Real Estate - Investing in Property

The first (and last) bit of investing advice most of our parents gave us – save, save, save and buy a house as soon as you can. You can never go wrong in real estate!

And it does seem like a good proposition. Just ask the people who’ve made millions from their ancestral properties or those who’ve recently made a killing in Bangalore or Gurgaon!

For many of us, buying a flat or a property is a big deal in every way. It is likely to be one of the biggest investments we ever make, it has a lot of sentiment attached to it and it does give a sense of fulfillment - I have a house, ergo I’ve arrived in life! Plus there’s the expectation of the property appreciating many times in value over time.

But is this expectation justified? Is real estate really an investment that defies the basic risk-return principle, yielding high returns for relatively low risk?

Consider This

Property purchases are fraught with uncertainty. For one, we never know what the ‘fair’ value of a property is. There are all kinds of intangibles determining the price, there is little or no flow of information and of course there are the buyer’s own biases involved as well. Further, during times of rapid expansion, ‘hot’ areas tend to appreciate to stratospheric levels (like parts of Gurgaon today) and there is rather inevitably a correction. Property prices, contrary to popular opinion, do not always tend northwards.

Further, as with any investment, one should consider the cost of funds and ongoing maintenance. In this context, we have tax breaks to consider, differing interest rates for loans, different payment schemes, stamp duties, property taxes, ongoing maintenance costs, brokerage…

In the following discussion, I propose to treat real estate as just another asset class in my portfolio and hence determine whether it compares favorably with other instruments. Of course, an underlying assumption here is that the purchase is purely for investment and not for personal use. In the latter case, just buy the best location you can afford - preferably in an area you’re comfortable with - and then forget it. Who cares what happens to the price? Your kids maybe, not you!

Some Basic Assumptions

In this discussion, I’ll focus on purchasing a house / apartment, not land. Land purchases, by their very nature, are speculative and the returns indeterminate. One buys land in the hope that it will appreciate in value but there’s no indication of what the appreciation might be.

In the case of an apartment, however, there is a clearly defined rental income that one can expect and I hope to use this as the primary basis for evaluating whether a property is a worthwhile investment or not.

Other assumptions (I’ve tried to take the worst case scenario) -

• The apartment costs Rs 10 lakhs, inclusive of stamp duty
• The property is bought on a 20-year loan @ 8.5% fixed interest rate working out to an EMI of Rs 900 per lakh or Rs 9,000 for the whole. I assume there’s no initial down payment required
• Inflation over 20 years will average at about 5% per annum. A higher inflation will be more beneficial by reducing the real interest rate on the loan
• The tax benefit on interest paid for housing loans does not exist.
• The rental yield on the property is about 4% per annum (about average for most cities in India, except Gurgaon, where the yield is higher), which works out to about Rs. 3,300 per month. This increases at par with inflation (usually the rental increases are higher)
• Ongoing maintenance costs plus applicable taxes are about Rs. 12,000 per annum (or about Rs. 1,000 per month), appreciating in line with inflation
• Tax on rental income is at 30%
• Post-tax returns on a low-risk bond are 6% per annum

For the above scenario, one could consider the property investment in two ways:

• As a pure investment: In this case, the buyer’s mindset would be of an investor looking to allocate his capital between various assets. The purchase of an apartment is incidental and the focus is on return on total investment
• As a mandatory purchase: In this case, the apartment price itself is above scrutiny and the focus is on determining whether the additional costs (interest, maintenance etc) are worthwhile in terms of returns.

Real Estate as a Pure Investment

The investor would only purchase an apartment if the returns (capital appreciation + post-tax rental income are comparable with other low-risk assets like bonds. Hence, the investor would consider the total cost to be the sum of the NPV of the total repayment over 20 years and the NPV of maintenance costs. This would be compared with the NPV of the rental income and the returns expected from a bond of similar cost in order to determine the capital appreciation required from the apartment.

In our example:

• NPV of loan repayment over 20 years = Rs. 13,45,920 (Rs. 1,08,000 per annum discounted at 5% rate of inflation)
• NPV of maintenance costs over 20 years = Rs. 2,40,000 (Rs. 12,000 per annum, rising in line with inflation)
• NPV of post-tax rental income over 20 years = Rs. 4,80,000 (Rs. 24,000 per annum post-tax over 20 years, rising in line with inflation)

Total investment in today’s prices = Rs. 13,45,920 + Rs. 2,40,000 = Rs. 15,85,920

Value of similarly-priced 6% bond over the same 20-year period = Rs. 50,86,250

In order to be an equally good investment, the ten lakh rupee property must appreciate to Rs. 46,06,250 (since the rental income is about Rs. 4,80,000) i.e. it must grow at a cumulative rate of 8.37% per annum.

One should purchase the apartment only if the expectation is for the property to grow at this aggressive rate year after year.

Real Estate as a Mandatory Purchase

The mandatory purchaser would not focus on the cost of the property, assuming that the price is a fair one. The only concern here would be to ensure that the extra cost of maintenance and interest is met by the rental income and the gain in apartment value so that the there is no loss incurred in the purchase.

In our example:

• NPV of interest repayment over 20 years = Rs. 7,47,730 (Rs. 60,000 interest payment per annum discounted at 5% rate of inflation)
• NPV of maintenance costs over 20 years = Rs. 2,40,000 (Rs. 12,000 per annum, rising in line with inflation)
• NPV of post-tax rental income over 20 years = Rs. 4,80,000 (Rs. 24,000 per annum post-tax over 20 years, rising in line with inflation)

Total investment in today’s prices = Rs. 9,87,730
Value of similarly-priced 6% bond over the same 20-year period = Rs. 31,67,790

In order to be an equally good investment, the ten lakh rupee property must appreciate to Rs. 26,87,790 (since the rental income is about Rs. 4,80,000) i.e. it must grow at a cumulative rate of 5.34% per annum.

One should purchase the apartment only if the expectation is for the property to keep pace with inflation year after year, a not unreasonable requirement.

Final Thoughts

The above analysis does not really throw up anything new other than the idea that real estate, as a pure investment, seems to be rather speculative. It’s not the sure-fire winner that people would have one believe. The best bet is probably to purchase apartments on the outskirts of growing metro cities or in B-category towns with the potential to scale up fast. It might even be a better idea to just buy land.

Buying an apartment for security and the feel-good factor seems to be a better motive. It’s also probably a good idea for people who currently stay in rented accommodation. Even apartments in mature parts of large cities should at the very least keep pace with inflation.

Returns could be juiced up a bit by holding for short period of time and selling out on substantial jumps in value, obtaining tax benefits on interest repayment, finding an apartment with a high and growing rental yield and perhaps reinvesting the rental income into interest-bearing investments.