House prices have risen rapidly in India in recent years. There is now a lot of uncertainty as to whether the present level of house prices is sustainable.

Anecdotal reports in the press talk of an on-going correction in real estate prices - both residential and commercial. It can be said that such corrections have not assumed the proportions of a widespread or omnibus price fall in the asset category itself as has happened in the case of equities. Overall, while prices in some localities (and some buyer segments) have corrected lower (by up to 15 / 20 per cent), it remains to be seen if this will extend into a more severe and general correction in house prices.

But, in the backdrop of rising economic uncertainty and volatility - evidenced by the slowdown in overall economic activity, high inflation, stiff interest rates and a general decline in risk appetite marked by considerable downward corrections in other asset markets such as equities - it may be important to examine whether the house property market (and broadly the real estate market) could stand out and remain unaffected.

The accompanying table shows the price trajectory of both land and built-up space in Mylapore, a prime residential locality in Chennai city. The level of prices and the rate of price increase in other residential areas in Chennai may be somewhat lower than that registered in Mylapore in the past decade, adjusting for differences in accessibility/amenities, etc. Like in Chennai, vigorous house price increases have been noted in other cities also in the past few years.

House prices in relation to fundamentals
The fact that no two houses are identical and the relative infrequency with which a house property is traded make house price measurement and monitoring movement in the prices somewhat more difficult when compared with identical assets such as corporate equities. Prices of house property, nevertheless, should bear some relation to or be a function of fundamentals such as the level of returns the asset generates, the level of household income and the cost of construction.

If house prices are out of kilt with the level of household income or the cost of construction, they will have a vitiating impact on affordability and demand and may then have to correct lower. Again, if house prices are out of line relative to the cash flows (or earnings) the asset generates, they could be vulnerable to a correction like in the equity markets. In this context and in a limited sense, the house price-to-rent ratio is somewhat analogous to the equity market's price-to-earnings ratio. In a broader sense, the house price-to-rent ratio will also be a function of the capital gains expected from the asset.

We present below an analysis of the level and movements in house prices in Mylapore in the past 2 decades (Mylapore being taken as representative of many of the inner city residential areas in other metros in the country) in relation to the fundamentals indicated above - level of household income and cash flows (rent) generated by the property.

As the charts depict, house prices in Mylapore have risen significantly faster than average household incomes as well as average rents.

(All the charts are based on inflation-adjusted data in order to remove the effect of the general increase in price levels and study the impact of the interaction of ‘real’ demand and supply).

Prima facie, it appears that affordability should be under considerable strain now if the large gap between house price growth and income growth indicated by Chart 1 is any indication. House prices have increased almost 20 times whereas income has grown only by around 2 times, both relative to the base year of 1990. This inference, though, may have to be qualified on account of the following -

a. The household income considered for the study is the average income of the urban population of Tamil Nadu which disguises the fairly large differences in the distribution of the urban income. (The average income of the urban household has been estimated based on the overall GDP, the share of the non-agricultural and urban sector in the GDP and the size of the urban population. Tamil Nadu's urban population as a proportion of total population at 45 per cent is also much higher than the national average of 30 per cent. This will have the effect of lowering average urban household income).

b. That there are significant distributional differences is clear from the latest statistics of the National Family Health Survey 3 (NFHS 3) which shows that 50 per cent of the households in Chennai are in the highest (top 2) wealth quintiles compared to 34 per cent of households in other urban areas of the state. The average household income for Chennai, therefore, would be higher than that depicted here. (Further, the NFHS 3 shows a similar level of differences in income distribution in the other metros also).

c. The median household income for Tamil Nadu and Chennai would clearly be a better indicator of the average household income. Given the distributional differences shown by the NFHS 3, the median income is bound to be several notches higher. To that extent, the affordability ratios will improve and support house prices.

Rental growth has been strong
But, what is clear from Chart 1 is that rental growth has been quite strong. Inflation-adjusted rents have increased almost 13 times compared to a growth of 20 times in ‘real’ house prices, relative to 1990. The absolute value of annual rents, though, is still small relative to the level of house prices. The resultant house price-to-rent ratio therefore appears to be ‘high’ at around 40 (Chart 2). But what is possibly sustaining the ratio at these levels is the prospect of the recent high growth rate in cash flows (rents and in a broader sense capital appreciation) from the property being sustained.

The popular equity valuations model shows that a high rate of growth in earnings combined with low and declining interest rates and low risk premium can support high asset prices. House prices, particularly in the major urban agglomerations in India, appear to have been influenced by the phenomenon of high expected growth in earnings and low/declining interest rates.

High earnings growth and falling interest rates, though, cannot account fully for the rapid increase in house prices. The housing risk premium would also need to have fallen sharply in the last 7 or 8 years to support the present level of house prices.

But, like in the equity market, the housing risk premium is quite unobservable though it is possible to make some inferences about how this risk premium may have evolved. High economic growth, increasing levels of income, greater financial sector development, higher and easier availability of finance - all noticed in India in the past few years - may have reduced the expectations about future economic shocks and the level of economic uncertainties. These, in turn, may have resulted in property buyers demanding a lower risk premium for buying / investing in house property - that is, becoming less risk averse.

What about prices in suburbs / fringes of cities?

It is not that the demand factors enumerated above - the fairly long economic expansion, high income growth, lower interest rates, higher confidence and lower risk premium - have supported housing prices only in the cities. They have played a part in boosting real estate and housing prices sharply even in the outlying suburbs. For example, it is not uncommon for developers to be quoting something like Rs.3000 per sq ft of a residential apartment in a Chennai suburb which is at least 40 kilometer from the inner city and which does not possess many of the amenities which one takes for granted in the cities. It is interesting to note that prices in Mylapore itself were only around Rs.3000 per square feet some 3/4 years ago.

One would feel that supply factors - mainly land availability - would operate more forcefully in the suburbs and fringes of the cities so as to have a restraining influence on house prices. In principle, the price of housing in the suburbs should be close to its marginal cost - which will be the cost of construction + land development costs + cost of raw land. Assuming that there are no restrictions in supply of land (as is the case in the cities), the price of raw land in the suburbs should be tied reasonably closely to its value in alternative uses, such as agriculture. So, unless there has been a marked increase in the value of this land when used for other purposes, the greater supply of land in the suburbs should have moderated the increases in house prices there.

But industry representatives have pointed out that land prices on the OMR, which was around Rs.1 crore per acre some 5 years ago, zoomed to the Rs.15/20 crore range a couple of years back. So, the run-up in house prices is explained not only by demand side factors but also possibly by supply-side constraints relating to land usage. While the demand factors may dominate in the inner cities and suburbs closer to the cities, a combination of high demand and some supply restrictions are possibly influencing house prices in the outer suburbs / fringes of the cities.

Lower demand may lead short-term correction

Though the assessment of affordability - in the case of Chennai and other metros - may have to be qualified because of the factors listed earlier (the distributional differences in income etc), it is still the case that the present general level of house prices are way out of the reach of people in the lower income / wealth brackets who may clearly be a numerical majority also. High house prices pose problems both for renters - who may have to earmark a high proportion of their monthly incomes to paying rent and consequently cut down on other spending- as well as to prospective first-time house buyers whose income levels may not place them in the higher income / wealth brackets.

Given the interplay of the forces of demand and supply, it is clear that government has a role here in adopting such policies as would moderate the demand pressures as well as improve the responsiveness of supply to demand. Such policies could reduce the ‘average’ house prices over future economic cycles and improve the general level of affordability. But like in many other segments of the economy, supply responses tend to be structural and therefore take more time to come through.

For the short term, it is clear that policies that just give people more money to spend (an off shoot of the fiscal expansionism and loose monetary policies which have been followed in India) are most likely to be capitalised into higher housing prices or higher prices for other assets. The correction, therefore, in housing / real estate prices, in the short-term, is more likely to come through from the demand side as the economy slows, income growth moderates, interest rates turn volatile and financing becomes difficult - all of which may result in a higher level of risk aversion and lower demand.