Some New Old Lessons in Real Estate

India-Real-Estate-Market

Yesterday (August 1, 2016), the Mumbai edition of The Times of India had a very interesting piece of news.

A bungalow on Nepean Sea Road (one of the poshest areas in South Mumbai), built in 1904, is on sale. The bungalow was last sold in 1917, for a little over Rs 1 lakh. In the recent past, similar properties in vicinity have been sold for Rs 400 crore, or so reports The Times of India.

Imagine, something bought for something as little as Rs 1 lakh being sold for Rs 400 crore. That is exactly what I was told by a friend who called me after he read the news. “See, this is why I keep saying property is the best form of investment. Nothing beats it,” he said. “Such huge returns make real estate such a fantastic form of investment,” he added for good measure.

I was groggy having just woken up, so just heard him out.

A little while later having read the news, I figured out that my friend had fallen for what I call the fallacy of absolute numbers in real estate.

The trouble is that whenever real estate is sold, we tend to look at absolute numbers. “You know, my grandfather bought this house a long time back for a few lakhs and now it’s worth a few crores.” That kind of stuff.

No one bothers to calculate the real rate of return. We just look at absolute numbers and conclude that real estate is a fantastic form of investment. But that is not the right way.

Let’s look at the Nepean Sea Road bungalow with which I started this piece. It was a bought for around Rs 1 lakh and is now worth Rs 400 crore. The value has gone up by around 40,000 times in 99 years. Doesn’t that sound fantastic? It surely does.

Nevertheless, what is the rate of return? The rate of return is 11.3 per cent per year. Over a period of 100 years, a return of 11.3 per cent per year, is very good. But a return of 11.3 per cent per year, sounds nowhere as sexy as the value of the bungalow going up by 40,000 times.

But they are one and the same thing. Further, in an Indian case, comparisons cannot be made, given that data for other forms of investment for such a long period of time, are simply not available.

Also, the question is would you buy real estate now, if it promises you a rate of return of 11.3 per cent per year, over a period of time? In most cases, the answer will definitely be no, given the hassles that come with owning real estate.

Also, there are other mistakes that are made while evaluating real estate returns. Over a period of 100 years a lot of money would have gone into maintaining the house as well as paying those who maintain it. Further, property taxes would have been paid as well. Given that, such expenditure is regular in nature, nobody keeps a record of it, and hence, is not taken into account while calculating the rate of return on a property. This is a basic mistake that keeps getting made all the time.

Also, most people while selling property tend to deal in black and hence, they don’t take into account the fact that a tax needs to be paid on a house being sold. Real estate returns are not tax-free though you can take inflation into account while determining the cost of purchase of a house.

Once we take these factors into account, the real rate of return on property can rarely be calculated and given this people tend to go with absolute numbers. And when we look at absolute numbers it is easy to come to the conclusion that property is the best form of investing.

In this particular case one needs to take into account the fact that the property is based on the Nepean Sea Road, one of the toniest neighbourhoods in Mumbai as well as India. Hence, there will be some premium for it.

Similar properties in not so tony neighbourhoods would not have given this kind of return.

In the India that we live in, there is a danger of the builder disappearing, and the home being built not being delivered. In that situation you will have to continue to pay the rent of the home that you are living in, along with the EMI on the home loan that you have taken in order to buy the house.

If you haven’t taken on a home loan, then your savings are stuck in an asset that isn’t giving you any return really.

More than the money, the stress that comes with an uncompleted home and the builder disappearing with the money, is extremely huge. I have seen a number of such examples among my friends and family, and believe me it’s simply not worth the trouble. It’s amazing to see so many builders get away after not delivering homes on time. There are those who disappear with the money as well. It’s still more amazing to see people believing homes are the best investment.

Another factor that most people don’t realise while buying property as an investment is that the timing the investment is very important. If you had bought property any time during the period 2002 and 2009, and sold it by now, you would have made good money. There is no doubt about it.

But if you had bought property post 2010 onwards, and if you take into account, the cost of maintenance (which needs to be paid every month in most building societies these days), property tax, EMI interest, or loss of interest on the amount invested in the property, etc., chances are your returns would be in single digit territory. In many cases, the returns will be flat. And if you start taking inflation into account, then the value of the home, would have actually gone down in real terms.

But the human brain is not used to dealing with so many factors at the same time. In the simplistic world of the human brain, investing in property continues to be a good form of investing and will continue to be so because it tends to look at absolute numbers and not the real returns.

The column originally appeared in Vivek Kaul’s Diary on August 2, 2016

 

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About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

12 Responses to Some New Old Lessons in Real Estate

  1. Kalyanaraman says:

    1) honestly, how many companies listed in the Mumbai stock exchange will last for 99 years? Most likely, the money if invested in ONE company, will be zero after a hundred years. Even if that company is Airtel, reliance or Infosys. But land is more likely to survive as an investment even after a century, except for a nuclear war (the stocks too wouldnt exist then)

    2) what about the rental yield from that property? For 99 years? Even if the rental yield was 3% p.a, if reinvested religiously, it would have yielded another few hundred crores. Or roughly assume 14.3% p.a returns compounded annually.

    3) The loud talk of all the stock market enthusiasts claiming consistent double digit returns are only in the post globalisation years. But here you are talking about a property which has survived 75 years of freedom struggle, partition, political instability, licence Raj and so on. Only the last 25 years of the life of the property has witnessed globalisation. Can any stock consistently give double digit returns when the economy was growing at 3.5% per annum? For 5-6 decades continuously?

  2. Kalyan says:

    Hi

    I wud like to highlight a few points

    1) how many companies in the stock exchange can survive 99 years? Airtel? Reliance? Infosys? I don’t think so. Hence buying an asset and leaving it unmonitored for 99 years and still pocketing a handsome profit, is not possible in equity.

    2) the author conveniently forgets the rental yield from the property. At 3% per annum, the rent, if suitabily reinvested, would have yielded another few hundred crores. It may not be inaccurate to assume that the actual rate of returns (including rent) will be between 14-15% p.a

    3) This 14-15% yield was obtained in an era which was mostly characterised by political instability, two world wars, freedom struggle, partition, Indo Pak wars, socialism and license Raj. Only the last 25 years of the tenure witnessed liberalisation. Do you think equity (if invested in just ONE single company shares and left undisturbed for 99 years) would have fared so well?

  3. Kalyan says:

    Hi

    I wud like to highlight a few points

    1) how many companies in the stock exchange can survive 99 years? Airtel? Reliance? Infosys? I don’t think so. Hence buying an asset and leaving it unmonitored for 99 years and still pocketing a handsome profit, is not possible in equity.

    2) the author conveniently forgets the rental yield from the property. At 3% per annum, the rent, if suitabily reinvested, would have yielded another few hundred crores. It may not be inaccurate to assume that the actual rate of returns (including rent) will be between 14-15% p.a

    3) This 14-15% yield was obtained in an era which was mostly characterised by political instability, two world wars, freedom struggle, partition, Indo Pak wars, socialism and license Raj. Only the last 25 years of the tenure witnessed liberalisation. Do you think equity (if invested in just ONE single company shares and left undisturbed for 99 years) would have fared so well?

  4. Kalyan says:

    Hi,
    I wud like to highlight a few points
    1) how many companies in the stock exchange can survive 99 years? Airtel? Reliance? Infosys? I don’t think so. Hence buying an asset and leaving it unmonitored for 99 years and still pocketing a handsome profit, is not possible in equity.
    2) the author conveniently forgets the rental yield from the property. At 3% per annum, the rent, if suitabily reinvested, would have yielded another few hundred crores. It may not be inaccurate to assume that the actual rate of returns (including rent) will be between 14-15% p.a
    3) This 14-15% yield was obtained in an era which was mostly characterised by political instability, two world wars, freedom struggle, partition, famines, poor rate of ecenomic growth, Indo Pak wars, socialism and license Raj. Only the last 25 years of the tenure witnessed liberalisation. Do you think equity (if invested in just ONE single company shares and left undisturbed for 99 years) would have fared so well?

  5. kanishk says:

    Nice write up . Comparison of YoY return and absolute numbers is mind blowing.

  6. Shiva says:

    What you have missed out is the rent and other expenses that has been saved over the years of the owners living in the property. Of course you cannot value the other benefits that the owners may have realized having living the that piece of property

  7. bb lakhani says:

    you forgetting that the bungalow was fully utilized and not kept vacant so if you consider cost of utilization as per the market rental value this 11 percent can come to even 16 persant

  8. Ricky says:

    I have a observation. But before that just to share “I personally stay on rent and do believe that rent makes more sense than buying a property as of today, 4th Aug’16”. Now the observation is – 11.3% returns is based on the appreciation, and while you are listing everything around maintenance cost, you aren’t factoring the rent money (yield of 2-3% pa) one would have received over these 100 years, over and above the 11.3% returns.

  9. Pingback: 40,000 times in hundred years= 11.3% « Wise Wealth Advisors

  10. denimsox says:

    What are you guys commenting about?
    The writer is making a simple point, the 11.3% CAGR does not sound as sexy as 40,000X return over 99 years.

    As for the rent, don’t you all agree that the rent would have cancelled out the transaction cost, building cost, property tax, maintenance costs for upkeep or repairs, the cost of maintaining a bit of staff to upkeep this property?

    So, the situation would be different for somebody who not only saves on the rent but also prefers living at such a prestigious address and derives joy out of the ownership, and another man, who needs an asset to park his money, for growth over time.

    And, it is unwise to talk about a “limitation” that “no single stock can be stayed with for 99 years.”
    Why would anyone want to stay with the same bunch of stocks for 100 years, when every decade or two brings up a paradigm shift or value migration or game changing disruptions or an entirely new technology or a new field of business.

    For ex, you could have invested in tech in early 90s, real estate in the next date, and now NBFCs are in vogue, and indigenous defence production is all set for long term growth.

    Why did he even bring this up, who did?

  11. Pingback: How to calculate investment returns? | rammoney

  12. Pingback: Reblog: 40,000 times in hundred years = 11.3% – StockArchitect

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