In our journey as financial planners, one of the biggest constants that we see in most customer portfolios is: they are either already real estate heavy, or their high-priority goals include buying additional homes as an investment.
This should come as no surprise: since as late as 2017, an overwhelming 84 percent of all household investment assets in India (RBI Household Finance Committee Report, 2017) are in real estate. Nice-looking gated communities and plushly-designed apartments play the role of Bollywood seductresses and temptresses in the common Indian investor’s life. You bought a house a few years ago and have barely started to knock off the principal from the loan when the latest upgrade available in the market catches your eye, replete with that additional half bedroom that you forgot you needed, and the tennis court that your current apartment complex so badly needs and doesn’t have.
As life returns to pre-COVID normalcy, and the economy moves into higher gear, this is becoming more and more visible. A conversation I had with a group of friends last week was revealing; one of them, who is in the construction business, confirmed that just in our small suburb of Mumbai, there are currently 100+ redevelopment projects in progress at this point, with a similar number to be added over the next 3-4 months. Clearly, there are buyers in the market driving the demand for this supply, and the demand is only picking up. In other words, real estate is looking up as an investment opportunity right now.
That being the case, since many of you reading this are likely to be among those considering buying a house now as an investment, it may be prudent to consider some of the investment risks associated with this asset class. While this list is not exhaustive, each risk has the potential of causing significant damage to your financial independence.
Concentration
When one of our customers first came to us, nearly 70 percent of his net worth and 100 percent of his disposable savings were in real estate. When we drew up his financial plan, at an overall level he was financially very secure and well on the path to achieving financial independence. But, all his eggs were in the same basket.
In fact, the reason he decided to come to a financial planner was because of the prolonged slump in the real estate market over the last decade. His overall wealth building efforts had taken a big hit and he realised that some of his future goals were not as easily achievable as he had assumed.
So, this is an obvious one: too much concentration in one asset class can lead to an overall portfolio underperforming, and at times even seeing significant overall wealth erosion. Having investments in real estate that exceed 20-25 percent of your net worth is something that you should be wary about.
Also read: Buying a home too early in your career is a financial mistake you’ll repent later
Liquidity
Apart from concentration, another fairly commonly understood risk is Liquidity. While most people will be aware of this risk, it is something they haven’t felt the impact of, until they experience it under not-so-pleasant circumstances.
We will continue with the earlier example. While on paper, the financial health and journey looked comfortable, it was when it came to execution and implementation of the same that this risk came to the fore. One of the customer’s financial goals (a child’s education overseas) is due for fulfilment next year and this had been flagged off last year itself. In order to achieve that goal, the customer had identified a property that was to be sold to fund the child’s education. It has been many months now that the property has been up for sale, and while there have been enquiries, including serious ones, it remains unsold.
If you have a real estate asset (apartment, house, land, shop, etc) that is mapped to a goal, then make sure that you have taken into account the chances that the asset will not get liquidated within your timelines and a plan B may therefore be needed.
While the above risks are “obvious” ones, the next three, from experience, are not so.
Value Discovery
A follow-up risk to Liquidity is Value Discovery. Unlike market-linked assets, where value discovery is instant and everyday, in the case of a real estate asset, the value can only be estimated basis other recent transactions in the same area or through extrapolation over time. Hence, this estimate can go widely off the mark at times, leading to both value erosion as well as financial delay to the attached goals.
In a recent case, one of our customers needed to fulfil a retirement goal and hence had to liquidate her house. Since there had been no transaction in her locality for a very long time, the valuation was basis both extrapolation as well as benchmarking vs other buildings in the area. Unfortunately, when the time came to sell, the actual price quoted was as low as 70 percent of the originally estimated value! Despite the best of efforts, the final transaction value didn’t improve much. As you can imagine, this threw a rather large spanner into her retirement plan works.
What compounds the issue is that values are not strictly comparable and extrapolatable over time since market cycles in real estate can be both vicious and long. In an estimate that we did for many of our customers, we noted that in most cases, from a taxation perspective, real estate investments held over the last decade had actually delivered a capital loss post-indexation, i.e., they had not even beaten inflation.
Obsolescence
While buildings age, they do so slowly. Until maybe a decade back, a 15- or 20-year-old building constructed by a reputed builder gave one no cause for worry. But that is not the case now. One of the reasons why Liquidity and Value Discovery have become a problem is that while the market cycle in real estate has its effect, the product cycle gives it another twist. The amenities and features of a launch in 2021 are very different from the ones that one saw in 2011. Hence, even a ten-year-old house of good quality does not make the consideration set anymore. And if there is enough supply of new buildings in the vicinity, even your high-quality 10- to 15-year-old apartment becomes obsolete as far as new buyers are concerned.
The impact of obsolescence is severe —while buyers shrink in numbers, supply doesn’t, since the number of old houses available for sale only goes up year after year.
Also read: Eager to buy a house? Check your readiness first
Hidden costs
Last but not the least, even if you are able to identify a house as an investment that is resistant to the above four risks, hidden costs are a risk that most people do not account for. While society maintenance costs are something that people know exist, there are other costs that are not so apparent, especially when one is planning an investment.
These hidden costs range from income taxes, to periodic refurbishments (even if you change tenants every three years, you need to spend a good sum on getting the house repainted every time), brokerages (payable every time you have a new tenant) and non-occupancy (even a couple of months delay in finding a tenant means no income). Lastly, in the last couple of years, even the inflation-hedge that rentals provided due to the annual escalation has evaporated, with rentals actually going down during the COVID period.
Hidden costs can put a significant dent into already-meagre rental yields and can knock off as much as 50 percent of the overall yield. And this is something that most people do not account for when they calculate investment returns.
Any good investor evaluates a new investment on the basis of two important factors: the returns that the investment will likely provide over a particular tenure, and the risk that one needs to take in order to get that likely return. The latter is far more important than the former, since risks enumerate the various possibilities due to which the likely return might be impacted.
While buying a house as an investment can seem quite glamorous, these are factors that any serious investor must pay deep attention to, so that at a later stage, the investment remains a raging bull, not a white elephant.
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