Riding On Hope & Prayer - By Sanjeev Pandiya

It isn't really about whether land has suddenly become an 'el dorado' for investors. It is about understanding the difference between “store of value” investments (that are secondary derivatives of economic activity) and those investments that create value by generating economic activity, like equities and debt.

Let me explain. Land, or gold, for that matter, do not create wealth. They are only worth what someone else (perhaps a bigger fool) will pay for them. They do not generate value. And they actually are sometimes cash-negative. The cost of maintaining a store of gold (security, transportation, insurance, etc) is to be deducted from the capital gains earned from gold. And in case gold prices are stagnant or declining (1981- 2001), investors suffer losses even in nominal terms. In case of land, you might get rent, but after deducting costs, the effective yield is marginal. Mostly, land is held for the capital gains it yields.

In parts of Delhi/ Gurgaon, where the rental yield (i.e. the annual rent divided by the market value of the property) is down to 1-2%, there is nothing left for the landlord investor after maintenance, repairs, security, municipal charges, insurance, rates and taxes. The net cashflow from holding a property in Delhi may actually be negative. Investors find it worthwhile to hold land only because of the capital appreciation that accrues from selling it to the bigger fool. Theoretically, economists would argue that normal returns would accrue to investors in the long run. In Gurgaon, for example, the landlord investor who chooses to hold on to his property at these rates, is giving up the option of selling his property and parking his funds in the bank at 8%, or getting a post-tax return of 6.5% from mutual funds. He is expecting a capital appreciation of at least 7%, otherwise this is not a rational choice.

There are other factors at play, however. For example, the flow of black money into real estate ensures that the "opportunity cost" of the capital flowing in has to be adjusted downward. Black money carries a storage cost, security risk (of being found out by the CBI, I-T dept etc). This drives down the return expectation from real estate, ensuring that even after the above obvious calculation, there is no capital flight from this sector.

Just like you fill up a balloon only when you pump in air at a pressure higher than the atmospheric pressure prevailing outside, a bubble (in asset markets) blows up only when the cost of capital (i.e. the return expectation) drops below the levels prevailing in the outside economy. This can happen for structural reasons (like the flow of black money, Japanese funds flowing in stock and bond markets, etc) or for sentimental reasons (like the mindless manner in which people bought IT shares in 2000), or even for technical reasons (like farmers in Punjab not knowing where to put their cash surpluses, leading to a steep hike in the prices of agricultural land). Sometimes, regulations can create such bubbles (like capital convertibility restrictions in forex markets). The drivers may be different, but the fundamental phenomenon is the same: the cost of capital drops.

To understand what happens next, let us go back to the balloon example. To hold up the balloon's shape, you need to close off the vent. If you leave a small hole, the balloon starts to deflate. The bigger the hole, the steeper the rate of deflation, till at one tipping point, it can be called a full-scale collapse. But in every case, the pattern is the same……different words are used to describe different rates of deflation.

Now let us look at what it takes to hold up the balloon. There is a certain amount of air which needs to be pumped in, without which the bubble would move from inflationary mode to deflationary mode. This certain amount of air would be directly dependent on the size of the balloon/ bubble and the size of the vent. A small balloon with a small vent can be held up by a child's mouth.

But a large (hot-air) balloon with a big vent needs a pump machine to hold up the balloon (like those gas balloons we see on buildings). The bigger the balloon, the bigger the vent…the bigger the incremental flow of air needed to keep up the balloon/ bubble from inflating.

Now let's get back to financial market bubbles/ balloons. The incremental flow of funds that is needed to hold up an ever larger bubble will keep growing. When Gurgaon was just a village outside Delhi, prices could be kept up by the small amounts of funds (including black money) that flowed from real estate speculators. As it grew bigger, the number of segments that needed to join in, also increased. First, the BPO segments, then the affluent middle class from Delhi, then the NRIs and finally, the big housing finance banks with their mortgage finance. In short, you needed ever larger amounts of 'incremental flows' to hold up the bubble.

Momentum ensures that the number of segments that follows quickly on the heels of its predecessors is an ever-proliferating phenomena. The Gurgaon bubble has created interest in the big real estate companies, who were pre-May favourites on the stock markets (Unitech, DLF, Ansals, et al) and would have raised large sums on the stock markets, effectively involving the man in the street finally. Lastly, the big overseas flows would have started, creating a full-fledged 'hot-air' balloon.

Now the balloon would have got unstable. If even one segment withdrew (like the RBI-mandated exit of the banks from realty sector lending), it would have led to slow deflation. Thereafter, the build-up of momentum of would depend on the interplay between two factors: the continuous, steady inflow of black money and increased savings (from all wage inflation that Sudhendu Bali talks about in his article) would trade off against the downward pressure exerted by all the the earlier segments wanting to make a slow exit. Any sudden change in the balance of power (the interplay referred to above) would create a disorderly exit, leading to a sharp dip in prices.

Have I explained the sequence of events? To repeat myself, let me give you my famous Jaipur example again. The city has no industry, lives on just three businesses: tourism, gemstones and garments. Why do people buy real estate there? Because outsiders (Jaipur supplies Indian industry with its entrepreneurs and senior managers, who send back their savings to the city, buying their post-retirement real estate) keep buying real estate, which is funded with equity, not debt. These properties never come on the market, even if vacancy levels exceed 50%. That explains why Jaipur has a perpetual real estate bubble for the last 30 years. As the city has got larger, newer segments have had to come in. BPO players and the banks have bought real estate in Jaipur, then the big industrial houses moved in. Now this size of bubble cannot be held up with the flows coming from Jaipur's traditional sources: their domestic industry (tourism, gemstones and garments) and its diaspora.

The short point: anybody who puts his money behind such a phenomenon is not really investing. He is putting his money onto a momentum-driven rally hoping to find a bigger fool. The supply of bigger fools does not seem like drying up any time soon. But this can hardly be called investing. Is there any sensible way you can beat the market in a steady, non-random fashion? Can you really hold on to your gains? You keep rolling over your gains, till you reach one steep, Japan-style deflation in asset values that will take away the wealth accumulated by generations. What did you say? It hasn't happened in India?……….in inflation-adjusted terms, look at real estate in Kolkata over the period 1971-1990.

Hence, real estate investment returns are the mere product of liquidity and savings flows, not their fundamental cashflow generation capability. Investors can be good at predicting the latter, but there is simply no way of predicting accurately the former. If you really want to get rich in a sustainable, non-random fashion, equities are better.