Real estate is probably the single largest investment in the portfolio of every family across the globe. Most middle-class families invest the maximum amount of money in their residential homes. In many parts of the world, this belief has been reinforced by the fact that houses have exponentially risen in value. Stories of 100 times appreciation over a period of 50 years are not uncommon. However, it is important to note that this nowhere near an extraordinary rate of return. Even if a property has grown 100 times in 50 years, its annual rate of growth is less than 10%! It is lack of literacy about the magical effects of compounding that makes people blindly chase real estate.
The important point is that people look at historical data about real estate and expect the trend to continue. This means that they expect that over the next 50 years the property prices will once again increase by a multiple of 100. This may or may not be true depending upon the specific location.
In this article, we will look at the underlying factors which drive real estate growth.
Factor #1: Zoning Laws
One of the major reasons for the change of price in the real estate sector is the change in the zoning of land. For instance, 50 years earlier, the population was not as much as it is today. Hence, a lot of land was intended for agricultural use. Agricultural land does not have as much commercial value. Therefore the prices of these lands were lower.
As a result, when the zoning laws change and the land is allowed to be used for commercial as well as residential purposes, the value of the land increases. A lot of appreciation over the past 50 years has been due to changes in zoning laws. This is particularly true regarding the locations adjoining megacities. Over time, cities tend to grow in size and as a result, the agricultural land adjoining these cities tends to become valuable. However, many cities of the world have already expanded too much. It is unlikely that they will face more expansion in the future. Hence, what has happened in the past 50 years may or may not be repeated in the next 50 years.
Factor #2: Infrastructure Development
If residential and commercial construction is allowed on a particular plot of land, then infrastructure development also needs to begin accordingly. New roads have to be developed. Also, the livability increases when markets, hospitals and schools are built nearby. The infrastructure development takes a long period of time. This stage may last for close to a decade. However, if changes are continuously visible, then the price of land will keep on increasing
Factor #3: Workplace Connectivity
People are tired of having long commutes. They are not paid for the time they commute. However, the commute certainly does waste some very valuable hours during the day. As a result, millennials prefer to stay in a location which is closer to their workplace. As a result, if a location is close to the workplace, it starts commanding a premium price. The relocation of central business districts to the outskirts of several cities has created the possibility of price appreciation in those areas. However, nowadays people do not buy open plots of land. Rather they buy developed properties. Hence, a lot of the appreciation that accrues because of workplace connectivity is pocketed by the developers themselves. The price at which the apartment is sold often factors in the developments likely to happen in the future. As a result, individual investors do not really have much to gain from increased connectivity.
Factor #4: Network Externalities
Once a location becomes popular with residents, it becomes a hotbed for several social activities. Hobby classes, restaurants, shopping malls, multiplexes etc. start operating in that area. This suits the lifestyle of many people and hence the properties in this residential market start trading at a premium. The more developed a location becomes, the more people want to live in it and prices continue to rise.
Factor #5: General Inflation
Lastly, properties become expensive to develop each year. This is because the price of inputs like cement, steel and skilled labor tends to increase every year. As a result, general inflation makes properties more expensive. If the nominal price of the property is not increasing by 2% to 3% every year, it means that the homeowner is actually losing money in real terms. This is because inflation is increasing whereas the price of the properties is not!