A client called me for advice on a real estate investment. He had recently sold some old family property and wanted to invest his share of the proceeds in a commercial property. Real estate dominated his portfolio, so I told him not to put all eggs in one basket. The client shared his inherited piece of wisdom that since time immemorial, real estate has given great returns: "Invest in thousands and reap in lakhs."
In this case, the inherited property had been bought by his grandfather for a paltry sum of Rs 99,000 in 1959. It was sold at a stupendous price of Rs 2.50 crore this year. In fact, had it not been for some legal issues about tenancy and some family issues, the sale price would have been much higher.
My next question to the client was if he knew how much returns he had made. Given my tone of questioning, he became cautious. He hesitatingly said, "It is less than 11 per cent." And after taking capital gains tax into account, the returns stand at 10 per cent, I added. The return may not be bad but it's not spectacular either.
I was not telling him equity was a better investment but that no one should get swayed by the large investments that real estate entails. The client was not alone in vastly overestimating the actual returns from real estate due to the long period of holdings and the huge investment values. After all, an investment that multiplied 250 times can't be anything but spectacular. What he (and most real estate investors forget) is that over long periods it is not the high returns but the power of compounding that is producing the huge sale price. In our workshops when we ask, for examples, of spectacular investments that have multiplied 100 times over long periods and then ask them to guess the actual rate of return, we find most people's guesses are way higher than the actual return. Nobody, except perhaps a Shakuntala Devi, can actually work out the compounded return in their heads without the use of an excel sheet.
The belief that real estate gives spectacular returns is so widespread that an investment expert I met extolled the virtue of investing in a plot on the outskirts of large cities. It is available in lakhs today and because it is illiquid you won't be able to sell it. You will reap a sale price in crores in 20-25 years, he told me. I asked him an estimate of the sale price in 25 years and his best estimate turned out to be just a good return, not a spectacular one. Add the risk of encroachment, zoning changes, compulsory acquisitions at low prices and so on. If you consider the time and effort required to manage an investment in a remotely located plot, even this good return will start looking a little inadequate.
I showed him our research data in six Mumbai localities (based on the ready reckoner prices from 1990 to 2013), which showed the 10-year moving average return of the best performing locality was 8.96 per cent. In fact, the best 10-year return was 15.95 per cent before tax.
I am not trying to argue that real estate is a bad investment. Just that it is like any other investment, with risks that require the reasonable return it provides. It should be a part of any portfolio that is big enough to accommodate the lumpy nature of its investment. And clearly, buying a house for yourself is not an investment. For most people, the psychological stability of having their own house adds tremendous value and makes this a must.
Let me return to my client. What did he do? The last I heard is he had bought the shop he had asked me about.
Clearly, my client is not the only one who continues to follow this dated advice by Mark Twain: "Buy land. They've stopped making it."
In this case, the inherited property had been bought by his grandfather for a paltry sum of Rs 99,000 in 1959. It was sold at a stupendous price of Rs 2.50 crore this year. In fact, had it not been for some legal issues about tenancy and some family issues, the sale price would have been much higher.
My next question to the client was if he knew how much returns he had made. Given my tone of questioning, he became cautious. He hesitatingly said, "It is less than 11 per cent." And after taking capital gains tax into account, the returns stand at 10 per cent, I added. The return may not be bad but it's not spectacular either.
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A simple calculation convinced him that. I told him if his grandfather had actually put the money in an asset class that could deliver 15 per cent a year, the sale price would have been Rs 19 crore. I informed him the BSE Sensex had delivered 17 per cent a year in the past 34 years, that is, since its inception. And the returns from the Sensex were tax-exempt, too.
I was not telling him equity was a better investment but that no one should get swayed by the large investments that real estate entails. The client was not alone in vastly overestimating the actual returns from real estate due to the long period of holdings and the huge investment values. After all, an investment that multiplied 250 times can't be anything but spectacular. What he (and most real estate investors forget) is that over long periods it is not the high returns but the power of compounding that is producing the huge sale price. In our workshops when we ask, for examples, of spectacular investments that have multiplied 100 times over long periods and then ask them to guess the actual rate of return, we find most people's guesses are way higher than the actual return. Nobody, except perhaps a Shakuntala Devi, can actually work out the compounded return in their heads without the use of an excel sheet.
The belief that real estate gives spectacular returns is so widespread that an investment expert I met extolled the virtue of investing in a plot on the outskirts of large cities. It is available in lakhs today and because it is illiquid you won't be able to sell it. You will reap a sale price in crores in 20-25 years, he told me. I asked him an estimate of the sale price in 25 years and his best estimate turned out to be just a good return, not a spectacular one. Add the risk of encroachment, zoning changes, compulsory acquisitions at low prices and so on. If you consider the time and effort required to manage an investment in a remotely located plot, even this good return will start looking a little inadequate.
I showed him our research data in six Mumbai localities (based on the ready reckoner prices from 1990 to 2013), which showed the 10-year moving average return of the best performing locality was 8.96 per cent. In fact, the best 10-year return was 15.95 per cent before tax.
I am not trying to argue that real estate is a bad investment. Just that it is like any other investment, with risks that require the reasonable return it provides. It should be a part of any portfolio that is big enough to accommodate the lumpy nature of its investment. And clearly, buying a house for yourself is not an investment. For most people, the psychological stability of having their own house adds tremendous value and makes this a must.
Let me return to my client. What did he do? The last I heard is he had bought the shop he had asked me about.
Clearly, my client is not the only one who continues to follow this dated advice by Mark Twain: "Buy land. They've stopped making it."