»Vivek Kaul's Diary

Some New Old Lessons in Real Estate
2 AUGUST 2016

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Yesterday (August 1, 2016), the Mumbai edition of The Times of India had a very interesting piece of news.

A bungalow on Nepean Sea Road (one of the poshest areas in South Mumbai), built in 1904, is on sale. The bungalow was last sold in 1917, for a little over Rs 1 lakh. In the recent past, similar properties in vicinity have been sold for Rs 400 crore, or so reports The Times of India.

Imagine, something bought for something as little as Rs 1 lakh being sold for Rs 400 crore. That is exactly what I was told by a friend who called me after he read the news. "See, this is why I keep saying property is the best form of investment. Nothing beats it," he said. "Such huge returns make real estate such a fantastic form of investment," he added for good measure.

I was groggy having just woken up, so just heard him out.

A little while later having read the news, I figured out that my friend had fallen for what I call the fallacy of absolute numbers in real estate.

The trouble is that whenever real estate is sold, we tend to look at absolute numbers. "You know, my grandfather bought this house a long time back for a few lakhs and now it's worth a few crores." That kind of stuff.

No one bothers to calculate the real rate of return. We just look at absolute numbers and conclude that real estate is a fantastic form of investment. But that is not the right way.

Let's look at the Nepean Sea Road bungalow with which I started this piece. It was a bought for around Rs 1 lakh and is now worth Rs 400 crore. The value has gone up by around 40,000 times in 99 years. Doesn't that sound fantastic? It surely does.

Nevertheless, what is the rate of return? The rate of return is 11.3 per cent per year. Over a period of 100 years, a return of 11.3 per cent per year, is very good. But a return of 11.3 per cent per year, sounds nowhere as sexy as the value of the bungalow going up by 40,000 times.

But they are one and the same thing. Further, in an Indian case, comparisons cannot be made, given that data for other forms of investment for such a long period of time, are simply not available.

Also, the question is would you buy real estate now, if it promises you a rate of return of 11.3 per cent per year, over a period of time? In most cases, the answer will definitely be no, given the hassles that come with owning real estate.

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Also, there are other mistakes that are made while evaluating real estate returns. Over a period of 100 years a lot of money would have gone into maintaining the house as well as paying those who maintain it. Further, property taxes would have been paid as well. Given that, such expenditure is regular in nature, nobody keeps a record of it, and hence, is not taken into account while calculating the rate of return on a property. This is a basic mistake that keeps getting made all the time.

Also, most people while selling property tend to deal in black and hence, they don't take into account the fact that a tax needs to be paid on a house being sold. Real estate returns are not tax-free though you can take inflation into account while determining the cost of purchase of a house.

Once we take these factors into account, the real rate of return on property can rarely be calculated and given this people tend to go with absolute numbers. And when we look at absolute numbers it is easy to come to the conclusion that property is the best form of investing.

In this particular case one needs to take into account the fact that the property is based on the Nepean Sea Road, one of the toniest neighbourhoods in Mumbai as well as India. Hence, there will be some premium for it.

Similar properties in not so tony neighbourhoods would not have given this kind of return.

In the India that we live in, there is a danger of the builder disappearing, and the home being built not being delivered. In that situation you will have to continue to pay the rent of the home that you are living in, along with the EMI on the home loan that you have taken in order to buy the house.

If you haven't taken on a home loan, then your savings are stuck in an asset that isn't giving you any return really.

More than the money, the stress that comes with an uncompleted home and the builder disappearing with the money, is extremely huge. I have seen a number of such examples among my friends and family, and believe me it's simply not worth the trouble. It's amazing to see so many builders get away after not delivering homes on time. There are those who disappear with the money as well. It's still more amazing to see people believing homes are the best investment.

Another factor that most people don't realise while buying property as an investment is that the timing the investment is very important. If you had bought property any time during the period 2002 and 2009, and sold it by now, you would have made good money. There is no doubt about it.

But if you had bought property post 2010 onwards, and if you take into account, the cost of maintenance (which needs to be paid every month in most building societies these days), property tax, EMI interest, or loss of interest on the amount invested in the property, etc., chances are your returns would be in single digit territory. In many cases, the returns will be flat. And if you start taking inflation into account, then the value of the home, would have actually gone down in real terms.

But the human brain is not used to dealing with so many factors at the same time. In the simplistic world of the human brain, investing in property continues to be a good form of investing and will continue to be so because it tends to look at absolute numbers and not the real returns.

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