Real estate as an Asset Class

Please read an interesting blog by Ajay Shah Real Estate as an Asset Class :

Many people are increasingly comfortable treating real estate as `an asset class'. It is argued that land isn't being produced, that as the population grows, demand for real estate only goes up. Astronomical prices of real estate in India encourage holding real estate assets in the hope of obtaining high profits in the future.

This proposition is debatable. There is actually ample land out there. A calculation shows that even if all of India's population had a dwelling of 1000 square feet per family of 4, this requires only 0.76% of India's land area, assuming a low FSI of 1.

In the case of equities, we know that in all countries, a diversified portfolio of equities earns a few percent per year in real terms over long time periods. Some papers show that this is not the case with real estate (!).

If land isn't scarce, then the cost of built-up housing isn't much, it's just the cost of steel and bricks. To think of it as an asset class is as odd as treating (say) a car as a financial asset. The only challenge is one of overcoming government zoning restrictions, and building enough property, so that prices can then crash.

This is part of the story of the US housing market in recent years. Thanks to sound urban policies, there are no real entry barriers to building houses in the US. Zoning rules are sensible, and the policy framework supports easy extension of urban areas into outlying barren land. When houses could be sold for more than the price of cement and steel required to make them, this kicked off a massive supply response. This kicked up GDP growth for a few years. It took a little time, but this killed off the phase of rising prices. For some time now, house prices in the US will be low because of this overhang of supply.

There are legitimate concerns about bank exposures to real estate, since the market is non-transparent and marking to market is difficult. I think it is easy to build a risk management system governing loans against shares or bonds, but I'd worry about loans against houses or cars.

There are strong concerns about foreign capital coming into the real estate sector of a country like India. It is claimed that foreign speculators will drive up prices and thus make housing unaffordable. This needs to be questioned, for foreign capital that goes into development (directly or indirectly) ultimately drives up supply and thus solves the problem (see above link).

Transforming the real estate sector requires a sustained push in terms of financial capital in development, professional management teams that will build millions of square feet instead of thousands of square feet, and a big jump in the FSI. Once these initiatives are in place, real estate prices will drop, households and businesses will find space to be much more affordable, and it will not look so good as an asset class.

Some of these pieces are now coming together. A new breed of firms are now accessing public markets to obtain capital on a scale that was previously unimaginable, and bringing modern professional organisations to bear on the task of rapidly building properties. Foreign capital and foreign firms are increasingly coming into this area, though much slower than would be the case thanks to capital controls.

The CMIE executive summary for this sector shows a growth in total assets from Rs.22,156 crore in 2004-05 to Rs.53,522 crore in 2006-07. The market capitalisation of listed firms on NSE in this sector is Rs.3,13,981 crore, and the P/E of 37.3 will attract entry. Of the 80 firms in this sector, CMIE finds that 54 have adequate liquidity to make it into the price index for this sector. These are all still small numbers compared with the size of India, but it looks like serious firms are finally coming together, that might ultimately be able to pull off a massive supply response.

In this context, I was intruiged by this story by Raghavendra Kamath in Business Standard, describing incremental supply of ~ 15 million square feet in Bombay in a year. That sounds nice, it represents the kind of dent that is required on the part of supply to make a serious difference to prices