Do you know your home's PE ratio?

Property prices have zoomed in the past three years, but rentals haven’t kept pace. Here’s what that means for your real estate investment.

By Babar Zaidi | Print Edition: November 30, 2006

There’s some good and some bad news for investors in property. The good news is that real estate prices are expected to keep going up even though the climb will not be as spectacular as in the past three years. The bad news is for those who intend to rent out their property. Rentals have not moved up as fast as prices, pushing down rental yields (the percentage return from the investment).

Those who buy property as an investment—as different from those who buy to live in it—usually expect a twin benefit: a steady rental income and a rise in value. The ratio of the rental income to the price of the property is the rental yield. If a flat worth Rs 30 lakh fetches an annual rent of Rs 1.2 lakh (monthly Rs 10,000), its rental yield is 4%. Many landlords would be content with such returns. Especially if they expect the rent to finance a large part of the EMI of the home loan for the property.

But the steep rise in property prices has upset this equation. In Indirapuram, on the outskirts of Delhi, property prices have more than doubled in the past three years but rentals have increased by only 30-35%. So, a flat purchased for Rs 15 lakh in 2003 is now selling for Rs 36 lakh. But it now fetches a rent of only Rs 84,000 (monthly Rs 7,000). That pushes down the rental yield to 2.3%. It is not too attractive a return for those buying the flat for Rs 36 lakh.

Why haven’t rentals kept pace? It’s not as if there has been a drop in the demand for rented accommodation. Only that property prices have risen too high too fast, and to a lesser extent so has the supply of new houses. In some overheated pockets, such as Gurgaon and Noida near Delhi, the rental yield is down to 2-3%. A luxury condominium costing Rs 1 crore fetches a rent of Rs 20,000-25,000 a month. An independent house priced at Rs 2 crore will bring in Rs 30,000-40,000. The situation is no different in other cities where a large supply of residential housing has either just entered the market or is nearing completion. Rental values have risen marginally or have remained flat in the past two years. In the stock markets, the dividend yield of a share falls as its price rises.

A low dividend yield signals that the share is overvalued. More than the dividend yield, it is the PE (or price to earnings ratio) of a stock that is more widely used to determine a share’s value. Divide the earnings per share (EPS) with the current price of a share to arrive at the PE of a stock. Usually, a high PE means the share is overpriced; a low PE means it is cheap. To some extent, the same method of valuation could be extended to the realty market. If a Rs 50 lakh house is earning Rs 1.2 lakh a year as rent, its PE will be over 40. That’s dangerously high.

Right now, when the stock markets are at an all-time high, the average weighted PE of the 50 shares on the Nifty index is less than 21. It seems unlikely that rentals will move up in a hurry—at least not in upcoming residential areas. A massive stock of houses is under construction in almost every city. Over the next two or three years, some 245 million sq ft of residential space will be ready in just the six metros. A good percentage of these houses will be available for rent. Of course, there are pockets of exceptions in this trend. It is only in the suburbs and newly developed areas where rentals have not moved in tandem with real estate prices.

Areas within a city where there is no fresh supply of housing— fully developed areas or those in the central part of cities—continue to see higher rentals. Similarly, there are areas where the location advantage overrides other factors. For instance, an infrastructure improvement (a new bridge, road or train station) can make an area more attractive to those seeking a house on rent. Barring these exceptions, if you plan to buy a house for investment and hope for a monthly flow of income in the form of rent, you are better off checking other investment opportunities.

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