Wednesday, November 3, 2010

Personal Finance - Part 20: Talking of Real Estate

(this is the concluding part of my series on Personal Finance in Fidelity's internal newsletter BitsnBytes)
How many cases have you heard of people in India who have invested in Real Estate and regretted it? Even the few who manage to somehow invest at the peak of a boom, tend to recover their principal in a few years if they hold on. I don’t know who said it but “they don’t make any more of it any more”, so it is always likely to be a scarce resource. 

Any poll of retired people on their financial status invariably has the following two questions –  a) what is the wisest thing you think you did in your lifelong financial plan? And (b) what is the biggest regret you have – something you should have done but didn’t?   The answer in both cases, not surprisingly, revolves around having bought a house (in the first case) to regretting that they never bought a house when they could have afforded it. 


That brings us to the first point in Real Estate. Buy your own house. That needs to be your primary priority. Unless you are the only child of your parents, and will inherit the 50x80 plot in Jayanagar. Or your spouse is the only child of their parents, etc. While buying the first house, the considerations are a little different than what is normally used for investment decisions. Decide what is the kind of house you would like to stay in in the long term. Do you fancy an independent house, or want to be part of the community in an apartment complex?  Do you want a single-bedroom apartment or a three-bedroom one? Even if your job involves moving cities, decide on one city where you will buy your primary home. 


To buy that house, you need to wait till you have earned for a few years at least, since you need some money in hand, and a decent enough salary to be able to pay the EMI’s. If you are married and your spouse works too, then your affordability increases drastically. When you are buying your first house do not worry too much about where the market is, or where it is headed, just buy.  When you buy the house, you should liquidate all your other investments (except some cash kept aside for emergency needs) to make the down payment. Go in for as large an EMI as you can afford, and then some. Don’t forget to take out a term insurance policy covering the value of the house on yourself and/or spouse. 


It will take you a few years to pay back the EMI’s fully – any incremental money you get in the interim should be used to prepay some EMI. To start with, you can go in for a fifteen-year loan (twenty years is too long, given that our interest rates are quite high), but as you keep prepaying (without reducing the EMI amount, just reducing the term), you should be able to repay the loan in seven to ten years’ time. Till then it is understandable if you do not have any investments in equity or debt or any other kind of asset class.  


Once you have your own house and have cleared the loan against it, you then come to evaluating real estate as an alternative asset class in competition with equity and debt. I am not including gold as an alternative asset class here since I assume a small part of your portfolio (5 to 15%) will be invested in gold for the long term. The conventional rule for asset allocation states that, between equity and debt, you invest 100 minus your age as a percentage in equity and the balance in debt. While the rule is a broad guideline, you are free to ignore it. Keep investing incrementally in a mix of equity and debt depending on your comfort and keep an eye out for good real estate opportunities.  


The trick is to identify plots of land on the outskirts of the city (I am now continuing the argument keeping Bangalore in mind – these arguments will apply to most other cities except perhaps Mumbai and Delhi where the dynamics are a little different, as are the amounts involved) which will develop in the next ten years or so. Go too far out and you may not get quick appreciation anytime soon. Come too close or buy in a place that is already developed, and you will most likely see a good rise in price over the years, but nothing spectacular. It is safe to go in for “converted” land, preferably BDA plots. 30 x 40 sites require a lower amount and are more salable in future since they have a more liquid market than larger sites. Having said that, 60 x 40 is a good size to aim for.

Any bank will be willing to lend you money against buying the property. First liquidate all your investments so that you can put in as much as you can upfront and minimize the loan.  As to any incremental amounts that you make later like bonus or savings, you have to take a call – whether to invest in equity or prepay some part of the loan. Investing in debt on the one side while keeping a housing loan on the other does not normally make sense since you will be earning less interest than what you are paying. Investing in equity while you have a loan on one side though, means that you are in effect borrowing (at the rate which the Bank charges you for the housing loan) to invest in equity. Think about whether you are comfortable doing that; make sure you don’t over-leverage yourself. 


You can decide to build a house on the plot of land that you purchase. In fact, the loan terms are better if you intend to build a house on it. This has the advantage of bringing in rent for you once the house is ready. You could, alternatively, build a “portion” and live in one part of the house and rent the other, a very popular Bangalore model. If you are an old-time Bangalorean you must be having a dozen uncles and aunts who have done that – in my view, we have a lot to learn from them when it comes to financial planning!  


Real Estate requires large sums of money as an investment upfront. It forces you to save for the down payment; it forces you to save more to pay the EMI, and it forces you to save to prepay the loan. All this while your money is invested in an asset that appreciates on its own without much intervention on your part. On the other hand, if you are invested in equity, and let’s say the value doubles, you suffer from the itchy fingers syndrome and want to sell. Given human psychology and the way all of us are, it makes sense to invest in real estate for more reasons than one! 


Check with your parents’ contemporaries (if you are old enough, check with your contemporaries) who have invested in real estate any time between twenty and forty years back.  Find out what price they paid while buying, and check the price now. Work out the CAGR (Compounded  Annual Growth Rate). It is likely to be anywhere between 12 and 18 percent. 12 to 18 percent on a sustained basis is a big deal. The biggest advantage that real estate has is that it allows the power of compounding to kick in. And this calculation does not take into account any rental incomes that the house may have earned! 


Talking of rental incomes – rental incomes on real estate are not very high. But it is still good option to consider since the amount turns out to be decent due to the high value of the underlying! You can typically expect 2.5% to 3.5% per annum of the current market value of the house as rent. This implies that the rental values keep going up to keep pace with inflation. Building one house to stay in, and one house to rent out (or of course one portion each) is the best option in financial planning that I can think of! 


And then say you make more money. Lots of it. You have already bought a couple of properties. What next?  You should look at investing in commercial real estate. Ideally, buy a 50 x 80 corner site on the side of a 100 feet wide road in an upcoming layout; wait for a few years; then build a shopping complex on the ground floor with offices on the top. You need not worry about the money for “building”, banks will be glad to lend it to you based on the security of the underlying land.  


And then you have a dozen tenants who take care that you have sufficient income every month. By the time this happens, of course, you have retired. You can hire a manager to make sure the rents come in on time every month, and tour the world with your spouse or significant other. 


If that’s not a good dream to work towards, I don’t know what is! Happy dreaming, happy working, and happy investing!  With this, we come to the end of our series on Personal Finance. I hope you enjoyed reading it as much as I enjoyed writing it. Feel free to write to me any time with your comments, suggestions, or queries.  Bye!




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