Thomas Jefferson once said, “It takes time to persuade men to do even what is for their own good.”
If you (like we used to) think that people are very receptive to ideas which would benefit them, think again. We are often confronted with people who think that an investment of Rs. 100 which yields Rs. 125 over the next five years is better than the one which yields Rs. 150. You might be surprised at first, but many people make this mistake when it comes to real estate investments. This probably has to do with the fact that most of us look at real estate in absolute terms and do not calculate the annual percentage returns from such investments (i.e. in financial terms, CAGR).
The total return of any real estate investment is the sum of the following:
- Return generated from utilising the property, for e.g., rent received from letting out; and
- The appreciation in the value of the property.
Let me explain this with a real life situation we were confronted with recently. We belong to a business family and like any business family, we have some real estate investments which have been rented out. In one of these investments, we receive a rental of 5% on today’s value of the property. Considering its location and other factors, none of the family members were expecting much appreciation in the value of the property over the next 5 years. Thus the total expected annual return in such a scenario, works out to:
Note that the 5% annual return is before considering property tax on the value of the property, income tax on the rent received, incidental costs of holding the property, etc. Thus, the actual return will be even lower than 5%.
Now everyone knows that today you can generate a return of 9 – 10% after tax, without taking much risk. Given the above, our proposal was to liquidate the property and invest the proceeds elsewhere. And as you would have guessed by now, we were unable to convince them despite the obvious mathematics of this investment.
We are not trying to say that real estate is a poor investment and in some cases it can even give good results. But, just buying property, (a) in the hope that it would always appreciate or, (b) because others are buying; are not the most logical or scientific of reasons for investing in real estate. In our view, any asset’s investment merits – whether real estate or otherwise – should be judged based on the following:
- The goal you are trying to achieve by making the investment (whether it’s a short term goal like keeping an emergency fund or a long term goal like retirement);
- Safety of principal;
- Returns of alternative investments;
- Tax treatment of gains (or loss) arising from the investments;
- Cost of holding the investment (e.g. property and other taxes);
- Incidental expenses (like registration costs, cost of maintenance, etc.).
So the next time you take any investment decisions, give some thought to the above factors instead of on what others are doing. And who knows, you might find much more attractive opportunities elsewhere.
P.S. This list is by no means a comprehensive one but provides a fairly reasonable checklist for making investment decisions.