Valuing real estate

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.