Identifying a real estate bubble

Property prices

Real estate prices depend upon a number of local factors. For example,property in a locality that has good roads,power and water will command a higher price than one without these basic amenities. The property market in India is not homogenous. In fact,even within a city there are areas where prices rise faster than others. Therefore,I believe that many local factors should be taken into account and a pan-India view is quite out of place, I replied.

But real estate prices also depend upon the state of the countrys economy,and if the economy continues to do well prices will keep rising, said Vikas.

But there will be a limit to how much they can rise,isnt it? Kavita enquired.

What is a bubble?

The economy does play a role in creating demand for housing. However,beyond a certain point,other factors contribute to the irrational rise of prices and the creation of a bubble.

Some indicators do exist that can warn us of a bubble in real estate prices. To understand these let us first examine the cause of a bubble. A bubble is essentially unrealistically high real estate prices that are not sustainable. Investors who buy at these high prices suffer losses when prices fall.

Property prices are broadly decided by demand and supply. If demand increases faster than supply property prices will rise. With the population growing and work opportunities multiplying demand for housing in most cities keeps rising. Demand can be from genuine home buyers who intend to reside in that apartment or from investors or speculators.

The primary reason for a bubble is speculation in property markets. The formation of a bubble takes some time. Initially,there is a genuine demand for new housing. As more and more people buy houses to live in,the price of real estate begins to rise. To take advantage of this rise,speculators enter the market. They start buying properties not to live in,but to make a quick profit by selling them at higher prices a few months later. This cycle is self perpetuating. As more speculators enter,the demand for apartments increases although there is no genuine use for them. This causes prices to rise to stratospheric levels. Buying property at this point is dangerous because artificial demand by speculators cannot sustain prices in the long run, I said.

But how would we know if the apartment purchasers are speculators? Savita queried. Vikas nodded at Kavita.

Indicators of a bubble

We really do not need to know the names of all the buyers and the reason for their interest in the property. If the interest in a locality is for genuine housing,you will find that most apartments are occupied. On the other hand,if there are many vacant apartments in the area it would indicate that most of the purchaser have been met by investors or speculators. If you walk around the locality at night and observe the number of apartments that have their lights on,it will give you an idea of the number of occupied apartments.

Another indicator of excessive supply is if rents in the area are falling. When there is an increase in speculative purchases a number of apartments are vacant. This causes rents in the area to fall although property prices continue to rise.

In summary,two indicators of excessive supply and the formation of a bubble are decrease in rents in an area and increase in the number of unoccupied apartments, I said.

Savita thanked me for my inputs. Vikas shook my hand and left. His mood was a lot more sombre. But knowing him he would be back to his over-confident self before they reached the elevators!

The author,a certified financial planner,is the chief executive of Sardesai Finance. ceosardesai.com