The Housing Market… Why the Price-to-Rent Ratio is Signaling More Pain Ahead

Whether you’re investing in real estate, stocks, bonds, or gold coins, you are rewarded primarily for your exposure to one thing – risk. After all, markets are only risk transferring mechanism.

In the summer of 2007, I warned friends that if they were “speculating” in the current housing market, the time had come to cash in their chips and get out of the game. I listed a number of reasons, but the biggest one was that ordinarily sensible people were talking and acting as if highly-leveraged home purchases were “risk-free” transactions. After all, they kept telling me, “real estate always goes up.” I think this is pure BS. Real estate is as much a commodity as cement or steel (oops, it is that?) so the supply and demand will determine price. So real estate does not keep going up.

It doesn’t, of course. And now everybody knows it. Now!

Unfortunately there is no “real estate index” in India. There is no scientific measurement of real estate price movement – and the press is not credible enough in its reporting.

I would love to tell you that the worst is over. (After all, I own a home myself.) But the reality is we may be only in the beginning! Real estate has much further to fall and you should govern yourself accordingly. Here’s why…

Residential Housing Market

Last year was the most painful in decades for the residential housing market in the US of A. Home prices fell, home ownership dropped, foreclosures soared, and the housing market emerged as perhaps the weakest part of the entire U.S. economy.

But in Indian conditions housing prices maybe set to slide considerably further. Banks and mortgage lenders are raising their lending standards. That means credit will remain tight, boxing out many potential buyers. Interest rates on many mortgages are about to reset, increasing the pain on many borrowers and triggering more defaults. Home inventory is still growing and must be worked off before the market gains some kind of equilibrium.

My take on the Indian Housing market however, is a little different. When the rents do not go up as fast as housing prices, it creates panic in me.

An Accurate Gauge Of Home Value: Price-to-Rent Ratio

Economists feel the price-to-rent ratio is perhaps the most accurate gauge of fair home value. Most human beings are rational animals (assumption, sorry!):

• If home prices get too high, many will choose to rent. If rents get too high, many will choose to buy.
• Unfortunately, no detailed studies in India is available regarding the relationship between rents and base price of a house.

So let us go the US of A and see what a Federal Study on Housing has to say. Here I quote from the study:

• “The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995.

But starting in 1996 – the birth of the housing bubble – home prices soared much more rapidly than rents. In fact, by the end of 2006 they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%, a third below its long-term average.

The study concludes that to reach equilibrium, housing prices need to fall 3% a year for a decade, even if rents grow in line with their average 4% annual increase. (Of course, if home prices fall faster – and harder – equilibrium could be reached sooner.)”

How does this translate in Indian conditions?

The Current Housing Market Has Yet To Hit Bottom

In other words, we’re still a long way from the bottom of the current housing market. And there may be some further anecdotal evidence to prove it.

Most homebuilders know the score, of course. But friends who are out looking for homes right now tell me that many sellers remain deluded.

I find the lack of good proper information in the real estate market a big killer of liquidity. If real estate could be listed like equity shares you would know the price of your house (you may not want to buy or sell). Now you are completely at the mercy of a few “informed” people in the business. And you can only guess whether they are lying or just hoping. I have met mid level employees holding on to a living house, a second house and an investment house – hugely leveraged. These would be the first guys to get lynched. Of course when you believe your area sells for Rs. 7000 psf and your neighbour sells for Rs. 4800 psf, you get into denial mode. Like my friend Prakash Natrajan says “My house has a green window, so it will fetch 7000 unlike my neighbor who had a red window” is Denial mode!

No one has a crystal ball, of course. Even the experts on TV only have a teleprompter…