Vikram booked a flat in 1991 at the launch of a new project in Mulund, Mumbai @ 1400/- per sq ft aggregating to Rs 1500000/- (rounded off) with the idea of investing as the price aof properties that time was only going up. Not to be left out his cousin Jitendra also decided to jump & invested in late1992 in the same project @ 3200/- per sq ft aggregating approx. Rs 35,00,000/- and the prices further went up and peaked to 4200/-per sq ft by 1994.
During the fag end of 1994 the property market crashed… a downward journey started which lasted for 10 long years. This very property was available at 2500/- in 2002 or 3200 in 2004, with few buyers & more sellers. 10 years gone, capital still negative and home loan interest had only taken the cost of the house still higher. The only saviour was the rent earned. All this made Jitendra a worried man.
Come 2011, they sell the houses at the prevailing rate of around 10000/- a sq ft. or Rs 1, 05, 00,000/-, great isn’t it. Against 35 lacs invested, Jitendra received 105 lacs. Was this a gain for Jitendra? On the face of it yes, on second thought a big NO. The annualised return realised was 10% over a 20 year period for Vikram while Jitendra realised 6% by way of capital gains, (Assuming the rent earned compensated for the cost of the interest paid on their home loans).
Some lessons from Jitendra’s experience:
- Clarity about the objective behind the purchase?
- What money shall it earn? Will it earn real returns, beat inflation?
- How liquid is it, especially during a bad phase?
- Does one get the right price during rough times, i.e. a genuine 2 way quote?
- The Endowment effect? Endowment effect means, whatever I OWN is more worth than what the neighbour/seller has to offer and, and simultaneously what the neighbour has to offer has to come at a discount, particularly if I have to buy. This is very natural, since there is no index/quote. The market is run by the whims & fancies of the emotions of the participants without any barometer.
Real estate or property as we call in daily parlance is the most sought after asset class like gold, which lasts beyond our lifetimes in most of the cases. It shares a unique relationship both as a utility as well as an investment. Most individuals dream of having it the moment one has an independent income and definitely after having a family, a “Home Sweet Home” for himself & his near & dear ones. And at times many such homes – holiday home, second home etc.
Some more reasons for its importance include the following:
- A sense of security, utility, a shelter, an attachment since one can see it, show it, feel it, etc.
- Its value can only go up, a historical view, hence invest. (Hope this is clear by now).
- Regular cash flow by way of rentals, plus capital appreciation.
- Can be bought in instalments i.e. can be leveraged.
The American property market is yet to recover from its 2008 fall, still available at a 40% discount from its peak prices and the culprit was over leverage.
Rent is a great source of regular cash flow from a property investment. Going back to our two friends, Vikram & Jitendra the rental income was the same for both. The return was again higher for Vikram in percentage terms, since his cost was lower. Rent is something like the dividend yield to equities.
Residential property historically enjoys rent @ 4 – 6 % on the value, while a Commercial @ 9-12 %. Though, exceptions as always exist. At times this relationship is strained, like in today’s situation. The rental has not kept pace with the rising rates of the property or vice versa. The rents today are approximately @ 2.5% only for residential & around 6% for commercial. Which only means is that anomaly prevails and makes it really interesting, let’s see what corrects; the price or the rent, since the rents are at its low.
Lower the cost higher the rental and vice versa.
The interest rates on home loans were reasonably high in those days and this added to Jitendra’s woes as they have been troubling most of the home loan buyers for the last 12 months. Many existing home owners are facing a rise in their EMI outgo, thus having tough times with their cash flows.
So as Financial planners we always insist our clients to act holistically, looking at their overall financial situation & the future needs while also keeping margins for eventualities.
To conclude, Jitendra would have been a happy man, had he made the decision keeping in mind the following factors:
- The allocation
- The nature /behaviour of the asset class.
- The other alternative assets.
- The EMI/ instalments outflow as against the overall cash flow.
- The rent – value parity, the yield.