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Forecasting value of a Real Estate Property

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“Real estate is  the safest and most rewarding investment” . This idea has been thurst into our understanding like devine words. No one ever dared to question, fearing it would be sacrilegious, and would amount to utter stupidity till recent financial turmoil.

The assumtion that real estate value increases perpetually was one of the basic mistakes that led to this crisis. Now the fundamental has been jolted, there is a need and urgency to develop a model to forecast house price. How can we understand this variable with other macroeconomic parameters.

Let me digress for a while, for two paragraphs.

What do you think house price would be leading, co-incidental or lagging indicator. To me, at first thought, it should be co-incidental.  Moreover, It would rarely be used as an economic indicator to forecast economy. Real estate market is so illiquid, and data points are so less that it would not be too wise to use it as independent variable. Nonetheless research has shown that there is high correlation between  REIT ( Real Estate Investment Trust) index  and S&P 500 stock index.

Secondly, the most basic logic in favor of perpetual increase in real estate value I hear is that population is increasing, and everyone needs a home to stay, so price of land has to increase, and so of house. There is no denying to this simplistic logic. Simple logic more often than not are the most valid logic, but here there are number of other factors.

Now coming back to forecasting real estate value. It would be better if we first go through common and current methods of valuation of  real estate property.

The four common methods to value real estate:

1: Cost method: here the value is determined by replacement cost of improvements plus an estimate of the value of land. The replacement cost os relatively easy to determine using current construction cost, but valuation of land is a tricky business.

2: Sales comparison method: this method uses the price of similar property or properties from recent trsactions. Prices from other properties must be adjust for chracteristic unique to to each property and market condition. This method requires comparable sales data. If we have good data points, more comprehensive approach would be to go fo hedonic regression, where specific characteristic of properties are quantified.

3: Income method: This method as name implies uses the discounted cash flow model, that is present value of future income.  NOI is net operation income from property, and so value of property is NOI/r ; where r is estimated required market rate.

4: Discount after tax cash flow model. This is variation of above model where we consider marginal tax rate of investor as well. The net present value of an property equals the present value of after tax cash flows, discounted at the investors rate of return, minus the equity portion of the inmvestment.

Now going through all the methods of valuation, it is clear that more than us choosing the method, it’s method that chooses us depending upon the context, situation and availability of data.

Forecasting real estate values won’t be an easy path. We might have to use various methods, make number of assumption. In next post will discuss few common approaches economists have adopted for it, meanwhile pleae let me know how would you tackle this problem.

Written by SK

July 31, 2009 at 1:50 pm

NHB Residex

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Few months ago CNBC TV18 alongwith Boston Analytics launched India’ first consumer confidence index. It was a pleasant news to know, and a sign of maturity of India’s business world. Now today again I am surprised to know that we have a housing price index as well that too from 2007.

The index has been prepared by National Housing Bank. In first stage they prepared index for five cities (Bangalore, Bhopal, Delhi, Kolkata and Mumbai). The base period was 2001. At present NHB residex has fifteen cities with base period 2007, now the plan to prepare index for thirty five cities having million plus population. The details can be found here.

Have a look at the chart below from NHB. It seems that Bangalore has been worst hit by financial crisis.At first thought sounds intuitive.  Export sector is most exposed to sub-prime crisis, and Bangalore’s vein and artery is IT and ITES sector, that does export of services. By the way within Bangalore housing prices in Lavelle Road plunged lowest in Jan-June 2008. Any explanation.

NHB Residex

Zone C is Lavelle Road, D is Richmond Town,  E is Jayanagar and Rajajinagar, F is Madiwala and Banaswadi. Any explanation on why Lavelle road turned out to be so fickle and whimsicle.

Price fluctuation within Bangalore

Price fluctuation within Bangalore

Will write sometime on why Housing price is one of the most important indicator of economy, and how NHB has calculated their index. As of now for methodology refer CS index.

Written by SK

July 29, 2009 at 6:20 pm

Posted in Housing

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