Real Estate in India has had a very long bull run in India. Some people feel it is high priced other feel it is still undervalued.
Two indicators that can be used to determine this are 1) Price to Rental Ratio and 2) Demand Supply gap, 3) Spread between buy and sell rates for the same property and 4) Return from real estate sector vis a vis other investments.
Price to rental ratio is a good indicator to gauge valuations in real estate irrespective of nature of property. This is somewhat similar to price to earnings ratio in stock market. Higher price to earnings ratio means that the company’s returns are lower vis a vis a price. A higher ratio would be sustainable only if the company grows at a high rate and delivers higher earnings in future. A higher price to rental ratio would indicate the same. If a property has a rental to price ratio of 3%, then it would have to deliver another 2-3 percent in capital appreciation or price appreciation to match returns of Fixed Deposits.
Capital appreciation is a function of demand and supply gap. In a country like India, demand supply gap varies for different cities or geographies and for different segments within a geography. The demand may not only be a function of demand for use but could also come from demand for investment which could arise due to excess liquidity, under-valuation. Real estate for a long time was also favourite of investors. Easy liquidity may also create asset bubbles.
Another indicator for stability of the market could be the difference in purchase and selling price. Taking stock market as an example, there was a time when market had “jobbers”. The role of jobber was to provide both buy and sell quote for a scrip. The difference between the quotes indicated stability of the market and turnover of stock. Higher the turnover and stability, lower was the difference between buy and sell quotes. Lower the turnover, higher was the difference. Some of the cities under Delhi NCR reflect the same where brokers provide two very different quotes for the same property.
The third and final angle for triangulation is to remember that real estate is also an asset class and just like other asset classes. It cannot beat the market consistently. Over a period of time, all asset prices end up giving similar kind of returns especially after adjustment for risk. Some of the assets like real estate and gold may not show high fluctuations, unlike stock markets. A comparison of returns across financial assets also gives us a good idea about how much returns can we expect from an asset class over the years. Real estate is no exception. Please see the charts below to see returns from different asset classes in US and India.
If we draw similar chart for India, Equity has given returns of 17%, with real estate at 15%. The bonds and Gold have returned lesser returns than both these asset classes.
We can use Noida as an example to see how we can use the above triangulation points.
If we look at residential sector in Noida. The land prices peaked around 2014-15. At that time, the price to rental ratio was more than 50 years (ranging from 50-55 years, depending on sector). The prices have come down around 30% of the peak rates. The flats have seen marginal increase in rates.
At current prices, Noida has a price to rental ratio of around 45% with the rental income ranging from 1.5-2.5% in the city. With banks offering FD rates of around 6%, either the rentals should increase to that level or rental returns should be supplemented with increase of prices. The price increase should be more than 3.5%.
If we look at the demand-supply situation, the city has a population of around 1.1 million which is growing at a rate of round 8-10% p.a. That implies adding roughly 100,000 persons every year. Assuming a family size of 4, the total demand would be roughly 25,000-35,000 every year. But the real estate in the city is not focussed on EWS which would be roughly 40% of the population. If we take out 40% population which is not target of builders, the additional demand each year would be roughly 15,000-20,000 flats (assuming a family size of 4).
This translates to roughly 4.5 years of demand. This does not include inventory held by investors who are looking to sell their properties. Now with economic conditions deteriorating due to Corona, the demand will come down further. Given the demand-supply, the prices should not increase. The only way, current investors can get a return of 6% is if the prices come down further and rental to price returns equal 6% for the next 4-5 years. Hence, we can say that residential real estate is overpriced in Noida. The same framework can be used to evaluate prices in Industrial and commercial sector.