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GMO on Real Estate Cycles

GMO has a great report on Real Estate and what drives it. They say that the drivers are:

  • Demographics: More people, more demand. More people into cities, more city home demand. But at some point if construction grows more than the demographic change, we end up with oversupply. People move, and that causes pockets of demand and supply.
  • Pyschology: People like to earn the truckloads of money their neighbour made in real estate. Enough said.
  • Availability of credit: When credit is easy, demand goes up. In tough times, even though money might look easy (like the US today) lenders tighten their lending criteria.
  • Governments do things that increase demand. Building new infrastructure like bridges or airports or roads will change real estate demand patterns. When the govt has little to spend, demand slackens.
  • Global cycle: “When New York sneezes, London catches a cold” – a phenomenon that has recently replaced by “decoupling, my boy, decoupling”. But in a crisis all correlations go to 1 – everyone catches a cold and everyone sneezes.

It’s a great read and talks about how you might be able to identify a peak of the RE cycle. Let’s look at India:

  • RE Valuations more than 2SD above long term trend. I don’t have a long term trend but prices have doubled in the last four years, which seems to me like way above normal. (Check)
  • Above trend credit growth: The last four years have seen credit growth above 20% a year, which is definitely above longer term trend. Yet, not enough of this is mortgages, and we just kinda-sorta came into the liberalization period since 1992, so it might not be enough info. Still, Check.
  • New fangled instruments: Floating rate loans linked to every changing BPLR numbers, teaser loans, builder financed EMIs till possession…Check.
  • High levels of construction. Oh, Check.
  • Rising Vacancy rates: Don’t know. They don’t seem that bad in Gurgaon or BLR. No check.
  • Speculative purchases: Three cities I’m familar with – Mumbai, Gurgaon, Bangalore – Check.
  • Measures to dampen speculation: RBI increased home loan provisioning and reserves, teaser rates get more capital allocated…Check.
  • Rising Interest Rates: Oh yes, Check.
  • Credit Crunch: One year G-Secs are higher priced than 10 year bonds; this points to a small issue with near term liquidity. Not yet a credit crunch but the rate we’re going, we’ll get there.(half check)
  • Defaults on existing property loans: We’ll know in a few quarters (because NPAs can take upto 6 months to be recognized) The grapevine says that there is negotiation going on already. (half check)

And a neat little graph:

image

(Read the full article)