Most of us complain about high residential real estate prices. We have been reading for many years the real estate developers have been saddled with high debt and have been sitting on huge inventory. With this cash crunch, many people have forecast that the fall in real estate prices is imminent. The argument is quite logical too. You have been waiting patiently for the real estate prices to fall but fall has not come.
In any capital market, where there is oversupply, you expect prices to fall. This happens regularly in commodity markets. However, despite real estate developers sitting on huge inventory, the prices have not come down or the builders have not reduced prices. It goes against the basic principle of demand and supply. What could be the reasons behind this anomaly?
To answer this question, we need to look at different kinds of demand for residential real estate. Though it may sound bizarre, if the real estate developers feel that reducing prices may impact a certain kind of demand for their projects adversely, they will not reduce prices.
Let’s look at various kinds of demand for real estate.
- Own demand: This is the demand for own residential use. You need just one house to stay in. Therefore, this demand cannot go beyond a point. It is not that people do not want to purchase houses but affordability is a big problem. A loan of Rs 50 lacs at 10% per annum for 20 years will cost an EMI of Rs 48,251. How many households can afford this kind of EMI? With affordability a serious issue, you cannot expect this demand to be too high. A minor 5-10% cut in prices won’t address the affordability issue beyond a point.
- Rental Income: This demand is generated by people who invest in residential real estate for regular rental income. However, if you look at rental yields, the yields are abysmally low at 2-3% p.a. I don’t know much about other cities. I stay in Mumbai. An apartment with a market price of Rs 1.5 crores won’t get the owner more than Rs 3.5-4 lacs in annual rent. That is an annual yield of around 2.5% p.a. I have not even considered society and maintenance charges that have to be paid out of this rent. A bank fixed deposit will get you 7-8% per annum. So, you will do far better by investing in a plain vanilla bank fixed deposit. Please note I have not considered the tax benefits available to home loan borrowers since the extent of benefit depends on multiple parameters. With the rental yields abysmally low, you cannot expect rental income demand to be too high. Again, a 5-10% reduction in prices won’t shoot up rental yields.
- Investor demand (Capital Appreciation): A number of investors invest in real estate hoping for capital appreciation. In fact, most people think that the real estate prices cannot fall. With this belief, investors won’t shy away from purchasing multiple houses. If the investor feels that the property will appreciate 15-20% in the next year or two, why would he care about demand supply dynamics? Since this demand is based on irrational expectations, this type of demand can be really high. A reduction in residential real estate prices will kill this demand.
So, it is the investor demand that the real estate developers have to rely upon. It is this investor demand the real estate developers cannot afford to kill. If the prices fall, the myth that the real estate prices never fall will be broken. With the strong belief gone, the investor demand will take a severe hit. Therefore, despite sitting on high inventory and facing severe cash crunch, real estate developers cannot afford to reduce prices.
Reducing prices will impact own demand and rental income demand positively but the impact, as discussed above, won’t be that high. However, drop in prices will kill investor demand. Hence, from the perspective of real estate developers, it makes sense to stick with status quo or perhaps even increase prices.
PersonalFinancePlan Take
I am all for purchasing a house to stay in. You should not wait beyond a point. By purchasing a house, you will save on rent. An own house also assures financial security to the family. There are tax benefits on housing loans too. However, do not pay through the nose. Keep the EMIs affordable. There are many debates on Buy or Rent but that’s not the topic of this post.
Investment in residential real estate for rental income makes little sense. Buyers hoping for high capital appreciation need to revisit their rationale for investment. I am not sure how long real estate companies can continue to defy this basic demand supply logic. Perhaps, they can do it for a very long time or long enough for you to give up. Only time will tell.
Image Credit: You can download the original image and information about usage rights from Pixabay.
Deepesh is a SEBI registered Investment Adviser and Founder, PersonalFinancePlan.in
Disclaimer: I am no real estate expert. I have limited knowledge about real estate investments. You are advised to seek assistant from an honest real estate consultant for your decisions about investments in real estate. Please do not construe this as an advice to stay away from real estate investments and wait for real estate prices to fall.