Real estate in India is not a great asset class

Economic Times, 11 May 2013

Most people in India are convinced that real estate is a great asset. More caution is in order. Real estate investment is not a guarantee of profit. It is hard to be diversified, and illiquidity hampers portfolio structuring. Most important, the outlook for supply over the medium term implies that there is no great upside.

Too many intelligent people in India believe that one can never do wrong by investing in real estate. Some facts will help bring more sense. Consider investing in the best commercial real estate of Bombay -- Nariman Point -- in 1995. The price was Rs.35,000 per square foot. Today, almost 20 years later, the price is Rs.25,000 a square foot.

Over this period, Nifty produced returns of 362%. Inflation ate away 272%. Net of inflation, Nifty delivered an average annual return of 1% while Nariman Point commercial real estate delivered -9%. I have ignored rental yield on real estate and dividend yield on equity.

This is, of course, just an anecdote. Many individual real estate investments have done very well and have occasionally outperformed equities. My point is a limited one. We should not mindlessly assume that real estate is always a good investment. We should not assume that real estate will always outperform equities -- as the above example shows things can be as bad as underperformance (compared with the Nifty index fund) of 10 percentage points per year over a 19 year period.

Why did Nariman Point underperform over this period? Because of new supply. That is the heart of the problem of real estate as an asset class. There is no long term returns in owning steel or bricks. Every time there is a real estate boom, it triggers off fresh construction. This supply quenches the boom.

Bombay is a pretty bad place in terms of availability of space, because of both geography and governance. Elsewhere in India, the case against real estate is even stronger. The government in India is slow to build roads and water supply and police stations in outlying areas. But with a lag, these facilities do come about. Ultimately, when the price of structures exceeds the price of bricks and steel, new supply emerges, which is bad for real estate prices. The rise of a professional real estate industry, coupled with access to formal finance including foreign capital, has increased the scale of supply and given bigger and faster corrections.

Some claim that India has a large population and there is a shortage of land. A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India's land area assuming an FSI of 1. There is absolutely no shortage of land to house the great Indian population.

The biggest story about the future of real estate prices in India is the `floor space index', FSI, or rules that restrain building into the sky. In most of India, the FSI is below 2. This is an abysmally small number by global standards. All over Asia, FSIs are above 5, going up to 20 or to no limit. In the long run, politicians in India will see the light and FSI will rise. A higher FSI results in lower rental rates for households and firms, as was seen in Hyderabad which was a pioneer in FSI reform. When FSI goes up, this will unleash supply on a big scale. As an example, if Bombay moves from an FSI of 1 to 2 -- which would still make it worse than the FSI seen anywhere else in Asia -- this would trigger off a doubling of supply.

These arguments are not specific to India. While datasets about real estate investments over long time periods are not easy to come by, academic evidence is slowly building up of fairly poor returns to real estate. Net of inflation, real estate tends to produce roughly 0 over long periods, while equity indexes produce significant and positive returns after inflation.

Finally there are the practical difficulties of diversification and liquidity. Most people are not rich enough to buy 50 properties spread across India. Buying and selling involves very large transactions costs and delays, and generally involves black money.

Skepticism is in order. If less than 1% of the land area of India is built out, this is enough for the entire population. There is no long-run return in hoarding bricks and steel. Real estate booms the world over are quenched by supply. The prospect of holding real esate in India is worse because FSIs are tiny. In the future, FSIs will go up, which will further fuel supply. Households investing in real estate are also hurting on account of inadequate diversification, illiquidity and the use of cash.

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