third party is another rational person who is the actual user of the real
estate. You are just deriving a rental income out of the estate which is being
used by the other rational person for own residential or commercial purpose as
the same maybe. Discounting of future rental receipts at a present value using
an appropriate discount rate is the bed rock of real estate valuation. Any
price paid above such value would be an emotional or a commercial premium which
needs thorough justification. Premium would arise only when the estate is being
used for own residential or commercial purpose. Emotional premium may include
living near relatives, near a shopping mall, a sports facility, a party hangout
place, etc. because of which you are willing to value the place more than what the
tenant. Commercial premium would apply in case of commercial real estate when
you think it makes sense to have a shop attracting customers of a particular
type in a particular area, office space at an area which is more employee
friendly or near client sites, etc.
Valuing real estate which is based on personal preferences (i.e.
attaching premium to the fair price) can be tricky when it comes to residential
real estate because of emotions involved but in case of commercial real estate
it is simply a function of incremental cash flows or benefits derived by the
business which is more than what the tenant values it for.
Now I shall come to the computation/ mathematical part of valuation. As is
usually the case with any asset and real estate being no exception, value of
the asset is the discounted value of future cash flows derived from the asset.
In case of real estate, cash flows are the rental receipts on a constructed
piece of land while in case of large farms, it is the value of produce
generated from such farmland.
Consider a piece of land in which the developer has just started
construction of a house. The area of the land is 2700 square feet. The
developer would take 2 years to complete the house after which the same can be
used for dwelling. You are willing to purchase second floor of the house
alongwith two parking slots and access to the lift. The house has a covered
area of 1800 square feet and is located in a posh locality in Delhi. At current
prices, similar apartment houses in the locality are going on rent at a rate of
Rs. 50,000 per month. Since the apartment would be totally brand new, it is
usual for the tenant to give an extra 10-20% premium. Further, since the
rentals are going to come only after two years, the same also needs to be taken
into consideration. Thus, the value of such apartment house can be computed by
projecting the rental receipts using a growth rate (based on inflation
expectations) and discounting such rental receipts with investor’s rate of
return (keeping such rate of return far lower than rate of return earned while investing
in Sensex in the last 15 years).
Particulars
|
Amount
(Rs.)/ Percentage
|
Current monthly rentals
|
50,000
|
Yearly increase in rentals (based on
expected inflation)
|
7.00%
|
Monthly rentals after two years
|
57,245
|
Premium for new construction
|
20%
|
Expected monthly rentals earned from the
property
|
68,694
|
Expected yearly rentals
|
824,328
|
Considering 30% standard tax deduction for
house property income and applying a rate of tax of 30% of such income, tax
on such house property
|
173,109
|
Post tax yearly rentals
|
651,219
|
|
|
Expected growth in such rentals (based on
expected inflation)
|
7.00%
|
Return on market (past 15 years returns
earned by Sensex)
|
13.17%
|
Estimated return on investor's portfolio
(keeping it lower than market return)
|
10.00%
|
|
|
Value of real estate after two years =
(Post tax rentals)*(1+growth rate)/(return on investor's portfolio - growth
in rentals)
|
23,226,815
|
Current value of real estate =
Value post two years/ (1+Return on
investor's portfolio)^2
|
19,195,715
|
Thus, even after keeping expectations like yearly increase of 7% in
rentals till perpetuity (which is higher than normal inflation expectations of 4-6%
by RBI in the long run) and further, assuming a lower return by the investor on
his portfolio than what is earned by the stock market in the past 15 years, the
value of such apartment currently comes out to less than Rs. 2 crore. Lowering
the yearly increase in rentals or increasing the rate of return earned by the
investor on his portfolio would further reduce the fair value of that estate.
However, we are all aware of the maddening price rise in real estate in
India. The example is very much similar to the apartment houses in my locality 2-3
years back when at the same rentals, price of such an apartment went as high as
Rs. 5 crore. Even after the depression in prices, the apartment houses as such
are valued not below Rs. 3.5 crore. After working with the simple mathematical
formula provided above, Rs. 3.5 crore can only be arrived if the spread between
expected yearly increase in rentals and the estimated return on investor’s
portfolio falls to as low as 1.69% (the above example quoted a spread of 3%). A
lower spread would mean a lower denominator leading to higher value at the end;
a simple mathematical calculation.
No doubt I would be facing criticism from people who have made money in
real estate saying our forefathers bought a piece of land so cheap in the best
localities of Delhi and eventually we were able to sell them at such high
prices. First things first, buying something with a view to sell it later at a
profit is nothing more than speculation when the asset bought itself does not
yield a return or is not expected to yield a return. Such speculators have
earned and will earn profits in future also. They cannot and should not work on
the basis of the pre-defined formula or mathematical intelligence but should
lay focus on the behavioral patterns of people, policies of the Government,
dynamics of the area, etc. However, exposing yourself to the volatile sentiments
of people, changing policies of the Government or predicting the dynamics of the
area is dangerous and involves huge capital back up in case loss is
suffered or investment does not yield expected return. It is very usual to hear
of people “investing” in Gurgaon in early 1990s and they are currently living
in palatial bungalows and renting out 2-3 others. However, this is due to the
fact that in late 1990s and post 2000, the commercial activity in the area
increased tremendously and people working in such areas and those not able to
afford Delhi started living there. The extreme demand for real estate pushed
prices vertically up and within no time even Gurgaon became a “hot” property
destination. However, the same could never be replicated in Faridabad and
adjoining areas even though it was much better developed than Gurgaon back in
early 1990s. The development and the property boom of the 2000s seemed to have
missed that area in a big manner.
Thus, valuing real estate on the basis of what it will fetch two years or
two decades later would clearly mean speculating on the same. Investing in real
estate would mean deriving income out of such estate or putting money in the
estate to be used for own purposes in a rational manner using third party test
(as if the real estate was used by third party and you are deriving income out
of it). Such sense would not only reduce the meteoric irrational rise in real
estate prices but also save people and business houses from the pains they suffer
when property prices crash. Real estate price depression harms the economy in a
much bigger manner than stock market falls. The quantum of investment required in
making a real estate purchase is huge and thus, fall in prices of real estate
emotionally troubles the investor (who is unwilling to commit further funds in
other investment avenues) and keeps him with lower disposable income for a long
time as regular EMIs have to be paid on high purchase price. The fall in real
estate harms the banking system as indebted developers tend to book a lot of
losses on lands purchased at higher values. Further, such fall also reduces the
market liquidity and activity largely as sellers do not wish to part with their
property as they feel a higher price was being fetched six months ago and the
deal should not happen below that price.
Thus, the decision to purchase real estate should be taken in a much more
mature fashion keeping in mind a large number of factors and at the correct
time and at the correct price. Valuation should play a key role. Valuation
based on expected cash flows, expected growth rate and keeping in mind your return
on investible portfolio would go a long way in bringing sanity to the general
public and bring prices of commercial and residential real estate to levels
which are win-win for all people in the supply chain – purchaser, seller and tenant.
Pricing of real estate devoid of such inputs only leads to short term gains for
sellers, brokers and developers but being connected to real estate sector and
exposed to that asset class in the long run eventually harms them.