Wednesday, July 29, 2015

Inflation vs Investment

Real Estate: The fall has just begun

In global markets, gold has fallen over 40% in last 5 years and silver has fallen over whopping 70% during the same period. Commodities prices are also crashing. The Bloomberg commodity index is now at 13 year low.

About various asset cycles.

In stock markets, a bull market last on an average for 5 years and a bear market for 3 years. So it takes 8 years for equity market to go through one complete cycle. So any holding period for less than 10 years or so is speculation.

For gold, a bull market last on an average of 10 years and bear market for 20 years. So it takes 30 years for gold to go through one complete cycle. What is true for gold is true for many other commodities as well. Commodities had a good run from 2002 to 2012 and it would not be a surprise if the current bear cycle last for next 2 decades.

I’m saying the above based on my extensive reading and understanding. Again the term ‘average’ can be misleading, as one bull market in stocks can be for 10 years and a bear market can be for 6 years. The given number is an average over many cycles. Each cycle may vary.

As far as real estate is concerned, based on what I discussed with people who have been observing real estate in the country for long time, they say that the real estate bull cycle is usually for 10 years and followed by bear cycle for another 10 years. A complete cycle may take usually 20 years. It looks like the current bear cycle in real estate has started some time in 2013. Real estate had a good run between 2004 to 2013. The earlier bear cycle for real estate started in 1996 and lasted till 2003.

Instead of like sharp corrections in stock markets, real estate market corrections are slow and last over many years. A fall of even 50% is not uncommon. In the 1996-2003 bear cycle, properties in many part of India fell by 50%.

Assuming this bear cycle lasts for 10 years, we may expect the real estate to rise again only in the early part of next decade. One significant change which is happening to real estate is that black money in the same has started coming down. The direction is very clear. As the environment and legislations are getting tough for black money, over a period, black money would play a significantly lesser role in the years to come.

Indian real estate prices have been kept very high and unaffordable for common man due to black money. During the current bear cycle in real estate, the black money also would be largely brought under control. If that happens, in my opinion, we can longer expect mind boggling returns in real estate even in next bull cycle. Real estate would give around 2% to 3% more than inflation. If inflation is 5%, we can expect real estate to give 7% to 8%.

In a fair market, the rental yields are close to cost of borrowing. Whereas in India, the rental yields are 2% and the cost of borrowing is 10%. As interest rates soften, the cost of borrowing would come down. As real estate prices correct, the rental yields would also go up. This would narrow the gap between rental yield and cost of borrowing.

Another thumb rule is that the value of the property should not be more than 3 times one’s annual income. If your annual income is Rs.12 lakhs, your house purchase value should be Rs.36 lakhs. If just assumed someone in Chennai has a Rs.3 lakhs annual income and a good 2 BHK in any decent suburb costs not less than Rs.75 lakhs. So a Chennaiite need 25 years of income, if he wants to own a flat in his city.

From my interaction with many people, I find that they commit not less than their 10 years income for a flat. This is not accounting for interest component.

The house price to rent ratio should be around 15. If a house cost Rs.1 Crore and the annual rent is Rs.3 lakhs; the price to rent ratio works out to 33, which is very expensive. Going by the thumb rule, if this ratio is above 20, then the cost of owning is considered higher than cost of renting. This means you would be better of paying rent.

If the above ratio is 15, then the rental yield will be 6.7% per annum (example: Property price is Rs.30 lakhs and annual rental is Rs.2 lakhs). So the ideal rental yield should not be less than 5%.

It would not be a surprise that in next few years real estate prices fall to such an extent, that the rental yields may be around 5% instead of the current 2%.

In nut shell, the bear cycle in real estate has just begun. Don’t be surprised even if there is a 50% correction over next few years. Tone down your expectation on real estate even in the next bull cycle as black money would start playing a lesser role.

Learn to accept the following returns from asset classes over long run:

Fixed Deposits: Inflation + 1%

Gold: Inflation + 1.5%

Real Estate: Inflation + 3%

Equity: Inflation + 8%

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