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Why real estate prices are so high

By T N Ninan
April 01, 2006 15:31 IST
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When you hear of flats going in Mumbai at Rs 50,000 and Rs 70,000 per square foot, and housing plots in Delhi's suburb of Gurgaon at Rs 100,000 per square yard, it should be obvious that an asset price bubble is building up in real estate.

As in the stock market, this will look like good news for those who have been holding on to their assets for some time, and dangerous for those who enter the market as buyers at the last stages of the boom.

But whereas high prices for stocks make capital cheap for companies and thereby facilitate fresh investment, high real estate prices have mostly negative consequences for a broad cross-section of the economy. And when we have reached the stage where a premium flat in Mumbai commands a higher price than the average flat in Manhattan (about Rs 40,000 per square foot, after a prolonged boom in house prices), although construction costs in New York are five times as high as in Mumbai, it is time to raise the red flag.

Two issues should get attention. First, it is natural for house prices to climb when the economy is doing well, incomes are rising and interest rates are low. All those factors encourage investment in housing, so demand increases and there is nothing wrong with that. The issue that should get attention is the supply side: What are we doing to ensure that supply grows with demand, so that prices stay reasonable? The answer is: Precious little.

The key ratio to watch is the one that relates construction cost to sale price. The construction cost of most flats on the market today will be between Rs 1,000 and Rs 2,000 per square foot, depending on the quality of work and the materials used.

However, the sale price is usually multiples of that, even in Gurgaon and reflects the value of the underlying land. It might seem logical that there should be land scarcity in India's crowded cities, but the truth is that the scarcity is mostly the result of faulty policy.

In Delhi, for instance, the government and its various arms are sitting on thousands of acres of land, which can and should be thrown into the market so that today's crazy house prices take a knock.

All the land occupied by dead textile mills in central Mumbai, similarly, has been locked out of the market for decades, and is being unlocked only now in slow, small steps.

The second issue is the negative impact of high real estate prices. They lock the majority out of the housing market, and make more distant the dream of owning a home in a country where the majority in our cities are not home-owners, and the majority of home-owners crowd their families into one- or two-room apartments.

The second negative consequence of high real estate costs is that they drive up wages-because it has become more expensive to live in a big city. In other words, the competitiveness of Indian companies suffers.

One reason why Mumbai now has competition from Delhi/Gurgaon and Bangalore is precisely because real estate costs in Mumbai had gone much too high, and companies looked for cheaper alternatives. But if the disease of high house prices were to spread to all of India's 35 million-plus cities (as seems to have begun happening) there is trouble afoot.

What makes the picture move from "unfair" to "grotesque" is the fact that exceptionally high real estate prices exist with poor civic infrastructure and services (and this is the third issue).

This is partly because property taxes are not levied very sensibly, and then not collected very efficiently. The result is that cities are usually too broke to offer even rudimentary services to their citizens-like assured water supply, electricity, an effective law and order machinery, and an efficient public transport system.

The result is that even those who live in expensive homes can never forget that they dwell in a seriously malfunctioning system, and that they are surrounded by an urban mess of monumental proportions.

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T N Ninan
Source: source