Discounting Cash Flows to Value Real Estate

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The privileges that accompany living in the city of dreams are not few. One of the biggest traits I have developed, owing to this city is to question the commerce of everything that goes on here.


One thing that I could never get my mind around was the real estate market and all the postulations surrounding it. I’m of course talking about Mumbai. The houses in Mumbai are the size of a match box. And I’m baffled by the enormous prices attached to these properties that are disproportionately small in terms of floor space.

It’s not just the size of houses that is the issue here, but a myriad of various issues such as open gutters nearby, adjacent slums, poor roads, improper lights, and poor accessibility from major commercial centers, schools, hospitals or restaurants.

The mind, thus, begs the question, are these pieces of real estate really as valuable as they are priced? A simple exercise holds the answer.

In 1938, a text titled ‘The Theory of Investment Value’ was published by John Burr Williams and the concept of intrinsic valuation was presented to the world.

It remains one of the most profound concepts in modern finance.

Warren Buffett, in his Berkshire’s Letters to Shareholders (1992 Annual Report) wrote that: “In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.”

Though, usually used for valuing stocks or bonds or businesses, it is pertinent to note that, Mr. Buffett implies here that, any cash generating asset can be valued using the discounted cash flow technique ~ including my favorite asset: Real Estate.

In a fair market; the prices of assets must gravitate towards its underlying value. I am inclined to believe that, real estate too, must not be priced higher than the present value of cash flows that it produces.

My present home is a 3BHK flat in a slightly premium society in Suburban Mumbai. The rental income, one would generate on this property would approximately be rupees forty five thousand a month.

This translates into an annual inflow of five lac forty thousand rupees.
Let us ignore property taxes, society dues, and other costs, and arrive at an
annual net cash flow equivalent to the annual rental.

Now what would be the value of an asset that generates cash worth five lac forty thousand rupees today? How much would one be willing to pay for it?

The finance guru and a professor for valuation at NYU Stern School, Aswath
Damodaran remarks – valuation is more about a story than just the numbers. The
story of valuation is driven through certain assumptions. Soundness of these assumptions is judged by its proximity to economic reality. It is important that the investor always remains aware of these assumptions. You have been
warned!

In the bid to value my house, I am assuming that rentals will rise by five percent every year for the next ten years and thereafter will rise by two percent in perpetuity. It is ancient wisdom that money today is worth more than money tomorrow. The gap between the two is bridged by ‘interest rate’.

Presently, the lowest rate of interest on housing loans is approximately 6.5%. This is the rate at which today’s money depreciates. Finance wizards like to call this the ‘discounting rate’.

Let us employ the technique presented to the world by John Burr Williams and invariably used by Warren Buffett, to value my home sweet home.

For more nuanced readers, the assumptions are listed down here again:

  1. The net cash inflow from the asset is Rs.5,40,000/- p.a.
  2. Growth rate is assumed to be 5% per year for the next 10 years.
  3. After that, net cash inflow would grow at 2% p.a. for perpetuity.
  4. At the end of the 10th year, the asset would be sold at fair value
    then.
  5. The fair value at the end of 10th year would be derived by Gordon’s
    Formula for valuing perpetuity. This fair value is again discounted at
    PVIFA at year 10 for finding value today.
  6. The discount rate is 6.50% p.a. which is also the yield
    on 10 year G-Sec in India.

This is what the DCF table would look like for the aforementioned assumptions:

Year

Cash Flows

PVIFA

Present Value

1

5,40,000

0.9390

5,07,042

2

5,67,000

0.8817

4,99,901

3

5,95,350

0.8278

4,92,860

4

6,25,118

0.7773

4,85,918

5

6,56,373

0.7299

4,79,074

6

6,89,192

0.6853

4,72,327

7

7,23,652

0.6435

4,65,674

8

7,59,834

0.6042

4,59,116

9

7,97,826

0.5674

4,52,649

10

8,37,717

0.5327

4,46,274

10

1,89,88,257

0.5327

1,01,15,539

 

Value of the Asset

1,48,76,374

 

Thus, the technique employed by the great Warren Buffett would value my house at around one and half crore rupees.


However, the collective minds of Mumbai’s real estate developers, dealers,
brokers, investors, residents and other businessmen have somehow arrived at a whopping price of two and half crore rupees!

The price is 67% higher than the value!

One is compelled to ask if this is a short term gyration between prices
and valuations. But alas no! The bull market in Mumbai’s real estate never
witnessed a correction.

The prices continuously rose for years on and then stabilized but never has there been a decline. And this is not just the case in premium residential complexes. Corporate offices, middle class housing societies, commercial shops, shanties, and even slums have a huge gap in prices and valuations.

It is mind boggling and defies financial common sense. Either
rent is too low here or prices are too high.

Now this raises certain obvious questions such as:

  1. Land is a finite resource and population is ever
    increasing. Doesn’t that mean prices of real estate will always rise?

Response: It is true that land is finite and population is ever increasing. But that should also lead to increase in rentals. And value of properties is derived using present value of future rental incomes. Further, I think the burst of the US Housing Market in 2008 ended the global party and put a sufficient dent in the argument that prices will always go
up.

  1. Are properties really valued using the discounted cash flow technique? Isn’t real estate in Mumbai more expensive simply because it is India’s commercial capital & a financial hub and thus provides huge business and employment opportunities?

Response: It is true that Mumbai provides huge employment and business opportunities. When a person migrates from, say Bihar, and settles in a shanty in Mumbai, he makes a simple calculation.

If he could make five thousand rupees a month in his native village and fifteen thousand a month in Mumbai, he would be willing to migrate only if the cost of living in Mumbai is less than ten thousand rupees a month.


If his cost of living here is higher than the additional income he would make here, he would simply not migrate. The migrant must be left with some surplus in order to incentivize him to travel, stay and weather the harsh conditions.

The rules of economic equilibrium require the cost of living in Mumbai be
substantially equal to the marginal income earned by the migrant which will put an end to excess earning opportunity. This, simply means that the cost of living in Mumbai would approximately be ten thousand a month more than that in Bihar and thus, leaving the migrant with a meagre incentive.

And naturally, when one observes, the cost of living in Mumbai is in fact much higher than that of Bihar.

However, a major chunk of this increased cost of living is incorporated in the rentals that properties command here. And increased rentals lead to increase in valuations.

However, not the entirety of increased cost of living is incorporated in rentals. So we may see a divide in valuations and actual prices.

Anyway, this should not result in a gap of more than five or ten percentage points. And in spite of our valuations stemming from underlying rentals, there seems to be a huge gyration in price and the underlying value.

  1. Can we use some other multiple such as P/E Ratios to value Mumbai’s real estate?

Response: We can use the price to earnings multiple but it doesn’t really make any sense. The global average for Rent to Price ratio is 1:20. This means that rental yields are 5%.

In Mumbai the rental yields vary from 1.5% to 3.5%. In the erstwhile Pagdi system, one would pay twenty years’ worth rentals today to become the owner of the property. Today in Mumbai, this goes somewhere from thirty to sixty years.

This begs the question, why is real estate in Mumbai so expensive?

Honestly, I don’t know. But the following are my guesses:

  1. Falling interest rates: Interest is the cost of borrowing money. When rates go down, money becomes cheap. Cheap money has a tendency to push asset prices higher.
  1. Politician-Developer Nexus: Either the politicians have their own construction businesses or are in deep pockets with big builders. I think it is an open secret that most politicians have almost unlimited supply of money and can leverage their balance sheets to humongous levels through some questionable practices.
  1. Psychology of the Buyer: This, I think is the most crucial factor in understanding the irrational behavior of this market. Owning a home is everybody’s dream. A home is a social status and a matter of great pride. Living on rent is frowned upon and tenants aren’t treated
    as equal members in most co-operative societies.
    Further, most fathers
    wouldn’t hand their daughters off to grooms that aren’t paying EMIs on booked flats. It is deep-rooted in the mass psyche that a home is the greatest asset one can create and since prices always go up, a safe investment. It is considered to be the retirement pool and a
    source of generational wealth. Thus, the intrinsic value of a house is not just the monetary value it holds but also the emotional value it carries.

All said and done, this is my outlook for future:

Real Estate market has been facing tremendous strain for a long time. In 2015, the Real Estate (Regulation) Act, (RERA) was implemented to put a check upon construction malpractices.

On 8th November 2016, the Prime Minister scrapped a major chunk of hard cash which was historically parked in real estate and invariably held by many developers.

This move sent jitters across the whole real estate market. In the same year, The Insolvency & Bankruptcy Code was enacted which recognized flat buyers as operational creditors, further restraining the developer’s power. 

On 1st July 2017, the Goods & Services Tax (GST) came into force and brought real estate under its purview, which further discouraged a prospective buyer. The developers have been leveraged to neck since a long time now. Colossal projects are held up unfinished due to either legal disputes or lack of financing.

A huge inventory of completed flats piled up and not many buyers are willing to touch them at present prices.

And now the Covid-19 crisis has pushed the whole world into an inevitable recession. Would this be the last straw leading to the collapse of the proverbial camel? Let’s wait and watch.

 

Also Read on FinMedium:  Intelsense Capital Blog: Weekend Reading

Post Script:

Readers with non-finance or non-quantitative backgrounds may read this article to obtain a lucid explanation on discounted cash flow calculations.

Chartered Accountants & MBAs who may want to audit the above DCF Table, may find the calculation sheet in an Excel file here 🙂

Cover Image: Corporate Finance Institute

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Saurabh Dwivedi
Mind | Musings | Markets
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