India’s real estate market is being run by crooks

Vivek Kaul

The real estate sector remains down in the dumps. Nevertheless, insiders(the builders, the real estate consultants, the housing finance companies etc.) would like us to believe that “acche din” will be here for the sector pretty soon and hence, we should be investing in it.

In a recent report JLL India, a real estate consultant, pointed out that: “Many home buyers as well as investors have been speculating about the movement of residential property prices in Mumbai…The market’s readings indicate that that it will start moving up later this year. An average price appreciation of around 6% is expected by the end of Q4 2015. Mumbai’s residential property market will start seeing a lot of buying activity in around six months, with buyers taking advantage of prevailing market conditions to get good deals. The increased market activity is expected to continue next year too.”

What the report does not point out is the fact that the Mumbai Metropolitan Region has an unsold inventory of homes of close to 46 months or 192.27 million square feet. This data was released by Liases Foras, another real estate consultancy, sometime back. What it means is that if homes continues to sell at the current rate it would take around 46 months for the current stock to sell out. A healthy market maintains an inventory of eight to 12 months.

JLL India may have its own estimates of unsold inventory but they can’t be significantly different from that of Liases Foras. And if there is so much ready supply available, how can real estate prices go up?

This is just one example of research reports that real estate consultants keep coming up with where the conclusion is that “real estate prices will continue to go up”. For them it makes sense to do this simply because they make more money if the real estate sector is doing well, given that there are more deals to execute and more commission to be made in the process. And if the real estate sector is not doing well then they need to tell the world at large that it will start to do well, soon. These positive reports are splashed across the media, given that real estate companies are huge advertisers and a healthy real estate sector is a boon for the media.

The trouble is that the real estate sector in India has a huge information asymmetry, or something that the Nobel Prize winning economist George Akerlof referred to as a “market for lemons”. In a 1970 research paper titled The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, Akerlof talked about four kinds of cars: “There are new cars and used cars. There are good cars and bad cars (which in America are known as “lemons”). A new car may be a good car or a lemon, and of course the same is true of used cars.”

Akerlof then went on to explain why trying to sell a lemon is very difficult. In an essay titled Writing the “The Market for ‘Lemons'”, Akerlof wrote: “I knew that a major reason as to why people preferred to purchase new cars rather than used cars was their suspicion of the motives of the sellers of used cars.” Long story short—a buyer will not buy without proof of the used car being in good shape and the seller did not have the proof.

And this led to the market for second-hand cars not working well. Tim Harford explains this phenomenon very well in his book The Undercover Economist: “Anyone who has ever tried to buy a second-hand car will appreciate that Akerlof was on to something. The market doesn’t work nearly as well as it should; second-hand cards tend to be cheap and of poor quality. Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car is really a peach, they cannot get that price and prefer to keep the car for themselves. You might expect that the sellers would benefit from inside information, but in fact there are no winners: smart buyers simply don’t show up to play a rigged game.”

Hence, the market for second-hand cars has huge information asymmetry—one side has much more information(the seller) than the other(the buyer). And given that the market does not work well.
The real estate market in India is a tad like that. The insiders have all the information and there is no way to verify if the information they are putting out is correct. Take the case of something as simple as the prevailing price trend in a given locality.

There is no publicly available information. All you can do is ask the broker operating in that area and more often than not, he will tell you that “prices are on their way up”. If you are able to figure out a price, there is no way of figuring out whether there are deals happening at that price.

Hence, the system as it currently stands is totally rigged against the buyer. Even when the buyer buys an under-construction property there is no way of figuring out if the builder will deliver everything that he has promised at the time of the sale. There are regular cases of builders promising to build a swimming pool, taking money for it and then not building it. Then there are cases of parking lots being sold even though that is not allowed. In the recent past, builders have disappeared after taking on money and not completing the project.

As Nate Silver writes in The Signal and the Noise –The Art and the Science of Prediction: “In a market plagued by asymmetries of information, the quality of goods will decrease and the market will be dominated by crooked sellers and gullible and desperate buyers.” And that is precisely what is happening in India.

In fact, the real estate market in India currently is like the stock market used to be in the 80s and the 90s. India’s biggest exchange the Bombay Stock Exchange(BSE) was run by and for brokers. Other stock exchanges operating in different cities ran along similar lines. Small investors investing in the market were regularly taken for a ride.

The Securities Exchange Board of India was given statutory powers in 1992. And it took time to crack the whip. The National Stock Exchange started operations in November 1994 and gradually took away business from the broker dominated BSE. The BSE has been trying to play catchup since then.

The real estate business in India needs to be cleaned up along similar lines. The Real Estate (Regulation and Development) Bill, 2013, envisages setting up of a real estate regulator in each state. The builders need to be registered with the regulator and at the same time disclose essential details about the projects. These provisions if and when implemented are likely to reduce the information asymmetry which plagues the sector. But till then “caveat-emptor” will continue to prevail.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)  

The column originally appeared on DailyO on May 25, 2015

The theory that caused the financial crisis gets a Nobel prize

alfred nobelVivek Kaul
Do financial markets have bubbles? Like most things in economics, the answer to what seems like a rather straightforward question, is yes and no. It depends on which economist you are talking to.
Eugene Fama and Robert Shiller are two of the three economists(the third being Peter Hansen) who have won the Nobel Prize in Economics this year.
When it comes to the bubble question Fama feels there are no bubbles. Shiller, on the other hand, has done some of his best work in economics around financial market bubbles. In fact, he was one of the few economists, who predicted both the dotcom bubble as well as the real estate bubble. Ironically enough, both of them have won the Nobel Prize in the same year.
Eugene Fama, who teaches at the University of Chicago, came up with the efficient market hypothesis(EMH), sometime in the 1960s. A lot of financial theory that followed was built around EMH.
Benoit Mandelbrot, a mathematician who did some pioneering work in economics, was Fama’s thesis advisor. As Mandelbrot (along with Richard Hudson) writes in The (Mis) Behavior of Markets – A Fractal View of Risk, Ruin and Reward “It (i.e. EMH) became the intellectual bedrock on which orthodox financial theory sits.”
So what is the EMH? As Mandelbrot and Hudson write “At its heart: In an ideal market, security prices fully reflect all relevant information…Given that, the price at any particular moment must be the “right” one.”
And how is that possible? How can the price of a financial security( lets say a stock or a bond) at any point of time incorporate all the information?
Mark Buchanan explains this through a small thought experiment in his book Forecast – What Physics, Meteorology and Natural Sciences Can Teach Us About Economics “Let’s do a thought experiment, which I’ll call the 5 percent problem. Suppose that on Tuesday morning everyone knew for sure that the markets would recover, stocks gaining 5 percent(on average) in a big rally in the final half hour at the end of the day. Everyone in the market would expect this rise, and lots of people on that morning would be eager to pay up to 5 percent more than current values to buy stock, as they would profit by selling at the day’s very end. Knowledge of the coming afternoon rise would make the market rise immediately in the morning, violating the assumption we made to start this thought experiment; the prediction of a late rally would be totally wrong.” Hence, information about the market rising by 5% towards its close, would be incorporated into the price of the stocks immediately.
Mandelbrot and Hudson give another similar example to explain EMH. “Suppose a clever chart-reader thinks he has spotted a pattern in old price records – say, every January, stocks prices tend to rise. Can he get rich on that information by buying in December and selling in January? Answer: No. If the market is big and efficient then others will spot the trend, too, or at least spot his trading on it. Soon, as more traders anticipate the January rally, more people are buying in December – and then, to beat the trend for a December rally, in November. Eventually, the whole phenomenon is spread out over so many months that it ceases to be noticeable. The trend has vanished, killed by its very discovery,” write Mandelbrot and Hudson.
And this happens primarily because the market is made up of many investors, who are all working towards spotting a trend and trading on it. As Buchanan explains in 
Forecast “In this view, a market is a vast crowd of investors with diverse interests and skills all working hard to gather information on every kind of manufacturing company, bank, nation, technology, raw material, and so on. They use that information to make best investments they can, jumping on any new information that might affect prices as it comes along, and using that information to profit. They sell currently valued stocks, bonds, or other instruments, and buy undervalued ones. These very actions act to drive the prices back toward their proper, realistic, or “intrinsic” values.”
Given this financial markets are correctly priced all the time. Robert Shiller summarises this argument best in 
Irrational Exuberance. As he writes “The efficient markets theory asserts that all financial prices accurately reflect all public information at all times. In other words, financial assets are always priced correctly, given what is publicly known, at all times.”
And if financial assets are correctly priced, there is no question of any speculative bubbles occurring. As John Cassidy writes in 
How Markets Fail – The Logic of Economic Calamities “During the 1960s and ’70s, a group of economists, many of them associated with the University of Chicago, promoted the counter-intuitive idea…that speculative bubbles don’t exist. The efficient market hypothesis…states that financial markets always generate the correct prices, taking into account all of the available information…In short financial prices are tied to economic fundamentals: they don’t reflect any undue pessimism..If markets rise above the levels justified by fundamentals, well informed speculators step in and sell until prices return to their correct levels. If prices fall below their true values, speculators step in buy.”
This ensures that all the available information is priced in. Hence, at any point of time, the market price is the correct price. And given that where is the question of any bubbles popping up? As Fama put it in a 2010 interview, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
Robert Lucas, another University of Chicago economist who won the Nobel prize in 1995, reflected Fama’s sentiment when he said “The main lesson we should take away from the EMH for policy-making purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.”
And this is the view that came to dominate much of the prevailing economic establishment since the 1960s. It is surprising that economists have had so much confidence in a theory for which the evidence is at best sketchy. Raj Patel makes this point in 
The Value of Nothing “The problem with efficient market hypothesis is that it doesn’t work. If it were true, there’d be no incentive to invest in research because the market would, by magic, have beaten you to it. Economists Sanford Grossman and Joseph Stiglitz demonstrated this in 1980, and hundreds of subsequent studies have pointed out quite how unrealistic the hypothesis is, some of the most influential were written by Eugene Fama himself.”
Also, if EMH were true, prices of financial assets would be right all the time, which is clearly not the case. As Buchanan writes “In November 2010, the 
New York Times reported on a dozen “mini flash crashes” in which individual stocks plunged in value over a few seconds recovering shortly thereafter. In one episode, for example, stock of Progress Energy – a company with eleven thousand employees – dropped 90 percent in few seconds. There was no news released about the business prospects of Progress Energy either before or after the event…On May 13(2011), Enstar, an insurer, fell from roughly $100 a share to $0 a share, then zoomed back to $100 in just a few seconds.”
Shiller gives the example of eToys and Toys “R” Us, two companies which were into selling toys. As he writes “Consider, for example, eToys a firm established in 1997 to sell toys over the Internet. Shortly after its initial public offering in 1999, eToys’ stock value was $8 billion, exceeding the $6 billion value of the long established “brick and mortar” retailer Toys “R” Us. And yet in fiscal 1999 eToys’ sales were $30 million, while the sales of Toys “R” Us were $11.2 billion, almost 400 times larger. And eToys’ profits were a negative $28.6 million, while the profits of Toys “R” Us were a positive $376 million.”
So a company with no profits had a greater market capitalization in comparison to a company making substantial profits. Now as per the EMH this should have never happened. Investors would have sold the eToys’ stock and driven down its price. But that did not happen, at least for a few years. And the stock price of eToys went from strength to strength.
But despite the weak evidence in support of EMH, the prevailing economic thinking since the 1960s has been that market prices of financial assets reflect the fundamentals, and hence, there was no chance of bubbles popping up. And even if bubbles did pop up, now and then, there was no chance of identifying them in advance. Alan Greenspan, the Chairman of the Federal Reserve of United States between 1987 and 2006, believed that a central bank could not spot a bubble, but could hope to mitigate its fallout, once it burst.
This led to him letting the dotcom bubble run. A few years later he let the real estate bubble run as well. He was just following the economic theory that has dominated over the last few decades. As Patel writes “ Despite ample economic evidence to suggest it was false, the idea of efficient markets ran riot through governments. Alan Greenspan was not the only person to find the hypothesis a convenient untruth. By pushing regulators to behave as if the hypothesis were true, traders could make their titanic bets…Governments enabled the finance sector’s binge by promising to be there to pick up the pieces, and they were as good as their word.”
In the end, Greenspan did find out that the model did not work and that bubbles did occur, now and then. As he admitted to before a committee of the House of Representatives in October 2008, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak…I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
So Eugene Fama’s EMH doesn’t really work and has caused the world a lot of harm.
Now compare this to Robert Shiller who in the first edition of 
Irrational Exuberance, which released some time before the dotcom bubble burst, compared the stock market to a Ponzi scheme. As he wrote “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasise the positive news and give less emphasis to the negative.”
Hence, financial markets at times degenerate into Ponzi schemes, where prices are going up simply because prices are going up. These bubbles can keep running for a while, just as the dotcom bubble in the US and the real estate bubble all over the developed world, did. When these bubbles burst, they caused huge economic problems, as we have seen over the last few years.
The trouble is that the dazzle of efficient market hypothesis has blinded economists so much that they cannot spot bubbles anymore. Hence, it is important that economists junk the efficient market hypothesis, and start looking at a world where bubbles are possible and keep popping up all the time. Else, we will have more trouble ahead.

The article originally appeared on on October 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)