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 around 9.5%, taking a five-year average. High inflation has pulled down economic growth to 10-year lows of 5% while interest rates as measured by government bond yields are running at around 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 around 2.5% levels well below inflation. 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 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 house 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 10,00,000 a year. He borrows Rs 10,00,000 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 real income adjusted for inflation is Rs 9,05,000. Assuming his interest costs remain the same at 10%, the individual ends up paying Rs 100,000 as interest on a lower inflation adjusted income of Rs 905,000. His 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.
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 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.
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.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors
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Updated Date: Dec 21, 2014 01:12:41 IST