How we make property purchase decisions

Last week I met a person who had been aspiring to buy his own house since forever. And having bought his first house where he started living, his next goal was to buy the 2nd house.

As we grew up, we saw only a few places which could be called “investments”. The ladies of the family would relentlessly buy gold under the guise of “investment” and the men would invariably be on a lookout for more properties.

The human tendency is to justify everything with numbers. So someone told me last week that his flat which he bought for INR 1.5Cr has appreciated to 2.5Cr in 8 years. As financial advisers, we also have a tendency to talk numbers. So I told him that computes to 7% annual return, 6.6% to be precise. By the way, had he parked his 1.5Cr in fixed deposit, it would have generated the same corpus.

No I am not against buying property. I too, like majority of Indians want to live in my own house very soon. But once I buy a house for self - occupancy, if you ask me to buy another for investment, well, certainly not at this point in time.

Those of us who have grown up in Tier II and Tier III cities, have definitely seen our parental homes become multi fold in asset values. But a big reason behind that is the appreciation in land. A historical 15% annual return in a land owned self - constructed house can obviously not be compared to a flat where you own just a piece of the floor. And that is one big mis-perception why people still get lured to flats as a lucrative investment option. Our tendency to extrapolate historical returns from a similar asset class is likely to land us up in a very different scenario 10 years from now. Add this is likely to be more profound for salaried people who can only resort to white money because accept it or not, a good part of real estate investments of the previous generation are not even accounted for. And that changes a lot of things as we get exposed to stark realities of tax implications. And therefore, a lot of people tend to deploy capital gains from sale of one property to buying another property. Not because it makes a classic investment case but well, it saves the necessary evil called tax. It thus becomes a vicious circle where money keeps getting blocked for very long periods of time in an attempt to save tax. We as investors, hardly ascribe a cost to this illiquidity that real estate brings to the table.

The reason I decided to pen down this article is after I interacted with a 64 year old retired fellow who had 2 properties in Delhi and yet an uncomfortable retired lifestyle. His rentals were not enough to cover his rising expenses (mostly medical and utilities) and he didn’t want to sell off any property because come on, selling a property is so “social image” down-market. He firmly believed that property is only meant to be added to the portfolio, never disposed off. And that is our second problem. We are extremely emotional about our property assets. And a large part of this emotion is a result of attaching this stigma to disposing off property. People never congratulate you on shifting to a rental accommodation, but they will bring you gifts when you buy your own house, even for “investment”. Someone buying a second and a third property is just worth the gossip. I could have the same amount of wealth stashed amongst other instruments, but no one would even look at me, well because I am just a tenant in the recent high rise that came up in the city.

To everyone who is emotional about their property assets, it would be worth the time to calculate the annualized return that has been generated, something known as the IRR. Simply put, over a certain period of time, what is the average annual return generated. And this is our third problem. While we term everything as investments, we do not evaluate them using a common metric. While equity markets will be judged by the % return they generate over 3 and 6 month periods, real estate returns are expressed in absolute terms.

XYZ – Hamara 1.5 cr ka ghar 2.5 crore ka ho gaya

Me – Sir, kitne saal mei?

XYZ – Bas 8 saal hue hai

Me – Umm. Yeh toh 7% annual return hua. Itna toh aapki FD de deti

XYZ – Dhai crore bada amount hai

Me – Haan Sir, but itna toh aapki FD de deti

Perspective changes quite a bit when you evaluate assets on a common metric. Of course you should add to this the inflows you got through rentals, but you should also subtract the costs of maintenance. With rental yields being very low in India, that is unlikely to make a significant difference.

I am not trying to prove that real estate is a poor choice of investment. But the halo around it is probably undeserving. Also, a house purchased for living is not an investment at all because there are multiple other variables which come at play while making a decision around which house you should buy to live in. Locality, proximity to school and hospitals, safety and a number of other factors play a larger role in decision making than the expected rate of return. And if a house is being bought solely for “investment”, make sure you do your Mathematics right.

Another important consideration is asset allocation. If you already have a house and you are thinking of investing in another property and that constitutes 60-70% of your wealth, then you are taking a very concentrated investment call. If both your properties do well, you would end up creating a lot of wealth. But in case they don’t, you will perhaps move back 10-15 years behind in your wealth creation journey. Diversification of wealth therefore deserves a lot more importance than we ascribe to it.

And, for all those who want to add a passive source of income to their retirement, do take into consideration other investment avenues which are likely to give similar or better returns, because rent is not the only source of passive income.