Real Estate Psychology

I am currently in India enjoying my vacation. Couple of weeks back I met my friend who lives in Keelkattalai, Chennai. Near his place there was a new apartment complex that was being constructed. When asked about the price I was told that it costs Rs 6,200 per sqft.

At this price if you want to buy an apartment with 1000 sqft of carpet area then you will pay around Rs 85+ lakhs. Well if you multiply 6200 * 1000 you should get only Rs 62 lakhs. How did I arrive at Rs 85+ lakhs? It turns out that if you want to buy an apartment with a carpet area of 1000 sqft then you will actually pay for 1250 sqft (1000 / 0.8). Why? Builders charge you for super built-up area and in general carpet area will be 80% of super built-up area. The definition for carpet area and super built-up area is given below. You can get more information about this here.

Carpet area is the actual usable area of an apartment minus wall thickness. Carpet area is the area enclosed within the walls, actual area to lay the carpet. This area does not include the thickness of the inner walls. Built-up area is the carpet area plus the thickness of outer walls. Super built-up area is the built up area plus proportionate area of common areas such as the lobby, lifts shaft, stairs, etc.

So 1250 * 6200 comes to Rs 77.50 lakhs. To this add car parking, electricity, and registration charges and you will get at least Rs 85+ lakhs. Many of the buyers do not know and nor care to know about the difference between carpet and super built-up area. Also builders do not call this out explicitly and exploit gullible buyers by using availability bias. Remember you do not see what is not there in front of you.

What do I get from this Rs 85+ lakhs apartment? Before we find out what we get let us see what we do not get. There are few issues (1) roads leading to this property is not great (2) lack of proper water supply (3) you will have frequent power cuts. Also there is an opportunity cost. You could have invested that Rs 85+ lakhs elsewhere to earn a decent return. As of today you can invest this in fixed deposit at 8.5% interest. This translates to an income stream of Rs 60,000 per month. With this amount you need not work for someone and instead work for yourself.

Now let us look at what we get from this apartment. You can live in this apartment and raise a family and enjoy your life. This is a life style decision with emotions attached and hence I do not want to quantify this. Let us now look at this from an investment angle. The natural question one should ask is what is the return on invested capital? I can rent out this apartment and earn Rs 10,000 per month. This translates to a return on invested capital of 1.4%. This is without considering any operating costs. This is an awful return. But real estate also appreciates in value. Let us assume that price and rent increase at 10% and see what we get. If this assumption has to materialize then in 10 years the property should sell for around Rs 2.2 crores and rent per month should be Rs 25,937. Is this possible?

For this to happen there should be buyers. Let us assume that there are buyers willing to take loan to buy the property. They need to make a down payment of Rs 44 lakhs (20% down payment on Rs 2.2 crores) and if we assume that they take a home loan at 8% for 20 years then they need to make a monthly mortgage payment of Rs 1.5 lakhs.

To afford that payment a family needs to earn at least Rs 3 lakhs. Why? Remember they need to eat, send their kids to school, and take care of medical and other expenses. How many families can earn this much amount of money in that area in the next 10 years. I seriously doubt if they can. Why?  Everyone cannot be above average. On top of this why would someone buy a 10 year old property at the market price. Apartment depreciates in value. So you should consider lucky if you get 75% of market price. Also you cannot increase the rent 10% every year. Why? The tenant loses money and he will operate under deprival super reaction syndrome.

In spite of so many challenges why do so many people commit huge sums of money in real estate? This question can be easily answered using models from psychology (1) Everyone is buying it and hence it has be correct [ social proof ] (2) The price is going up and let me buy before it is too late [ scarcity ] (3) Those who already bought made a lot of money [ envy and jealousy ] (4) Real estate  always went up in value [ not considering negative black swans ] (5) My boss is buying and celebrities are recommending it in advertisements and hence it has to be correct [ authority bias ] (6) There is no price transparency and  brokers are incentivized to increase the prices artificially [ incentive caused bias ]

Is there a way to overcome these biases? Evolution has programmed these biases as it helped our ancestors to survive in the savannah 100,000 years ago. Depending on these biases in today’s world for taking major financial decisions is dangerous. We should learn how to train our minds to fight our own biology. Charlie Munger in elementary worldly wisdom tells

By and large, as it works out, people can’t naturally and automatically do this. If you understand elementary psychology, the reason they can’t is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it’s not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It’s got elements of Fermat/Pascal in it. However, it’s not good. So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

The best place to start training ourselves is to read Innumeracy and Munger’s psychology of human misjudgments.