I wanted to convince myself why Real Estate is NOT an investment option… and why we need only one house to live in! Yes, it might be right for you. Then again, it might not. Whilst real estate investing might not be a bad idea, it might not be a good one either. Whatever you do, do NOT make the largest decision in your life because it's something you ‘should do' – do not make it an emotional decision, make it an investment choice.
- Buy a HOME, not an investment.
- Buy vs. Rent?
- Invest to own vs. Invest to sell?
- Landlord vs. Tenant?
- Real Estate vs. Stock Market?
- Total Cost of Ownership and HIDDEN costs to renting…
- Residential vs. Commercial Property?
- House/Villa vs. Apartment?
- Selling Real Estate is not so easy…
- Taxation Benefits…
- Unlocking Value with leverage, refinancing & mortgaging…
- Indian Real Estate Story…
I love referring back to Warren Buffet. Not because of his wealth, but because of his simplicity. He still stays in the same house he bought in 1958. If one of the richest men in history has the foresight not to buy homes for investment but for living in, why wouldn't we see something so plain and simple? Well, let's use logic. After all, G-d did gives us brains to think.. and so we think. Before I go further, as with all my disclaimers – we're talking about relative stuff, so there's no absolute answer. For the sake of clarity, when I refer to real estate, although it may include land (developed or agricultural), commercial, residential, houses, apartments – I'm basically talking about properties – houses / apartments / flats / condominiums – call it what you will. If you're as old or as young as me… you've probably heard about the sub-prime crisis. What happened in 2008 was a culmination of low interest rates, over confidence, and trying to live a dream. And speaking of dreams, just like the American Dream, the Keralites like myself have a dream… work in the Gulf (or Persia as we used to call it), earn enough money, return to Kerala, build a grand house, own a car and get high on ‘spirits'. Whichever the dream, home ownership has always been a big part of it. Buying a home or apartment is probably going to be the most complicated purchase decision you'll make in your life. And you'll probably spend a good portion of your life paying it off! Isn't that such a waste of time?
1. Buy a HOME, not an investment.
Home ownership in and of itself is not necessarily a bad decision, if you're from India you've probably heard the phrase “Rotti (Food), Kapda (Clothing), Makaan (Shelter)” as the essentials of living and an ideal every country's government should strive towards. But the moment you crossover and transform Makaan (Property / Shelter / Homes) into an investment… things take a different course. This is probably one of the key reasons for the sub-prime. Properties are no longer homes, but houses that can be used to build wealth. Granted people have been buying and selling real estate for thousands of years before stock markets were born, but I don't want to be an operator or for that matter a landlord – I want to be an investor. I want to enjoy where I live, not wake up in the morning because my tenants toilet is overflowing and they need a fix! (Yes, I could have a property manager, but that's only possible if I'm making a good yield with a number of apartments on rent, read on for more on this). At the same time, you don't want to be at the mercy of some landlord increasing your rent – so own at least one home at best, to live in, to create memories… not nightmares. I guess we all want to raise families safely, securely and craft lasting memories for our lifetime. Now while I just stated above that it's best to own your home or apartment. If you can't don't worry. Just continue to rent, look at it this way, if you get bored of the view, or the neighbors – you can just find another place to stay, and hey… if you're living in a furnished apartment… even better! There's nothing to tie you down. And if you're going to buy a house, buy with CASH. Yes, you heard me… cash. You might think I'm crazy, but this is exactly what I did. How did I do it? I saved money, I negotiated with the property developer who sold me the property for a good discount on a lump sum payment and over a few large installments. You see property developers know that cash is king. If you're paying 11-12% as interest on your home loan, or receiving close to 9% on a term deposit – then save the money, ask for a deep discount on the property – you'll be surprised at what you get! Now that you've bought with cash, you'll never see that cash again. You may be so tired that you'll probably vouch never to buy another property. Even if you sell, a property owner will have to roll over that amount into a new property for tax purposes like in India, where you can get 2 – 3 years to re-invest those funds to avoid paying a 20% tax.
2. Buy vs. Rent?
Ok, so you don't have enough funds to buy a property with ALL cash. You're only option for now is to rent. Which reminds me of a friend who argued that rent is ‘forever' and mortgages ‘end'. I didn't bother telling him that his life would end some day as well… Think of it like this, renting will provide you with the flexibility of moving to another property if you find something you don't like, be it bad neighbors, ill maintained property… you can always move. Some may also view it as giving themselves a certain kind of freedom. But many people don't seem to understand that life will always be filled with “sunk” costs, as it is with the basics of life… Rotti (Food), Kapda (Clothing) AND Makaan (Shelter). Do a back-of-the-envelope calculation of your monthly food bill and extrapolate this over your lifetime – if you went with the logic that you should buy instead of rent, then you should apply the idea of starving yourself because it's a sunk cost in the digestive drain. When you buy your first home, buy it for the right reasons, not some weird logic. So having read this, wouldn't you prefer to keep your cash in fixed deposit, have less stress, no headaches and receive 8%-10% instead?
3. Invest to own vs. Invest to sell?
Now let's assume you ignored all my advice above and still wanted to play the real estate game… let's think this through for a minute. Depending on which school of thought you're in, you can look at real estate either as a cash flow business or a capital gains business. I'd rather be in the former, i.e. an asset is only an asset if it brings in cash, if it requires you only paying out cash… that's a liability. Also, cash coming in early means your IRR (Internal Rate of Return) is actually better than when you sell for capital gains. And if you get caught in the wrong end of the real estate cycle, you could end up waiting a loooong while! As an investor, you should be looking for maximum down-side protection on the asset. You sacrifice a lower purchasing price for a higher yield. If things do go south in the future, you can rest assured that your property has not been affected so much. The only way you'll make real money is not as an individual investor… doing one or two properties, but when you play big – say 100 or 200 units. That's when economies of scale kick in, everything becomes cheaper… material, labor, legal and finance fees and not to mention that the banks are happy to give lower interest rates and higher loan to value (LTV) on the project as a whole.
4. Landlord vs. Tenant?
Ok, so you've bought your property. Now you're a proud Landlord. Don't expect your Tenant to take care of the property as it if was his own. (As a Tenant, don't expect your Landlord not to ask you to leave on one month's notice so he can sell his property). You can also forget about all the cash you've invested into the property. If you're lucky you'll get 2-3% if you're in India, or at best 7-8% if you're in the Middle East (Bahrain or Dubai). That's okay, because your property is an investment, right?
5. Real Estate vs. Stock Market?
Maybe you'll start to see that real estate isn't so great as it was initially cut out to be. Now you start to hear about how your friends have made money in the stock markets, and you see them enjoying more… while you struggle to pay of that mortgage. According to Robert Shiller from Yale, in Irrational Exuberance, inflation-adjusted housing returned 0.4% from 1890 – 2004. You may say this is for the US alone, granted… but it is the largest market in the world. As the saying goes… there are lies, damned lies and statistics. I don't really agree with taking a long term view like the above study, just to prove a point – because it's assuming you're going to live 114 years, when in reality – if you're lucky – you'll have a productive adult life of 40-50 years. Yep… that should be your investment horizon – 30-40 years at best, invest too long, and enjoy nothing? Not me. I'd really like to do a proper calculation some day, but I don't have enough information to play out various scenarios. For example, not everyone can plunk down hard cash to buy a home in 1800s (unless, they're fairly wealthy)… more likely, they paid it off as we do these days – over a period of time. We could compare a Systematic Investment Plan (SIP) in the stock market as against an Equated Monthly Installment (EMI) for the same period to understand the real return on investment. I'll let the experts play those numbers and show me the facts.
6. Total Cost of Ownership and HIDDEN costs to renting…
As a landlord, you may own the property… but you also own the telephone, and you can expect a call to fix something. Because things break and with any asset, it requires maintenance – what people don't tell you is that when they receive rents, they have costs to keep the property in good condition. Have a deposit? Think it will cover the expenses after they leave? Go ahead… just burn the money… When people rent, and compare it with paying a mortgage – they fail to factor in all costs. That's because the landlord is probably taking the onus of it and as a tenant you're not aware of it. Well, just to put things into perspective, think about these costs – taxes (property, water, drainage, sanitation, lighting and G-d knows whatever the government thinks of), Maintenance (leakages, electricity, drainage), utilities (facilities that are commonly used by tenants, but never considered as part of your mortgage!), refurbishing or remodeling (usually after the tenant leaves), insurance premium, fixtures and fittings, furniture and add to that brokerage fees (finding tenants), mortgage costs (early payment penalties). When you start to think about all these… you will think twice or thrice about taking the mortgage and renting it out.
7. Residential vs. Commercial Property?
Still playing the real estate game? I can only give you my experience based on the Indian property scene, but I presume this is almost the same every where in the world. Whilst per square foot (or per square meter) prices for residential properties are cheaper than commercial properties – you have less to worry about in commercial properties. No fittings and fixtures to worry about, no guilt feeling about increasing rents, because the family is ‘surviving'. In fact, there are less moving parts in a commercial space – so if you want to dabble in real estate investing, do commercial property not residential, especially if you have funds for only one or two properties.
8. House/Villa vs. Apartment?
Maybe you only have funds for a small residential property, then should you buy a house or villa which comes with a piece of land attached or in a sky-rise apartment. I've always had this debate, should you buy a house or an apartment. With a house, you not only have land, but you also own the space, no shared walls, no need to worry about the plumbing on the apartments above or below you, no need to worry about common maintenance fees every month (irrespective of wether you're using the facilities or not), no fractional ownership (undivided share) of the land area. If you're building falls down (G-d forbid), then you're out of luck without any insurance. But at the same time, if you're lucky with good neighbors, you have a community, as you grow old, there are people who are near by, there's a sense of security and safety, or at least a bit more than in an independent house. And when you're old… you don't need to install a lift or escalator so you can get to the second floor! What about cost? Whilst it may cost you the same to buy an apartment as it does a small piece of land (depending on your geography) – you still need to build your own house on that land, and that might just cost double your land price. Whatever it is, house or apartment… you want to make it your home, so choose wisely.
9. Selling Real Estate is not so easy…
One fine day you want to sell your property… for a gain of course. But wait… When selling an illiquid asset such as real estate, you have to pay broker commissions, if involved, government sales or property taxes, loan pre-payment penalty and add to that the cost of maintenance over the last few years and it all adds up. Basically you will throw a lot of money around, lock it up for some time. If your financial situation becomes stressful and you can't make ends meet, don't worry – it's still a good investment. Yeah… right.
10. Taxation Benefits…
When owning a property, if you rent it out, you get a standard 30% tax deduction that assumes you have some expenses for repairing and maintaining the property. Plus you can depreciate the value of your asset over a period of time. If you sell a property, you have 2 – 3 years to deploy the cash in a new property to avoid paying a 20% long term property gains tax. If you sell a property within 3 years of buying, you'll have to pay a short term property gains tax of 10%. That's great… let's help the government make more money.
11. Unlocking Value with leverage, refinancing & mortgaging…
This is where 99% of people make the mistake, they make the wrong assumptions with respect to mortgage and refinancing. With the ability to refinance your property, you can not only live in it, but also take up some venture, fund it by mortgaging or pledging your property as an ‘asset'. By taking this additional risk, you might be able to build something and grow your wealth further. I on the other hand, would prefer to go and convince a venture capitalist that I'd like to play with OPM (Other People's Money) than my own – and still retain control of my business and keep my property! Also, suppose your entering the last stages of life, you're growing old, your kids – if you have any – have left the nest and are on their own. You can either gift it to them after your time, or you can reverse mortgage it and allow the bank to take ownership once you've kicked the bucket. This gives you some cash to cover your daily living. Consider a mortgage like paying the rent. If you don't make the payments, the lender or bank can legally kick you out of your ‘own' home. So for as long as the mortgage exists, you're just a renter who can own his property without having to worry about any rent increases, unless of course you're on a variable rate! Would you be willing to spend the next 10, 20 or 30 years of your life paying off a house or apartment which you could have bought at a fraction of the price, had you made (I said, made not saved) enough money sooner? Investing in real estate is equivalent to taking an investment product, leveraging 50%-70% and locking away the keys for a long time. The interest rates horrendous and I would definitely call that unsound investing, especially if house prices go down… oh what's that you say, real estate prices never go down? Ha… heard that before… real estate only gets sick, never dies. Then the sub-prime happened. What's the cheapest rate you can find on a mortgage (aka housing loan as we call it in India)? 8% or 9%… compare that to rates for leveraging on a margin stock trading account. And what are the current Indian rental yields 2% or 3%? If the interest on the mortgage is far cheaper than the rental yield on an equivalent property – go ahead and buy property. But if isn't – just wait to buy. This is just pure common sense.
12. Indian Real Estate Story…
In India, your average yield on rental property is around 2-3% if you're really lucky. With a population of over 1 BILLION, you'd think there would be a shortage of land and space. On the contrary, people converge in cities, whilst wide open plots of land remain un-used, un-developed, of course un-til the politicians can figure out a way of making money from and buy up prime space for a few paisa before promoting it as the next big development and selling out. The story gets worse, India has the problem of unaccounted money circulating in the economy, what is called ‘black money' vs. ‘white money' (or accounted in-the-system money). When a property is sold, a large percentage is paid in ‘black' and the remaining as ‘white' – the white money because it's accounted gets taxed at 20% (unless you reinvest it in some other property within 2-3 years). The black is paid in cash… and used to either pay for the construction of the new buildings or to buy expensive cars – expensive because Indians pay almost 100% tax on their cars. And if there's anything that can be bought with cash, it's bought. No questions asked. The Indian government has talked a lot about widening the tax net and closing all loopholes. Yet, less than 3% of the population are only paying taxes… that's almost 97% who ignore or don't pay… and that burden of paying is around 30% taxes directly, and I could estimate another 20% indirectly, through sales tax, VAT, service tax, luxury tax and every imaginable tax thought out by politicians. The government is getting smarter, whilst a 20% tax was paid on the registered value of the property (which is usually a fraction of the market value) – the government first started imposing the use of PAN cards, then having both buyers and sellers present for the exchange. You see, there are two agreements, one is the government ‘registered' value of the property and used for government registration purposes. Then there's the actual AGREEMENT which is what two people sign – this document contains the real value of the property exchange. I hear the government is now requiring to see this agreement. This is good, because you don't have brokers buying agreements with the intention to flip properties. Maybe this will reduce the amount of black money in circulation, but it also reduces the number of property transactions. And thus, people who speculated on land do not get what they want… because no one wants to pay 20% tax on the real value of exchange! If you're wondering about a legal way to get around this problem… at the risk of sounding like a car salesman – become a subscribing member. It get's worse… the nexus between banks, property developers, corrupt politicians and policy makers – makes common man's (…represented by the great Indian middle class) life miserable, and “Rotti, Kapda, Makaan” stays a distant Indian dream. But let's not play the blame game, those who can afford also help in keeping prices sky high. There's an invisible script that real estate is the best investment (in India or anywhere). It may not be. Hopefully factual data will clear this up, but I guess time will tell. What do you think? Is real estate the best investment of all? Sign up to share your thoughts…