The argument that
real estate is a good hedge against inflation does not hold true at all.
In fact, it is the
other way around. High inflation is the worst condition for real estate prices
to rise.
Let us examine why
inflation is a real estate killer. Inflation in India at the consumer level is
running at about 9.5 %, taking a 5 year average. High inflation has pulled down
economic growth to year year lows of 5 %
while interest rates as measured by government bond yields are running at
about 9 % levels.
Mortgage rates are
over 10 % levels. The Indian economy is not creating jobs given the economic
slowdown. Hence, household incomes barely manage to keep pace with inflation.
In these conditions, real estate makes a poor investment choice given that
rental yields in India are at about 2.5
% levels well below inflation.
Cost of buying..
A family investing
savings in real estate will be earning a negative 7 % every year given rental
yields at well below inflation levels. real estate makes a poor investment
choice given that rental yields in India are at about 2.5 % levels well below
inflation at 9.5 % levels real estate makes a poor investment choice given that
rental yields in India are at about 2.5 % levels well below inflation at 9.5 %
levels.
Real estate is largely mortgage
driven, as the cost of buying a house is too high for individuals. In the
current environment, an individual taking a loan to purchase a home is paying
10 % as interest. Inflation is running at 9.5 % levels. The individual’s income
has to rise 9.5 % every year just to keep pace with inflation.
If income does not
rise 9.5 % every year, the individuals borrowing cost in real terms goes up as
his income has fallen due to inflation but his loan costs remain the same or /
even rises as interest rates rise. Taking a hypothetical example, an individual
is earning Rs. 10 lakh a year. He borrows Rs 10 lakh to purchase a house. His borrowing cost is 10
%. Inflation is running at 9.5 %.
If the individual’s
income does not rise for one year, his/her real income adjusted for inflation
is Rs. 9.05 lakh. Assuming his interest costs remain the same at 10 %, the
individual ends up paying Rs. 1 lakh as interest on a lower inflation adjusted
income of Rs. 9.05 lakh. His/her real
interest cost has actually gone up by 1.05 % to 11.05 %. House prices have to
rise by a minimum of 9.5 % plus 1.05 % every year if an individual’s income
does not rise to compensate for inflation.
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| Arjun Parthasarathy |
The reason real
estate transactions have fallen by 50 % to 60 % over the last one year is that
affordability at the ground is just not there. Households are finding it
difficult to make ends meet given stagnant income and rising prices. Borrowing
costs are high as well as real estate prices are way above income levels.
Banks are tightening
lending norms given that household incomes adjusted for inflation is coming
down every year. Banks / Housing Finace companies (HFCs) are taking high
collateral, 25 % to 30 % of property value, which an average household does not
have.
In fact looking at it
from a lender’s point of view, if interest rates are not raised to compensate
for falling inflation adjusted income, banks are suffering credit risk erosion.
Banks should increase collateral to protect themselves against weak economy and
inflation.
Practical Realities..
Where does the case
for real estate as a hedge against inflation come from? The practical realities
do not suggest as given in the example above.
People find many
reasons to back an investment, and these reasons include black money,
politicians, speculation etc. Such reasons are hard to back given the lack of
transparency in data and it goes more in the realm of hearsay. It’s too big a
risk for an individual investing life savings in real estate to go by hearsay
rather than hard facts.
Mr. Arjun Parthasarathy
is the Editor of www.investorsareidiots.com a web site for investors
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