How to invest in real estate

Most friends think I am dead set against real estate. But just because I have not yet bought a house, does not mean I am against the notion. I am all for buying a house to live in - for its utility. But I am not keen on real estate as an investment.

Having said that, I came across an intelligent discussion on how to think about investing in real estate. Here is that idea along with some garnish.

It is from the podcast “The BarberShop with Shantanu” featuring Ajitesh Korupolu, CEO of ASBL. The relevant bit starts at the 44:40 mark. Let me simplify and write down what he is saying.

Ajitesh believes that real estate investing is really a leverage play, i.e. you have to “cleverly play with debt”.

• Buy a house worth 100
• Of this take 85 as a loan and 15 is from your savings.
• Say the house value grows at the rate of inflation of 6.5% p.a.
• Say you get possession of the house in 4 years and you sell it at that point
• At that point the house is worth about 130. [100 X (1.065)^4 = 128.64]
• Of this you pay back 85 to the lender. [130 - 85 = 45]
• And then pay another 15 as interest on this loan. (For the nerd in you who wants to see the calculations, go here.) [130 - 85 - 15 = 30]
• That leaves you with 30.

So in 4 years, an investment of 15 doubles to 30, i.e. an excellent return of 19% per annum.

Ajitesh is emphatic in his view that real estate as an investment makes sense only with leverage and a pure equity (i.e. 100% own money) investment does not make sense.

He suggests you invest when the project is approved and the first concrete is poured. And exit when the project receives the occupation certificate. As long as you do this in a metro city, selling the house should not be a problem.

The primary risk is in project delays which mean that interest costs will eat into your returns and a prolonged delay will lead to a loss.

Vishesh Tippani

I found Ajitesh’s construct interesting and have a few thoughts to add.

Prices of under-construction projects often rise faster than inflation. So one could make a higher return than Ajitesh suggests.

But if the project gets into trouble, and there are delays, one may struggle to even match inflation in terms of price rise. One way to avoid this risk is to restrict yourself to builders who have a reputation and track record of timely delivery.

Moreover, there is a lumpiness to this investment. The minimum ticket size is significant. And if you decide to diversify your risk across several projects - which you should - you’ll need a significant amount of capital to get started.

Value Creation

I like to view investments from the perspective of value creation. For example, Tata Motors takes steel and turns it into cars and buses. The company adds value to steel, that value translates into profit. And so the share price of the company rises over time.

In a housing project, value is created when land and concrete is used to make houses. And so theoretically speaking, it is only during the construction period that the value of the property should rise in excess of inflation. It should rise in line with the value being created, i.e. the cost of construction.

But once a house is ready, any further changes in value are a function of scarcity or glut. House prices don’t go up because any new value is being created. They go up because more people want to live in the same place.

Conversely if a new housing project comes up near an old one, the old one typically sees some diminution in value.

Take the other favourite real estate idea: buying land. From the perspective of value-creation, there is no reason for the value of the land to increase beyond inflation. Any expectation of greater increase is speculative. It is dependent on an airport or a highway coming up near the land you bought. It is certainly not based on creation of value.?

So am I ready to invest in real estate? While Ajitesh’s suggestion aligns well with my view of value creation I am not quite ready to go through the trouble of registry, brokers, taxes, cash-transactions, and whatnot. So for now I’ll stick to financial products for my investments.

Watch the full podcast here.