The Other Side Of Real Estate Investment – Livemint – 22-Dec-2014
December 27, 2014 - Uncategorized
Stories abound about wealth created on the back of real estate investments. It is one investment that is seen as providing income, appreciation in value and stability. And to top it all, there are tax benefits. Given all these, you have to contend with the risk of looking foolish if you did not invest in real estate. Not that it ever required too much persuasion to get anyone to invest in it. We are so conditioned to see only the appreciation in value that we overlook the drawbacks. The outcome then is that many portfolios become real estate heavy. And in our comfort with this asset class, we ignore others that may be better suited to our needs. Are we looking at all aspects of real estate investments when we make a decision to put all our funds there? Read on to find out the harm (and some good) we may be doing ourselves. The good The good in real estate investments is the role it can play as a hedge against the vagaries of stock and bond markets. This is because the performance of real estate and other traditional asset classes such as stocks or bonds don’t always move in the same direction. It lends stability to the returns from your overall portfolio even when other investments are performing poorly. But to get that benefit, you need other investments in your portfolio. Not real estate alone. Else your returns will go up when real estate is doing well and fall when there is a downturn, without a cushion from other investments. Real estate investments provide appreciation in value over time, along with income in the form of rentals. If you have selected the right property, and made the investment at the right time, you are on the right track to earn good inflation-adjusted returns. All of this make a very strong case for adding the asset class to your portfolio. But how much of your portfolio should be in real estate is a decision that you should take only after you look at the drawbacks too. “It mainly depends on your risk profile. For instance, if you are an individual with moderate risk appetite, 18% of your portfolio can be in real estate assets,” said Ravi Malani, director, wealth and investment management, Barclays Securities (India) Pvt. Ltd. The bad and the ugly Location and timing risk: Not all real estate properties have the same potential to generate rental income or appreciation in value. This depends on many factors such as location, potential in the area for development and demand and supply of dwelling units in the area. For example, homes near good schools always command a higher rental than other areas. Your returns from the investment will depend on the skill with which you have selected the property after evaluating all the factors, and timing of the purchase. Again, if you bought the property when the prices had already peaked, there is a good chance that you will see a correction in prices and have to wait longer for your investment to show profits. “Real estate is all about location. In a particular city, you may see price rise in one area and a correction in another. This can be due to multiple factors such as infrastructure and demand and supply. An individual looking to buy a property for end use will see it from a long-term perspective. Ideally, you should not time the market. But if real estate is for investment purpose, it is all about timing,” said Binaifer Jehani, director, Crisil Research. Concentration risk: How many properties are you likely to hold even if you had an all-real estate portfolio? Given that each would be of a large value, not too many. This means a large chunk of your portfolio value is concentrated here. If a property is selected wrongly and performs poorly in terms of rentals or capital appreciation, the impact on your overall portfolio returns will be high. Returns from real estate are cyclical, i.e., they go through highs and lows depending on how well the economy is doing. Your portfolio return is likely to go through these swings in the absence of other assets to stabilize it. Un-diversifiable risks: Sensitivity to interest rate movements and economic conditions affect all real estate investments across the board. It is not a risk that can be removed from your portfolio, even if you hold different types of property spread geographically. When the economy is doing well and income and earnings are good, real estate thrives. When interest rates go up, funds become costly, which affects demand and, therefore dampens the value of real estate investments. So, there may be periods when returns are high, and when returns nosedive. If you hold much of your investments in real estate, the returns will follow these cycles without the benefit of other types of investments to balance it out. Low liquidity: This is the primary drawback of real estate investments. Converting the asset to cash takes time, and you cannot depend on real estate to meet an immediate requirement for funds. It is difficult to quickly find a buyer willing to buy the property at a fair price. Then there are also legal procedures associated with selling property which makes it time consuming. Also, the transactions costs associated with selling are high, and this reduces the realized value from the sale. Even if your need is for a small amount, you may have to dispose off the entire property. While it is easy to take a loan against the property to the extent required, all loans come at a cost and take some time to be disbursed. Despite holding the investment, you may have to incur cost to realise some portion of its value and you may not even get it in time. “It’s illiquid because the quantum is large. Generally, when an individual looks to buy a property, she will take her own time to investigate, analyze and conclude the deal. Similarly, it takes time to get a buyer too. Property is mostly bought for long-term and personal use. So, it becomes even more difficult to get a buyer who will like your property and be willing to pay a huge amount immediately,” said Surya Bhatia, a Delhi-based financial planner. Holding costs: The cost of maintaining real estate can be high. There is maintenance, property taxes, brokerage, repairs, and other costs to be met. There can also be periods when the property is vacant and not earning rent. Apart from the monetary aspects, there are issues of managing the property. Remotely managing it is inconvenient and may require arrangements with a local agency. Just as there are many stories of real estate investing successes, there are an equal number of stories of investments lost due to illegal occupation and other disputes. Investment management: If an equity investment performs poorly, you would exit and invest in shares with good prospects. There is adequate information available that allows you to evaluate and take a view on its expected performance. Evaluating your real estate investment is difficult since there is very little organized or authentic information available. Switching from a poorly performing real estate investment and investing in other properties have costs and taxes associated with it. More often than not, you end up just holding what you have bought and rarely make rebalancing decisions since it is not easy. Real estate investments are subject to valuation risks both at the time of purchase and sale. There is no established way of determining the right price. There is a lot of price manipulation and very few regulatory checks and balances. You would typically go by property values and rental incomes in the locality as the value of your property too. Since two properties are seldom similar in all aspects, you may not get the same value. Depending on the urgency of the sale and the cycle through which property prices are going, the realized value may be very different from the high that the property has seen in the past and what you expected. Real estate is unregulated to a great extent with little transparency on pricing and transactions. Most real estate investments are leveraged, where a large loan is used to finance it. Till the loan is paid off, your income must be adequate to meet the loan repayment. The repayment may be affected if the loan repayment obligation goes up with an increase in interest rates or if there is a risk to your income. Default in repayment can lead to the asset being repossessed by the lender. The recently approved real estate investment trusts (REITs) are an alternate way to invest. The investment ticket size is lower, valuations are relatively transparent, the fund is professionally managed, and entry or exit is easier. But REIT is a financial product, comes with fund manager risk, and availability is still low in India. Before you make any new investment, consider your existing portfolio and how the new investment will contribute to your goals and needs. The same holds good for real estate too. Don’t let the disadvantages of real estate investments discourage you. It is a vital component of all portfolios. But it should be included in moderation for the benefits of diversification, stability and inflation-hedged returns.