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The Curious Case of Real Estate Investments

Estimated reading time: 4 minutes 52 seconds

Rs. 8 lakhs invested in a piece of land in 1990 in a non-metro city is worth Rs. 3 Cr today. We all have been reading and hearing about the phenomenal returns, that too risk-free (I will take that with a grain of salt), in real estate investments. Let us put things in perspective. The CAGR (Compounded Annual Growth Return) is 17% per annum on this investment. Now same 8 lakhs invested in the Sensex in 1990 - the index had touched 1000 first time that year - would have fetched Rs. 1.42 Cr today. Though the index return is 14% per annum the final amount is less than half due to the power of compounding. But if you just got lucky and invested Rs. 9,500 in the undersubscribed IPO of Infosys in 1993 then, your investment would be worth more than 3.2 Cr today!! The key word is 'lucky' and whether the value generated today is by luck or by a deliberate plan.

Investment in real estate in India and the stupendous returns is drawing more and more investors which in turn is further pushing the prices up. Should an investor put all the money in Real Estate and not consider the other asset classes? This would be no different from "putting all eggs in one basket" and taking more risk than the investor has the willingness and the ability to do so. Real estate investments have some key characteristics all over the globe.

  1. Illiquid investments that may take time to sell
  2. Investments cannot be made in small amount unlike shares, mutual funds
  3. Investments cannot be divided while buying and selling
  4. Information asymmetry is high
  5. Investments valuation is not easily determined as there is no exchange where everyday trading happens
  6. Investments are dependent upon location

In Indian context, there are some specific observations that all investors should be aware of. The ratio of median household prices to median income in US is 4-5 times. In India, due to income disparities, it is not right to take one number for the median household prices and the median income. The average per capita income in India is around Rs. 60,000. Even with some of the companies trying to provide affordable housing, the cost of a small flat (500-600 sq ft) is at a minimum more than 5 lakhs. This is 8 times of the per capita income. If we consider the average house price then the ratio number will be much higher. In Mitraz when working with clients, our experience has been that the ratio of the cost of a desired home in a suitable location to the earned income is around 8. While the housing demand due to the growing middle-class is increasing but the affordability is quickly becoming out of reach.

Real estate investments should certainly be considered but investors need to be wary of certain aspects besides the non-liquidity.

  1. For homes, apartments and buildings the developers and the builders have little accountability due to lack of regulatory framework. Individuals have almost no legal recourse in case of non-delivery. I have had a personal experience on this one.
  2. The social and the extended family system in India means that there can be claims of third fourth fifth and so on generations on a parcel of land. Title insurance still not being available implies that there is a risk of dispute and subsequent loss.
  3. There is a lot of unaccounted wealth being funnelled in the real estate. The actual transaction cost is much higher than what is captured in the official documents. With increasing focus on transparency and authorities cracking whip on tax evaders, there will be impact on the current value eventually.
  4. The appreciation in Land investments is more of a step function. The investment may not provide any upside for a considerable period of time and suddenly there may be a big step up in the value because of infrastructure development in and around the area. Hence, the investment horizon needs to be more than 5 years and many times even more than 10 years.
  5. A parcel of land left alone is a non-performing asset and attracts wealth tax according to the Indian tax laws. The current rules require individuals to pay 1% wealth tax on the value above 30 lakhs. So a land with current value as Rs. 1 Cr requires an investor to pay Rs. 70,000 for the year. The wealth tax rules may change in the new DTC whenever it comes into effect.
  6. Homes and apartments provide rental yield but it is quite low. Commercial real estate is better in this regard and has much better yield returns.
  7. More and more people are putting money in real estate for investment rather than consumption. There is an emotional attachment with the real estate investments. This is leading to more inventory as the developers and the sellers are not willing to adjust the price.

Increasing prices are quickly eroding the affordability for real consumers of houses, apartments and land. The bubble is in the making and is bound to burst if everyone invests and no one consumes. Sustainable returns will not be there from Real Estate if actual consumers continue to dwindle. We have seen that happen with the US real estate market where a boom induced by liquidity and low interest rates led to the housing market collapse in 2008.

Mitraz Financial believes in devising and advising effective hedging strategies. We do not recommend more than a certain percentage of the total assets into real estate. This is to ensure both risk and liquidity management. We also believe that there are investment instruments, e.g., realty funds, hostel apartment projects, that can provide exposure to real estate without some of the perils mentioned above. Investors should ensure that their real estate holdings are as per their risk profile and considered in the total asset allocation rather than as standalone.

The writer is the Managing Director of Mitraz Financial Services Pvt. Ltd and can be contacted at anup.bansal@mitrazonline.com

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Disclaimer - Mitraz is NOT a Loan Provider.

It is a Wealth Management & Advisory Firm.