Some Real Estate Facts To Mull Over
August 21, 2012 11 Comments
(1)Long term returns from residential real estate
Robert Shiller, by tracking the US home prices data from 1890 concluded that in the longer run, property prices grew at an annualised return of around 3%, just keeping pace with inflation.Housing price rises could not outstrip inflation in the long term because, except for land restricted sites, house prices would tend toward building costs plus normal economic profit.
I have no such data for India.But here is what I can attest to:an ancestral house acquired 120 years ago for 6000 Rupees is now valued at 1.2 crores-an annualized return of about 6%.I think this is close to the long term inflation rate in India.
(2)Is home ownership all that it is touted to be?
In a poorer country like Bangladesh, 90% of the houses are owner occupied. Whereas in a richer country like Switzerland, only 33% of the houses are owner occupied.
Europeans are more comfortable with renting compared to Anglo Saxons and we Indians need to decide whose model we choose to follow.Read what Niall Ferguson has to say about property ownership.
Niall Ferguson On The American Dream:
Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.
Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.
To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with—more than double what you would have made on bricks and mortar.
There is, obviously, an important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $100,000 would be worth some $600,000. But that still comfortably beat housing.
There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets. Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third—37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.
The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.
So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression. “You know, George,” his father tells him, “I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office.” George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: “[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?”
There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.
Remember that in the not so distant past real estate was the sole preserve of those who could seize it and hold it.Even today real estate needs more resources to own.Be sure you have developed the means to deal with its risks before investing in it.
(3)House price to (annual) rent ratio:
By international standards if the house price to (annual) rent ratio is above 20, then the cost of owning is considered higher than cost of renting.The generally accepted range is around 15. If you live in a metro city in India you will be doing very well if you are getting a 5% return.A 2% return is more common.And if you are uncomfortable with taking the risk of litigating with tenants you will earn nothing as rent.The majority of home owners in India are holding out expecting capital appreciation.Hence in the real estate market many a times the prices do not come down even during slowdowns but markets simply become illiquid. No transaction happens but still the price on paper remains high.
(4)Annual income and home prices:
Internationally it is held that the value of the property a person is planning to buy on a loan should not be more than 3 years of their annual income.However this is what the GOI thinks:http://wealthymatters.com/2012/07/16/affordable-housing-defined/ .As a result many of us are likely to be house rich and have fewer liquid savings and investments.This is likely to lead to an overall lowering in out standard of living and force us to miss out on other wealth building opportunities.
(4)EMI to income ratio:
A general rule of thumb is that your home loan EMI as a part of your income (debt to income ratio) should not exceed 35% to 40% (maximum). Anything beyond this may put a huge strain on you especially in a rising interest rate scenario or any other contingency in life.In fact this is something to think about very seriously.Mortgages are long term contracts and jobs and incomes can vanish really fast.It is very easy projecting out our current strong financial situation out to infinity.Don’t omit reading Priya’s Story.Always keep aside a few months worth of EMIs to help you cushion any fluctuations in income.Do buy mortgage insurance and as a measure of ample caution try to not opt for more than one loan at a time.Remember that bank officers are incentivised to extend loans.So be sure to think before opting for a tempting loan.The grass always looks better on the other side.Its nice being a home owner but a loan is not always the best way to fund your purchase.It’s OK to rent.If you can’t take the risk don’t try to ride the property tiger and try to realize capital gains.Good years and perpetual capital appreciation are not guaranteed even in India.