Irrational Exuberance – Gambling on Pakistani property market

The last three years have seen an unprecedented bull-market with asset prices quadrupling in certain sectors. Pundits are falling over themselves affirming bright prospects for investment opportunities and economists are scratching their heads to explain the phenomena. News bulletins are teeming with self-proclaimed gurus churning out research justifying the stratospherically high asset prices. Internet chat-rooms and drawing room conversations are buzzing with references to those shrewd investors who made a killing buying and then selling within a matter of months.

Sounds familiar?

You might think that I am referring to the current real estate market in Pakistan. In fact, the above scenario paints the picture of the dot.com boom shortly before the stock market bubble burst on 10 March 2000. Nevertheless, the similarities between the two are incredible and the lessons to be learnt are obvious.

In late 1990s when the dot.com boom reached frenzied levels, stock investing became a wideepread American obsession. Astronauts, doctors, garbage collectors et all discussed with great enthusiasm their latest trading strategies. Star-analysts such as Jack Grubman of Citigroup became household names while those who advocated a cautious approach were ridiculed for their apparent lack of vision! When Cisco Systems, a telecommunication-equipment manufacturer and darling of the dot.com investors, achieved market-capitalisation of $500 billion pundits confidently predicted that the company will grow 40% year-on-year for the foreseeable future and it was just a matter of time before Cisco becomes the first $1 trillion company.

Last year, Cisco Systems grew a miserly 13%, not the stellar 40% and its market-capitalisation was a lowly $ 110 billion, still bigger than the GDP of Pakistan, but not quite the $1 trillion zealously predicted by the so-called experts. Jack Grubman lost his job and faces multiple lawsuits for misleading the investment community. The legendary investor Warren Buffet, who was spurned for questioning the validity of the dot.com stock valuations, survived the collapse with his reputation untarnished.

Eight thousand miles away and a few years down the road, investing in real estate has become a national craze in Pakistan. On a recent trip to Pakistan, an acquaintance forced me to accompany him to a dream investment opportunity! I waited in anticipation as our 4x4 crossed the boundary of our city and raced ahead on the Grand Trunk Road. Massive real estate projects were marked on both sides of the highway– first it was Defence, followed by Bahria and so many others that I lost count. Suddenly, we took a turn and the vehicle jumped and jolted as it made its way on a beaten-down track. Finally after a while the 4x4 stopped with a thud. At last I could see for myself the great investment dream that had made so many millionaires and now it was going to be my turn! Barely controlling my excitement, I leapt out.

Once on ground, the first thing that struck me was the vast span of barren and desolate land that surrounded me. Not a single man-made structure in sight. The dead of the silence was occasionally broken by a donkey’s hee-haw; the poor soul too must have been feeling lonely in the middle-of-nowhere! I was informed that land in this development scheme had doubled in the last six months and one-kanal plot commanded a price-tag of Rs. 6 million. Vow! as I remembered that only three years ago, a built-up house in a decent locality within the city could be purchased for this handsome amount instead of undeveloped land more than 5 kilometres from the city’s boundaries. In addition, with mechanics of supply-and-demand severely skewed in favour of supply and dozens of similar land schemes being developed or in the process of getting approval, who would want to buy such speculative investment? It’s apparent that this point of view is in minority as land deals are executed at a frenetic pace.

However, a price-tag of Rs 6 million seems like a bargain when compared to the dizzying and gravity-defying prices in Islamabad. So high are the valuations, that it seems that Islamabad is not the capital of Pakistan but that of England with a house in some sought-after sectors putting you back by as much as Rs.80 million, an amount that could buy you a five-bed fully detached house in London’s financial district of Docklands!

To understand how absurdly high property prices are in Islamabad, one has to compare wealth generation or net worth of the two cities. London is the world’s second largest financial hub with an estimated Gross Domestic Product (GDP) of $350 billion and GDP per capita of $44,000. Compare this with Pakistan’s total GDP of approximately $90 billion. If we are extremely generous with Islamabad and assume that it generates a disproportionately high 15% of the entire country’s wealth, even then the city’s GDP per capita amounts to $16,000, about one-third of that of London. With this glaring difference in wealth per capita of the two cities, how is it that house prices in Islamabad are comparable with those in London?

Die-hard proponents of the property boom will retort that Rs. 80 million will buy you a 1250 sq. yard house in Islamabad, while the property in London will be at the most a quarter of its size. Ah ha, but then we are talking about Docklands, an exclusive district boasting the second highest concentration of elite financial institutions after Wall Street in New York. Although Islamabad is a beautiful metropolis it is hardly a match of London, a city of unparalleled historical significance and a melting pot of different cultures. No matter what the soothsayers claim, there can be no rational basis for Islamabad’s property prices to equate with those of London!

Also, a property’s value is rooted in its ability to generate return for its owner. If the return on property is below that on comparable or alternative investments then it indicates that property is over-valued. This is because investing in alternative assets would generate greater return for the investor and therefore demand for these alternative assets should rise relative to that of property. Economic theory dictates that as demand for property declines, price adjusts downwards until property’s return comes at par with other assets and thereby equilibrium is restored.

Currently, net rental yields in Islamabad are running at under 3%, whereas a comparable investment offering similar risk-reward profile, for example National Investment Trust units (NIT), have dividend yield in the range of 9%. Therefore, it makes economic sense to sell property and put cash in the NIT to earn an extra return of 6% per annum. This discrepancy between the dividend and rental yield has one serious and obvious implication for Islamabad’s property prices - they are overvalued! Either rents have to triple or property prices have to go down by two-thirds in order to bring the rental yields in line with return on other comparable investments. All right, the correction might not be that dramatic but you get the picture. Simple mathematics reveals the irrationality of the real estate bubble.

However, Pakistanis should draw comfort from the fact that we are neither the first nor the last ones to succumb to such bouts of irrational behaviour. In early seventeenth-century Netherlands, demand for tulip-bulbs became so frenzied that prices shot up tenfold in just one month. The more expensive the bulbs became the more people viewed them as smart investments, similar to what’s happening in the property market today! In the end, prices became so high that some people sold to lock-in their profits. As others followed suit, selling pressure intensified and panic reigned. Even government intervention could not halt the slide in tulip-bulb prices, eventually selling for no more than the price of a common onion – sanity eventually prevailed.

Such events are not confined to ancient history, but have frequently happened in recent past as well. In early 1920s, stories of investment doubling or tripling attracted speculators to the real estate market in Florida. Just like today, easy credit terms added fuel to the speculative frenzy. Just like today, real estate developers opined that prices can only go up. At the peak of the property boom, there were seventy-thousand real estate agents in Miami, one-third of the entire population of the city! Eventually, the boom became bust with investors losing their lifelong savings.

These events show that markets have a painful yet efficient way of correcting any excesses in asset prices. A vacuum cannot exist in nature, similarly asset prices cannot stay at inflated levels forever and they will always revert to their fundamental or intrinsic value. That is why we have seen periods of phenomenal growth in prices of tulip-bulbs, real estate in Florida or dot.com companies, but in the long-term valuations always come down to the asset’s true worth. When this correction takes place, it is an extremely painful process and is generally accompanied by a prolonged recession. Therefore the property bubble could also pose a serious challenge to the country’s macro economic stability.

There is a saying on Wall Street; markets are driven by emotions of fear or greed. At the moment, the pre-dominant emotion is greed, but it takes just a trigger for this sentiment to change to fear. Investors on NASDAQ stock exchange experienced this first-hand in March 2000 when the index tumbled by more than 10% within a few hours. My counsel will be to learn from the mistakes of the dot.com investors and those before them; like all spates of irrational exuberance, the property prices will reverse sooner-or-later!