A Guide to Real Estate Investment

By August 30, 2016Literature

A GUIDE TO REAL ESTATE INVESTMENT

Real estate is an excellent, long-term, wealth, enhancing avenue of investment. However, it suffers from some obvious and other not-so-obvious drawbacks.

The obvious drawbacks include:

  • Poor liquidity. Even in the most frenzied real estate boom, it is not easy to purchase and sell real estate. During a recession in the real estate market on the other hand, liquidity simply evaporates.
  • Despite best efforts and the opinion of legal and other experts, being absolutely sure about clear title to a real estate property can be challenging.
  • A large amount of capital is required for a single purchase.
  • Large amounts are also required for additional purchases even in a real estate market that has fallen sharply.
  • Black money is a menace that lurks behind almost all real estate transactions.
  • High stamp duty on purchases of real estate. If you purchase Rs 100 lakhs worth of equity shares, they are credited to your demat account without further cost. But if you purchase real estate worth Rs 100 lakhs, in the state of Karnataka at least, you will spend an additional Rs 7 lakhs approximately to register the transfer of the title thereof in your name.
  • Purchase and sale formalities in real estate are time consuming and cumbersome.
  • Real estate has certain administrative difficulties. For example, squatting, encroachment, fraud and criminal intimidation by the land mafia and a number of other problems, especially involving absentee landlordism.

The not-so-obvious drawbacks of real estate investing are:

First, misleading returns where income from either capital appreciation or rental is concerned.  The maintenance of physical real estate can be quite heavy.  Any developed structure like an apartment or commercial premises requires periodical painting, repairs, renovation, payment of property taxes, etc. Very often, the owner does not relate these expenses to the income received from the property. The expenses are met out of normal income from employment, business or profession.  The owner only thinks of the gross return that he is getting, without realising that the net return may be considerably less.

Second, thanks to the Securities Transactions Tax (STT) which at present is so negligible as to be laughable, stock market investment escapes capital gains tax in India.  Real estate investments are not so fortunate. Even after cost inflation indexing and all other tax avoidance measures, long-term capital gains taxes can be substantial.

Third, the greater the holdings of real estate, the more the hassles of maintenance, dealing with tenants, complaints from tenants or neighbours, etc., especially as real estate investors advance in age.  I have come across wealthy individuals who have sold real assets just to reduce stress caused by their holdings, and not because they needed the money.

There is also a trend today of youngsters studying, working and settling abroad.  This makes it even more difficult for ageing parents to look after real estate assets in India, especially if such assets are spread over 2 or 3 cities or states.  Children who are settled abroad for a considerable time are very often not interested in the real estate assets of their parents in India.  Transmission of these assets to the children after the lifetime of the parents is neither quick nor easy.

How would we define real estate investments?

Equity is a growth investment.  It is designed to increase the wealth of its owner over a period of time. Any growth investment must have two attributes. The first is a principal value that will fluctuate, sometimes violently, in the short-term, but grow in the long-term at a rate equal to or greater than inflation.

The second attribute is an income stream which may fluctuate in the short run but will grow in the long run, once again at a rate that is equal to or greater than inflation.  Therefore, to merit the term ‘growth investment’, there must not only be a principal amount invested but also an accompanying income stream. Thus, stocks yield dividends.  Real estate properties purchased as investments must yield rentals.

Seth Klarman gives us these insights into the vital importance of dividends, in his classic work on value investing called ‘Margin of Safety’:

“Just as financial-market participants can be divided into two groups, investors and speculators, assets and securities can often be characterized as either investments or speculations.  The distinction is not clear to most people.  Both investments and speculations can be bought and sold.  Both typically fluctuate in price and can thus appear to generate investment returns.  But there is one critical difference:  Investments throw off cash flow for the benefit of the owners; speculations do not.

“The return to the owners of speculations depends exclusively on the vagaries of the resale market.  Investments, even very long term investments like newly planted timber properties, will eventually throw off cash flow.  A machine makes widgets that are marketed, a building is occupied by tenants who pay rent, and trees on a timber property are eventually harvested and sold.  By contrast, collectibles throw off no cash flow; the only cash they can generate is from their eventual sale.  The future buyer is likewise dependent on his or her own prospects for resale.”

The same line of thinking can very definitely be applied to real estate.  Any asset that does not produce an income-stream does not deserve the title of investment. At best it is a ‘sterile’ or ‘inert’ asset. It is absolutely correct that the dividend or rental yield may be so small as to seem insignificant.  But there is a vast difference between seeming insignificant and being insignificant.  Dividends and rents can be reinvested and, over the long-run, such reinvestment can produce stunning results.

The power of dividend reinvestment in stocks can be appreciated when we consider the following example. According to research by Crandall, Pierce & Company, USA, an investment of 1 dollar in the S&P 500 stocks on 31st May 1946 would have been worth $ 47.53 on 31st July 2002, had dividends not been reinvested. Had dividends been reinvested, the said dollar would have grown to $ 405.92 in the same period! 

No wonder Benjamin Graham enlightens us that, “Far from being an afterthought, dividends are the greatest force in stock investing.”

Ditto for reinvesting rentals during one’s active working life.  It is difficult to reinvest rentals back into real estate, in view of the cost involved, unless a housing loan is taken and existing rentals go towards paying the loan installments.  Alternatively, several of our clients channel rentals into either stock or equity mutual fund investments on a systematic basis, which is an excellent idea.

Should one go in for real estate investments?

The best advice I have received on this subject is that human beings can be broadly divided into two categories where real estate is concerned. The first category has a special interest in, very often coupled with a talent for, real estate investment. If you fall into this category, you can by all means invest in real estate, bearing in mind that the real estate investment time horizon is 10 years. In short, you should be prepared to block your investment for at least 10 years, if required, in order to obtain optimum returns.

But if you fall into the second category of individuals, like this writer, who have no interest whatsoever in real estate, then you would be well advised to purchase real estate only to the extent that you have a use for it. One use of real estate is universal. Everyone requires a residence.  So it is incumbent upon everyone to acquire a dwelling.

In addition, a person in financial services, or a chartered accountant or physician, would require an office. So, this individual must try to eventually own both a residence and an office. Take one more example, of a person who designs, manufacturers and markets furniture. Such a person requires a residence, some sort of an old structure or shed in a non-prominent area, even a little away from the city, where the furniture can be manufactured, and a showroom in a high-visibility commercial area in the city, where the furniture can be displayed and marketed.  This person must ultimately try to own all three premises because he has a use for all three.

The difference between CONSUMPTION and INVESTMENT in real estate:

One residential apartment or house is not considered as an investment because it is consumed for the residence of the individual and his family.  Many people do not realise that the considerations when purchasing real estate for consumption are dramatically different from the considerations when purchasing real estate for investment.

When purchasing real estate for consumption, price may not be the sole deciding factor.  It is okay to pay even a fancy price, if the premises is in an outstanding location with good facilities and conveniences and if all members of the family agree that the premises in question is close to their concept of a dream home.  Since the happiness of the family cannot be measured in terms of money, resources permitting, it is okay to pay a price that is higher than the fair market value.

But when purchasing real estate for investment, it is only investment considerations that must apply. The best advice here comes from Professor Burton Malkiel, Princeton professor of economics and author of the investment classic “A Random Walk down Wall Street”.  Professor Malkiel says that real estate must be purchased as an investment only if the rental yield is equal to or greater than the yield on short-term bonds.

For example, the cost of a 2-bedroom apartment in Mangalore today would be Rs 75 lakhs. You can get a rent of Rs 16,000/- per month or Rs 1.92 lakhs per annum on this apartment. The rental yield therefore is: Rs 1,92,000 / Rs 65,00,000 x 100 = 2.56%. This has to be compared with the yield on short-term bonds which is presently about 6% per annum. If you cannot easily ascertain the yield on short-term bonds, the interest rate on the 6-month fixed deposit of any major bank will be a good substitute.  Clearly, purchasing an apartment in Mangalore for investment is lunacy.

Now take the example of a friend of mine who purchased a shop in Bangalore some time back for Rs 55 lakhs, including registration costs. This shop fetches him a rental of Rs 40,000/- per month.  The rental yield is 8.73%.  At the time he purchased the property, the yield on short-term bonds was 7.5%. It was still a superb deal.

Finally…..

I hope I have given you a theoretical framework to think about real estate investments. I caution you that I am no expert on real estate. I have put a few thoughts together from what a few real estate people I know have told me.  My clients have also shared their real estate experiences with me over the years.  To all this I have added a few of my own observations, a little common sense and certainly some wisdom shamelessly borrowed from my extensive reading on investment.

Author

Mr. Gerard Colaco
Partner, Colaco & Aranha,
Mangalore

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