The real state of real estate

There is no doubt that there is a huge demand for all kinds of real estate in India.
Unlike the situation in the developed countries like USA or UK, most people in India still need to buy their first home - their primary residence.
And, for many that do own their first home, there is a huge desire to buy a larger or better home.

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And what passes off for office buildings is mostly concrete junk. Office buildings lack the simple facilities like wide staircases, parking spaces, and breathing areas.

There is little safety or comfort in residential or commercial buildings.
And, yet, the price of real estate in India is way above what most people can afford.

As Table 1 indicates a typical very decent quality building should cost anywhere between Rs 1,000 per square foot and Rs 1,500 per square foot to construct.
A very well-fitted building with high quality tiles or average quality of marble flooring may cost Rs 1,500 per square foot to construct. A more modest building may cost Rs 1,000 per square foot to construct.

Table 1: Typical cost of construction for a residential or commercial building

	Quantity needed per square foot	Cost per square foot (Rs)
Steel	8 kilos	320
Cement	35 kilos	150
Labour		250
Other costs		280 to 780
Total materials		1,000 to 1,500

Then why do we pay Rs 5,000 per square foot for buying property in places like Bangalore, Gurgaon, Pune, or Thane? These are all circular cities with abundant land supplies around them. Every time land "runs out" the city can grow outward and create new city "centres" - like a ring of concentric circles.

South Bombay (like the Manhattan area in the southern end of New York City) is a problem because you cannot really create any new land - though it can be reclaimed from the sea. But the rest of India does not have the geography of south Bombay.

So why is constructed real estate so expensive in many parts of India?
Primarily, because of the cost of land.

Shortage of zoned land
Not that land is in short supply.
As Sam Zell, one of the most brilliant real estate investors of our times, explained to me on a trip to India a few years ago: There is no shortage of land, there is a shortage of zoned land.

Dwell on this statement.

For it is the foundation of a corrupt system which forces the price of developed real estate in most parts of India to be sold to users at prices which are a lot more than what the land is really worth.
Or, rather, what the price of the developed real estate could be worth if the conversion process of land into zoned, usable land was "freely" allowed.

I recognise that land can never be "freely" converted.

There will - and should - always be zoning rules and regulations to ensure that there is supporting infrastructure for all the newly constructed projects that come to fruition. If there are hundreds of acres of development in Powai or Pune or Gurgaon, those areas should have sufficient roads, buses, power, water, schools, colleges, and hospitals to support the human activity around that new development.

But, as buyers of property in these newly developed areas will vouch for, the price they paid for their island of prosperity does not give them access to any necessities. In fact, the few skeletal infrastructure facilities that these projects come with are greeted with sheer joy and ecstasy by the duped buyers.

Land is not expensive in most parts of India.
The powerful and well connected buy land for maybe between Rs 20 per square foot to Rs 200 per square foot from ignorant farmers.
Then they use their political connections (of course, many times the land grabber is a politician!) to convert what was classified as agricultural land into zoned, "sale-able" land.
Some municipalities have development charges (which can be Rs 500 per square foot) for the amenities that they are supposed to provide. Much of that money, needless to say, does not find its way into the purpose it was raised for.

Table 2: The abnormal, super-profits of a residential property in the rising cities

	Rs per sq ft
Cost of construction	1,500
Land cost	200
Land development cost	500
Total cost of project	2,200
Selling price to buyer	5,000
Profit before financing costs	2,800

Developers can also "creep" their way into low priced land banks.
They do this by first buying lands where there is a development charge and then buying the neighbouring lands - just outside the area in which they have these developing charges. In the example in Table 2, they would save Rs 500 per square foot and also get the land a bit cheaper. But their selling price would change by maybe Rs 250 per square foot. This ensures that the developer's average cost of land declines and profits surge. The buyer, on the other hand, ends up paying a high price and gets the same pathetic infrastructure.

Falling over their own greed?
We have no doubt that there is a huge demand for real estate in India.
But my negative view on real estate is based on one known fact: there is a significant amount of corruption in the land acquisition process.
Left to a more "free" market and an improved zoning process, the cost of real estate would decline.

And, unless the governments want to deal with a national Naxalite problem, they would deliver on:

1. providing housing at lower prices,
2. providing the infrastructure around it,
3. controlling the amount of profits that real estate companies make from "arranged" deals of zoning land.

Not that it will happen in a hurry.
Prime Minister Manmohan Singh has shown no courage so far in rooting out the corrupt - or corruption - from his government.
Armed with a wax smile and a mild manner, he is still busy building macro economic policies when the detail is in the micro-corruption.

But greed has played an important role in holding real estate prices down for the past 12 months.
Driven by their own frenzy to get rich quick, the real estate developers have started to build too much property.
The projects under construction are probably 5x what the actual demand will be at the price points being currently quoted.
Drop the price by 20%, and the demand could jump by 100%: still leaving an oversupply of 2.5x.
But drop the price by 40%, and probably every square foot available will be sold out.

The "problem", though, is that all the developers will be bust.

A game of chess
So, rather than let this happen (as suggested in a previous Honest Truth), the government arranged for the Indian banks to bail out many of these debt-laden developers. The arrangement must have been like what transpires when two friendly brothers meet over the dining table.

The surge in the Indian stock markets gave the developers a further respite: some of them were able to sell their overpriced shares and pay off some of their debt.
But they are still leveraged.
And they are still playing "survivor": they are hoping that you will read the trash in the media that makes it sound like real estate is in short supply. It is not.
The ability of the developer to wait out the slow down and tolerate lower volumes at lower prices is in short supply.
This is a game of chess. Of patience.
There is a limit to what banks can lend to the real estate sector.
There is a limit to what people will tolerate.
There is no limit to the attractiveness of the disenchanted towards a Naxalite kind of movement.
Or a genuine uprising.

Companies and businesses built on government favours can disappear pretty quickly.
Companies with no public sympathy can disappear pretty quickly when the monopoly over zoned land is challenged.
And if you happen to be around as a shareholder, remember it took Satyam a few minutes to lose -70% of its value.
If you are an investor in the real estate stocks dancing to this music, stay close to the door.

If you are looking to buy real estate - start asking your local politicians what they are doing about giving you quality houses at prices you can afford.
A flood of letters will not be ignored.
Any break in support from politicians, will cause a collapse in many real estate markets.

Never underestimate the power of the written question.
Or the politicians' desire to stay around for the next elections.
But never estimate the power of corruption to keep you from owning your own home.

It is, indeed, a game of chess.

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Note: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt Ltd and Quantum Asset Management Company Pvt Ltd.. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited. To write to Ajit, please click here.