Is there a bubble in Indian Real Estate?

3 weeks back I wrote a mail to Amit Varma of Indian Economy Blog. Amit was kind enough to post it in their blog. It recieved a good response and there was an interesting discussion in the comments section. This is the excerpt of my post and my initial response to the comments. For the complete post and discussion click here.
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I’ve heard and read reports about 5-15 times increase in land prices in Coimbatore, 1.5 crore apartments in Mumbai, 10% increase in apartment price every week in Hyderabad, Rs.27 Lakh apartments in Chennai (which will yield at the max Rs 7,000 in rent per month), Rs 50,00,000 apartment in Pune.

Being in the midst of a bursting housing bubble in US I sat down and came up with a rough calculation….

Chennai:

Residential Apartment in Velachery (close to IT shops): ~1000 sq.ft

Cost: Rs 27,00,000
Interest Rate: 8%
Interest Cost: Rs 2,16,000 per year
Tax Cost: Rs 4,000 per year
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Total Cost of owning the house: Rs 2,20,000 per year

Rent per month: Rs 7,000
Rent per year: Rs 84,000
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Total earnings from the house: Rs 84,000 per year

Without deducting maintenance costs the percentage of returns on this investment will be 3.11% (less than inflation).

For this investment to make any sense, the rental value of the apartment should go to Rs 20,000 per month (Rs 2,40,000 per year). This is completely absurd as this is not going to happen (even the person who bought this apartment scoffed when I mentioned it).

The only option for this scenario to make sense is for the apartment value to come down, which means it is a bubble.

The buyer of this apartment is actually betting on the price appreciation of the apartment rather than the rental income (This is pretty similar to the greater fool theory).

• People are investing in real estate currently not based on current rental returns.
• They are investing based on either one of the following
  
  • future price appreciation
  and/or
  • future rental growth.

I’m not sure if there is anything else. For some investors socio-psychological reasons can be there, but I doubt how much percentage of the real estate investors fall in that group.

• The price appreciation (15% - 200%) seen currently is not sustainable. ( for argument sake if it is going to increase at this scorching speed, in 25 years new generations will have to live in tents/huts, it will be so much unaffordable ).
• The prices have to stabilize ( at or near inflation rate and growth rate.. how many ever years it takes).
• Once the prices stabilize the rental returns have to make sense.

Let us assume a very rosy picture of prices stabilizing at the current levels. So now the real growth due to all the factors (NRI funds, Foreign funds, local growth ..) the actual person living in the area should have grown to a level where he can pay Rs 20,000 rent for this apartment. The question is will that happen? If yes when will it happen? Will it take 5 years, 10 years or 20 years. Based on what we come up with, that many years of growth is already priced in.

• So now either the prices can remain flat and meet the rental curve sometime in the future.

or

• Prices can grow and still take a longer time for the rental curve to meet the price curve.
  

or

• Prices can come down and meet the rental curve.

I’m betting on the 3rd possibility. But based on the responses am seeing for this type of discussion and exuberance abounding I feel it might take a couple of more years for that to happen.