Economic forecasting is a difficult business. It is even more difficult when one has to answer something as specific as: “when will home prices become affordable?”
Almost, anyone interested in buying a home currently knows that home prices are expensive. This, despite the fact that homes aren’t selling, and builders are sitting on a large number of unsold homes. But, they don’t seem to be in a hurry to cut prices.
Conventional economic theory suggests that when something is not selling, prices need to be cut, to attract prospective buyers.
But this does not seem to apply in the case of Indian real estate. Why? In the period between 2002 and 2012, real estate prices in India went up at a break neck speed. A significant portion of the real estate transactions was carried out in black.
Hence, while buying a home 20-30 per cent of the price had to be paid in black (i.e. in the form of cash). The money that the builders made in this form, has ensured that they continue to be liquid i.e. they have enough cash going around to meet their day to day expenses.
In the process, they are in no hurry to cut prices. But builders are not the only one who have a stake in this real estate game. Over the years, many individuals have become real estate investors as well. ”
Real estate returns across the country have either been very low or in negative territory, over the last few years. Also, once we take the risk involved in owning real estate and inflation, into account, investing in real estate starts to make financial sense only when the returns are greater than 10 per cent per year. Now that kind of return has been elusive on this investment.
Hence, the question is why are real estate investors holding on to the homes they bought as an investment, even when that investment is really not throwing up any return. It would simply make more sense for them to sell the home and invest the money somewhere else. Even something as simple as a fixed deposit is likely to earn more.
But before we figure out why these investors are not selling, let me tell you a little story. Recently, I was in Bali for a small family holiday. I wanted to buy a wooden carving, which I had taken a fancy to. The seller’s asking price was 6,00,000 Indonesian rupiah (around Rs 3,000). I started at 2,00,000 rupiah (Rs 1,000) and stuck to it. The seller kept dropping his price, till he came down to 2,50,000 rupiah (Rs 1,250).
After that we kept haggling for a good five minutes, but he stuck to his price. He wouldn’t drop it further, come what may. He had become “anchored” to that number, due to some reason. And this anchor ensured that finally I had to up the price I was willing to pay to 2,50,000 rupiah and seal the deal.
Anchoring is a very important concept in real estate. In his book A Man for All Markets, Edward O Thorp writes: “Anchoring is a subtle and pervasive aberration in investment thinking. For instance, a former neighbour, Mr Davis (as I shall call him), saw the market value of his house rise from his purchase price of $2,000,000 or so in the mid-1980s to $3,500,000 or so when the luxury home prices peaked in 1988-1989. Soon afterward, he decided he wanted to sell and anchored himself to the price of $3,500,000.”
Mr Davis became anchored to this price of $3.5 million. The trouble was that home prices started to fall pretty soon. But Mr Davis had become anchored to the high price and he wouldn’t sell.
The Indian real estate investors are going through a similar phase right now. They are anchored on to the high real estate prices they saw nearly five to six years back. The trouble is no buyer is willing to buy at that kind of price.
In fact, this psychological dimension in real estate, makes it even more difficult to predict, when home prices will become affordable, despite it being very clear that real estate prices are due for a huge correction.
The column originally appeared in Bangalore Mirror on October 25, 2017.