Buy That House … Now!

My second post in as many days and that’s something that doesn’t happen too often. And on a similar sounding topic. But no.

Last night on the way to Jazz, D, driving, asks me, why don’t I buy a house. She recommended a certain “almost south” Bombay property with a going rate of INR21,000 per sq. ft. (approximately USD500). That would typically translate into a cost of about INR 25 million for a decent house. Wow!!!

Now, its not as if I am a novice in these matters. For the last three or four years, with little money in my pocket, and thus an axe to grind, I have been prophesying a crash in property prices in Bombay and other such cities. But now it is unlikely to happen very soon. It is a classic case of markets remaining irrational longer than anyone can remain solvent.

But as a financial markets professional, I am expected to have a certain understanding of basic economics and I would be foolish to ignore the arguments that can be sought in the same to explain the current bubble phenomenon.

(The views that follow are personal)

I know at least 200 people who can afford a house that expensive. Mind you, afford, not simply write out a cheque. The difference between buying a house and buying any other item is that most people often leverage themselves quite easily. Take my example. I have been considering a new car for the last few weeks. However, even though the current choice is considered an expensive car, I am slightly averse to taking a loan to buy it. Thankfully being under-invested I can probably write that damn cheque and drive the baby home after the rains are over. However, if I wasn’t, I would probably have had considered something a little less expensive.

I am not saying people don’t take loans to buy a car, or a computer, it is just that in each of these cases there is an option of scaling down ones expectations, or desires and buying something out of savings. Not so with property anymore.

The problem with property is that one almost always will have to leverage. There are exceptions, but they are about 15 in my set of 200. So when I am borrowing I might as well buy quality, as long as I can foot the EMI. The other problem is that most people I know have little idea on what to do with their money. As the economy grows and we get the best bargain deal on our compensation, the resultant lifestyle leaves little time to consciously deploy that money. So after having burnt fingers with some investments, and dealing with spiraling rental yields, you look to land. So the demand for housing remains undiminished.

The next issue is that of wage inflation vis-à-vis the more commonly discussed consumer/ wholesale price inflation (CPI/ WPI). In India, we are currently seeing an explosion in wage inflation- this in the context of the fact that owing to structural and political policy CPI and WPI are targeted by central banks and kept low. Consider this, while WPI hovers around 4.50 to 6 percent, y-o-y, what are the chances you would settle for that kind of a hike the next time your boss calls you in for a compensation review? Highly unlikely. Such a vast disparity in these two measures leads to what is commonly called flight to quality. At a certain level, we realize that our earnings are growing much faster than our expenses, and hence we need to either escalate the quality of our spending (which is equivalent to moving to a higher consumption curve) or invest. This is a somewhat modified adaptation of the IS-LM model of macroeconomics.

Under a flight to quality scenario, quality housing, say in Cuffe Parade (or downtown Shanghai) is likely to remain expensive even as those in Dahisar are affected by factors such as rising cost of leverage. The cost of leverage is however the same irrespective of where you buy the asset, since the bank is not going to charge a higher rate of interest for property in the former. Quite the other way around, actually as the former is a better security. Moreover, since the people who buy property in search of quality, have a seriously steep forward income curve (i.e. their expectation of what they will earn 5 years from now), they become insensitive to small increases in interest rates (cost of leverage), since if you believe you will earn twice of what you earn today three years from now, you are unlikely to believe that you will run a 20 year mortgage for its entire duration.

Wage inflation is very grainy, different for every layer of society, different for every industry, and so on. Ideally under the wage Price/wage spiral concept of economics, this would lead to demand side inflation, and also pass through of labour cost into finished goods prices and the situation and could be explained very easily, and possible remedied with traditional macroeconomic policy measures. However, the situation in present day India is a little different. The highest wage inflation is in the services sector. The biggest consumer of the services sector is not in India, but overseas. Hence the burden of higher wages is passed on to clients in the US, or say Europe without any follow through effects on local prices.

The situation may reverse under the following circumstances though. First, wage inflation in the services sector becomes so high that India ceases to be a destination for outsourcing. It does not even have to get there. There might emerge a stronger, cheaper exporter of such services. Under these circumstances, wage inflation in those sectors will dip sharply, or even turn negative. Second, taking cognizance of this overheating, the central bank decides to mop up all available liquidity in the financial system. It has happened once before in the 1990s. Under that situation, money will not only be expensive (i.e. high rates of interest), it will be scarce, i.e. people will either run their loans to maturity, or at least be sensitive to its cost, or finally the demand for assets will plummet. Under either circumstances, interest rates in India will head very, very high. So whoever has been talking of overheating of India’s economy, ain’t seen nothing yet.

However, since either of the above two scenarios are unlikely in the very recent future, it is advisable to look up the property section in today’s (Sunday) papers and consider buying that house.

If I sound doomsday-ish and depressive, I shall leave you with this thought carried in the Times today (was read to me). With H.E. Pratibha Patil emerging as the strongest candidate for that big house on Raisina Hill, the term “R...pati” has come under threat. May be we should replace it with “R…patni”. But since that is likely to be a longer debate, let us settle for “R…Aunty” in the interim.