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Commentary

The Non-Universal Price-To-Income Ratio

Often, to figure out if a country is in a real estate bubble, what is measured is a price-to-income ratio. That is, a house price divided by the income of the buyer.

Typical P-I ratios, in 2007 in the US, went from 9.5 in New York to 6.2 in San Diego (and 0.9 in Detroit). The overall price to income index with a base of 1987, was at 1.6 in 2007 which has fallen to less than 1.1 (according to Calculated Risk). Consider that the base of 1987 means the ratio is a multiple of what it was then. (which I don’t know)

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Shanghai, in March 2010, was 27:1.

So price to income ratios can be confusing. Is 6 too high? Is 1 too low? But there is no universal answer. There is also no reason for there to be one universal answer.

1. Consider that houses are financed. Most buyers finance their purchases.

2. Consider that mortgages cost money in terms of interest and principal. This money has to go from a person’s income – and he has to have enough left over to feed his family.

3. The term of these mortgages differs with countries; the US offers 30 year loans, India goes to about 20.

4. The interest rate is the most important factor.

The recent US mortgage crisis has made lenders wary of lending to someone where the monthly payment is more than 38% of the monthly gross income before taxes. In India, lenders stretch up to 40%, I’m told.

Now, let’s consider a person earning Rs. 200,000 per month. This guy’s rich.

Income: 200,000 per month

Taxes: 50,000 per month.

Mortgage potential: 80,000 per month. (at 40% of monthly income).

He’s left with Rs. 70,000 which, because he’s rich and can afford it, spends much of it.

But what kind of house can you get for Rs. 80,000 per month? Assuming rates of 12%, the maximum loan of Rs. 72.65 lakhs. At a 20% downpayment the house can cost Rs. 90.6 lakhs.

This is a price-to-income of 3.77.

If Interest Rates go up to 13%, by the same calculation the highest price one can pay is Rs. 85 lakhs, for a price-to-income of 3.56. The P-I ratio changes based on mortgage rates and terms.

Now consider you’re not that rich. A person earning about 50,000 per month can’t really afford to pay 40% of income, because after that and taxes, what’s left over is too little. With the the P-I ratio will further reduce.

I don’t have a definitive source for Price-To-Income ratios in India but in the outer edge of Gurgaon, they seem to be around 5. A lot of these houses are speculative (i.e. not financed) and run with black money, but at some point, the greater fool will need to have a bank loan. It seems like an enormous bubble to me – especially as similar ratios in countries with much lower mortgage rates resulted in a bust. We’re even more stretched.

  • Sanjay says:

    It is wrong analysis. Loans go bust when downpayment is close to 0%. In India, downpayment is 20%. A person would never invest so much money just for speculation.
    If you want serious buyer, increase the downpayment requirement even more.

    • I don’t think you admire the amount of sheer speculation in the real estate market 🙂 Even with big downpayments people tend to default, when property prices fall below “Loan Value Minus Downpayment”. If a person pays 1.5 cr. for a property and the price falls to 90 lakhs, his 20% downpayment is of little use.
      Of course, some people will say prices won’t fall that much. But that is matter of opinion.
      You are right though, that higher downpayments should see lower defaults, because there is a cushion. Like the ‘black’ component of a sale is a cushion. Cushions only work if the force pushing them isn’t so strong it can break through.

      • Venkat says:

        Hi Deepak,
        While banks claim they fund uto 80%, it only considers basic agreement value. Society charges, parking, utilities, maintenance deposits all are to be paid by the individual. I recently concluded a deal where the bank loan of 80% actually translates to only 70% (and lesser, if I take into account interiors costs).

        • Sachin says:

          You are considering only Home Loans. I know few peoples have taken personnel loan to cover for remaining 20% house cost which is absurd but its fact.

  • Kaushik says:

    40-50L apartments are selling like hotcakes nowadays. Reason is in most of the cases husband-spouse both working and usually even if one is stretched theoretically as you are saying,the other can cushion. Banks always have that in mind even if they dont say on paper.
    Yes we have not seen the realestate bust,but then again we may not see it until US changes its pro status about offshoring.The way I see it,indian economy is solely balancing its weight on one pin-I-offshoring. A slightest touch of protectionism, and you will see how it breaks downs to pieces.Real estate will be a petty brick from 10th floor.