The Impending Demonetization of Real Estate

Real estate will lose its premium in the next two decades

Why do people invest in real estate? Why is it even called an investment and not a purchase? No one asks these questions because it is conventional wisdom. Just because something is conventional wisdom doesn’t mean it is right.

In India, housing prices are overvalued. In general, if you have a house worth 1 Crore rupees ($120,000) in India, the property's cash flow will generate around 40,000 INR per month in rental yield. That’s 4.8 Lakhs per year. Just 4.8% of the total capital value of the house. General interest rates in India revolve around 10% for a housing loan. You can’t even pay the EMI with the rental yield. This yield is way less than the real inflation.

People “invest” in real estate not because it produces cash-flow, but because it increases capital value over time. A house valued at 1 Crore or $120,000 will appreciate by 10-20% a year. Why does it appreciate in capital value? How does it appreciate? Because there is always someone else ready to pay more for it. But why is someone ready to pay even more for a house? Why are they bidding up the price? Is it because they need a house to live in? Or they expect that someone else will pay even more for it in the future?

People do not pay a premium for a property because of its utility value. A house is a house and with time it depreciates. A 10-year-old house often requires a lot of repairs and fixing stuff like broken plumbing. People pay a premium for property because it’s a store of value. Someone with capital who wants to “grow” their capital will invest in real estate to keep their capital from diluting away. That’s why many people own multiple houses and buildings. That’s their portfolio.

Understanding Capital Accumulation

Capital is something that is saved up over some time through frugality. If someone earns $1000 a month and only spends $500 a month, he has an extra $500. It’s around 42,000 INR. There is a need to protect this capital from dilution because it loses its purchasing power when it is kept as cash for a long time.

So the very reason for “investment” is not to undertake a risk and make gains but rather just to protect the capital that someone has earned in the first place. It’s about wealth preservation and not “making money”.

People take a risk first by choosing a vocation, an area of specialization. Some become engineers, some doctors and some become carpenters and plumbers. The world becomes a wealthy place because humans can communicate with each other and each person can focus on a specific area to build expertise in. When expertise is built, it leads to increased productivity. Sometimes people choose an area of expertise that might not have value in the future. For example, developers are being replaced by tools as we speak.

Life is pretty difficult when humans do not specialize. For example, in the movie Cast Away, Tom Hanks is stuck on a remote island and is waiting to be rescued. He lives there for years and he has to stay alive. He has to build a hut, hunt for food, and even take out his decaying tooth himself. Because he has to do everything by himself his quality of life is very poor. He is not able to focus on one thing for a long enough time because he has to do so many things and because of that his productivity is very low.

Now imagine there are 100 people on the island. A few people can focus just on fishing. A few people can focus on building huts. A few people can focus on providing medical care for other people. If a few people just focus on fishing, they can improve their productivity.

While a single person on an island can manage to fish only 1-2 fish a day, a group of people just focusing on fishing can build fishing nets, and fishing boats and probably catch enough fish for the entire island. They can even export fish if they are really good at their craft.

Today we live in a global village of 8 billion people connected through the internet and global trade routes. This enables us to go micro-niche and specialize thereby increasing wealth for everyone. Wealth is created through products and services that people produce. More money doesn’t mean more wealth because money itself doesn’t have any intrinsic value.

If people become an experts in something that other people do not want, then there is no ROI on their time and effort. So making money involves risk. But the current financial system forces people to take risks to preserve what they have already made. Because the “money” that you earn is a melting ice cube. You are forced to “invest” to preserve what you have already earned by taking a risk.

Money and Store of Value

In the beginning of civilization, people used to barter goods with each other. But bartering is inefficient because what you want from the other party might not immediately want what you are making. So we invented money. Money should be a medium of exchange and a store of value. But the money that we use today is just a medium of exchange, not a store of value. It’s not a store of value because the money is not scarce. So we “invest” the money in other scarce assets like real estate. And real estate becomes a store of value. A store of value doesn’t need any intrinsic value.

If people on the island used a specific type of shell as money, they got a certain number of shells in return for giving people something of value. A fisherman can sell fish for shells.

The shells do not need to have any intrinsic value because they are just a representation of the value that the fisherman has created for others and he can use those shells in a future date for value from others.

A fisherman earning 2 shells a day but spending only 1 shell a day accumulates a capital of 30 shells in a month and 360 shells in a year. He becomes rich because he produces more than what he consumes. That’s how wealth is built.

Now someone earning $1000 a month and spending only $500 a month cannot keep the $500 as savings for the next 10 years because the purchasing power of that $500 keeps diluting with time. So the very reason for “investing” in a store of value is because the money depreciates in value and purchasing power. If the money was scarce, there wouldn’t be any need to invest in the first place to save alone.

How and why the money keeps inflating is a topic for another post. But everyone knows that “cash is trash” and you cannot keep most of your wealth in cash.

Gold and Bitcoin as a Savings Vehicle

People look for vehicles to “save” their monetary energy and until recently we did not have a medium that would keep the value of money intact apart from real estate and stocks. Gold is relatively scarce and it is estimated that around 14% of the world’s gold supply is in the hands of Indian households.

However, gold lacks monetary properties and is inefficient. Gold also inflates by 2% a year and if the price of gold goes up too high, it might inflate faster because no one knows how much more gold can be mined from earth. Gold is relatively scarce but not absolutely scarce.

If the purpose of real estate is just to have a roof over your head then it’s just a utility like a car. But real estate has a perceived scarcity. There is no absolute scarcity because when demand goes up, houses are built vertically on top of each other and the new demand is met with new supply. There is plenty of land that is unused and agricultural land is being converted into residential plots all the time, throughout the world.

Gold, real estate, and stocks are relatively scarce and hence they protect people’s monetary energy better than cash, but it’s still a leaky bucket. Most people with excess capital invest in real estate not because they need a 2nd or a 3rd home but because real estate holds its value. But it’s not like first-time buyers buy real estate with their savings.

Most of the people who buy houses buy it with the help of a home loan (mortgage). If you understand how modern money works, you will also understand that new money comes into existence when it is lent into existence.

Excess capital is flushed into the economy which increases the price of real estate and it feels like people are getting wealthy. However, the high prices of real estate will sustain and grow only when people keep taking loans and buying houses (or spending on other goods and services with debt money). The economic stability depends on the total supply of money increasing all the time which makes the limited assets go up in perceived value.

The Money Bubble Cannot Burst

If everyone starts repaying their loans, the money supply will contract and asset values will go down. No one likes that and it’s called a recession. A recession will correct inflation and make the quality of living better for the bottom 90% of the people who don’t have assets, but they will also not have jobs and rich people will see their wealth erode because when people repay debts, the total money supply contracts. That’s when the central banks intervene and reduce interest rates to encourage more borrowing. They cannot let the bubble burst.

So everyone has to keep borrowing and not repay their loans in aggregate for this bubble to sustain or everything will collapse. Monetary contraction also happens when people default on their debts. The lender loses the money lent, but overall defaulting on a loan is the same as repaying the loan when it comes to the effect on total money in circulation.

In 2008, the great financial crisis happened because people defaulted on their loans. Many people would say that it was because the bankers lent money to people who didn’t have the repayment capacity. Yes, that’s true, but the bubble became so big because so many people bought houses on borrowed money. That’s leveraged money. Money that came into existence via debt.

Bitcoin: The Best Store of Value

Now there is a new asset class called Bitcoin which is giving better returns than real estate because it’s mathematically limited. But this asset class can also be used as money.

When people earn in Bitcoin, they can save in Bitcoin and need not take a risk by investing it in real estate or stocks. Younger generations understand Bitcoin and as this keeps going on, real estate will lose its premium as a store of value. Bitcoin becomes the new store of value because anyone can buy Bitcoin and hold it for several years, even if it is a small amount. If younger generations of people are not ready to go into debt to purchase new houses, the housing markets are likely to collapse.

The price of houses will not go to zero but it can collapse to the price of its utility value. When real estate loses its value as a store of value medium, the premium will shift to Bitcoin because Bitcoin is the best-known store of value since the beginning of humankind.

Until the internet, cryptography, and the information age, this was not possible. For the first time, what you own and what you know becomes the same thing. Bitcoin is the asset of the information age. As long as Bitcoin remains secure and decentralized, human greed to make returns and protect their capital will drive people towards Bitcoin.

The total market cap of Bitcoin is $1.5 Trillion and Real Estate is around $300 Trillion. Bitcoin is less than 1% of the total value locked in the real estate. It’s just a matter of time before Bitcoin is seen as a safe asset and the volatility is not translated into risk. Not everything that’s volatile is risky. It’s hard to understand Bitcoin because people have to learn how money works to realize the fragility of the existing financial system.

The more you understand Bitcoin and the traditional financial system, the more intuitive you will feel about the impending collapse of the equity and real estate markets. Most normal folks do not really want to take a risk to make out-sized returns.

They just want to work less and ensure that their savings are not devalued to have some security for the future. Because of the lack of a savings mechanism, savings, and investments have become the same thing and a “diversified portfolio” has become “safer”. All this has happened because of the lack of a perfect money system, which Bitcoin represents.

Image Source: Satoshi Nakamoto Institute

Bitcoin is perfect money, a money that doesn’t inflate. When people earn and save in Bitcoin, there is no need to take risk by investing in Real Estate or Stocks because your buying power is increasing in the same money that you earn and save in. As of now, anyone who has held Bitcoin for the past 5 years, their buying power has increased faster than people who had their wealth locked in other savings vehicles.

Disclaimer: I am making a prediction here and this is not financial advice. I am not recommending you to buy/invest in Bitcoin. However, I strongly recommend studying about Bitcoin. The more you learn about it, the more conviction you will have. Allocate at least 1% of your savings portfolio to Bitcoin and observe what happens.

I have made a free course on Bitcoin which you can learn from. I am not promoting anything and I have nothing to sell. It’s purely for educational purposes.