I wrote about real estate investing and how it must be evaluated according to the same basic criteria as any other investment. I received a large number of responses, many from people who made money in real estate till about 2005 and lost a lot since.
These letters made me think about how a piece of real estate gains value and how that value can be captured by people who own it at various stages in its life cycle. Broadly, here are the six sources of real estate value creation. One: the legal ‘state change’ from agricultural or unused land to residential or commercial. Two: the creation of a physical environment which makes the real estate usable (construction and infrastructure). Three: the improvement in actual livability (or commercial viability) as an area becomes populated. Four: inflation and general economic growth over time. Five: periodic booms and manias that inflict real estate. And six: periodic slumps.
Of these, one, two and three occur sequentially during the life of an asset. Number four overlaps all others and is continuous, while numbers five or six could happen at any time.
In the old way of investing in real estate, one bought a plot of land in substantially underdeveloped area. Typically, the seller would be a government agency which had acquired it and changed the land use, or a private entity that had done the same. In that model, you would capture all the sources of value creation except some part of stage one.
All price increases that happen because of the other five factors would add to your returns.
Things are very different now, when real estate investors buy apartments constructed by a developer. Obviously, stage one and two are completely taken over by the land acquisition agency and the developer. However, what has been happening is actually far worse for the buyer. The general hype around real estate, high prices and high-pitched marketing means that the developer has already captured a lot of the future value accretion of stages three and four. You the buyer are told that the area in question would be the next central Delhi or south Mumbai, so pony up a futuristic price right now.
From an investment perspective, this basically means that your acquisition price has factored in a high valuation for future earnings. All that is left to you as an investor is numbers five and six in the list — if you are lucky enough to buy into six and sell out at five.
And that doesn’t always happen, as real estate investors have found out in the last year or so.