The Greater Fool Theory of Real Estate


Some regular readers of the Diary have been asking on the social media as to why I have stopped writing on real estate.

Actually, I haven’t, it’s just when it comes to real estate, I have had nothing new to say for a while. But today’s piece is about real estate. Not that this has something very new to say, but the story that I came across was interesting enough to be discussed in detail.

First and foremost, I would like to thank Pune based Ashish Deshpande, Director, Paradigm Wealth Managers, for bringing this to my notice. So here is the story.

On the insistence of a friend, Deshpande went to check out a new real estate development in Wadala in Mumbai.

His friend could only afford the one bed room hall kitchen (BHK) that was on offer. And how much did it cost? Rs 1.8 crore. Deshpande got chatting to the builder’s sales guy and asked him, how many end users were actually buying the one BHK apartments. The sales guy, not surprisingly, answered 90 per cent. I mean, what else could he have said. He is expected to sell apartments not philosophise about them.

Of course, like a good sales guy, he was lying. Deshpande then asked the sales manager to imagine the profile of the guy who would in a position to pay Rs 1.8 crore to buy an apartment to live in it. Let’s do a little maths to get into a little more detail here.

A bank or a housing finance company would finance up to 80 per cent of the value of the apartment. This means a home loan of Rs 1.44 crore (80 per cent of Rs 1.8 crore). Let’s say the individual who wants to buy this apartment goes to the State Bank of India. He takes on a twenty-year home loan at 9.25 per cent per year.

How much does the EMI on this amount to? Rs 1,31,885 per month. How much does a person need to earn per month for the bank or the housing finance company, to give him the required home loan? Assuming around 40 per cent of the salary goes towards the EMI, the monthly salary would have to be around Rs 3.3 lakh. This would mean an annual pay of around Rs 40 lakh.

How many people actually earn that kind of money? Further, the individual would also have to arrange for a downpayment of Rs 36 lakh (Rs 1.8 crore – Rs 1.44 crore). How many people have such a saving? Also, would you expect someone earning as much as Rs 40 lakh per year to live in a one BHK apartment? Would take a very desperate person to do that.

Deshpande offered this logic to the sales manager (not in as much detail). Then the manager let the cat out of the bag and said that most of the people purchasing one BHKs were buying it as a second home. People buy second homes typically to put it on rent to make a regular income, avail of the huge tax deduction that is available or to simply invest money and stay put. Or they simply have some money lying around and they don’t know what to do with it.

Rental yields (annual rent divided by the market price of the apartment) are currently around 2 per cent. So why would anyone in their right mind buy a home to put it on rent? Even after tax returns on fixed deposits, for those in the 30 per cent tax bracket work out to around 5 per cent.

When it comes to saving tax, the strategy perhaps makes some sense. In case of a second home loan (and third and fourth and so on) the entire interest paid on a home loan is tax-deductible as long as a notional rent is added to the income.

But what complicates matters in this case is that the delivery of the apartment is not scheduled up until 2020. That essentially increases the risk given that there are a whole host of under construction properties that haven’t been delivered over the last few years.

Also, the apartment comes with the condition that it cannot be sold before possession is granted. So this basically means that it is a five-year investment and can be sold only by around 2021. So what is a reasonable rate of return for an investor to expect in this case? Deshpande works with a simple rate of return (and not compounded) of 8 per cent per year. This would mean an absolute rate of return of 40 per cent over a period of five-year.

This basically means that five years later the apartment should be worth at least Rs 2.5 crore (actually Rs 2.52 crore to be very precise). If we include stamp duty and other charges (which also need to be recovered) the apartment should fetch at least Rs 2.75 crore in 2021.

A simple rate of return of 8 per cent per year might just work in this case because the buyer is also getting a huge deduction for the interest that he pays on the home loan. But what if someone is looking at least at a compounded rate of return of 10 per cent per year? Then the price of the apartment has to be around Rs 2.9 crore in 2021. And this is without taking the stamp duty into account.

Now, imagine one BHK apartments selling for Rs 3 crore in 2021? These are the numbers we are looking at. What if there are no buyers? As Deshpande puts it: “in the absence of an end user your investment becomes a fixed deposit fetching 2% return annually with principal not in sight or at least at big risk.”

So where does that leave us? It brings us back to the Greater Fool Theory of Real Estate. Or the theory on the basis of which people are still betting on real estate. The expectation is that at the end of the holding period of five years (in this specific case) one will always be able to find a greater fool who is willing to buy real estate at an even higher price. In more general cases, the expectation is to find a greater fool who is willing to buy.

If that is how you like to invest, then all I can say is best of luck. Or maybe you have a lot of black money lying around. And there is still no place better than real estate to launder it.

The column originally appeared in Vivek Kaul’s Diary on October 19, 2016