Tuesday, July 20, 2010

Investing in Real Estate – Putting Your Money Where Your House Is!

I recently made a real estate investment – a 1,200 square feet (sf) 2 bedroom apartment in Koramangala (Bangalore). In my first blog, I had mentioned that real estate is an interesting investment opportunity especially in an inflationary environment. I had further pointed out that one has to be extremely careful while buying property in India given the fact that developers are not always dependable and are mostly out to screw the buyer.

I think the best way to invest in residential real estate is by purchasing completed or near completion properties in good established locations thus reducing construction, leasing and liquidity risk. It may entail paying a slightly higher amount per sf and a bulkier upfront amount (instead of a staggered construction-linked payment) but the benefits far outweigh the costs.

Before we go any further I would like to share some numbers from my investment: (click to enlarge)

The table above is a simple quarterly financial model I created to understand how much and under what circumstances I can make returns from this investment. The first box titled “COST OF PROPERTY” lays out all the costs I incurred in closing the deal including registration, stamp duty, brokerage and loan charges. As you can see, the total cost of this apartment came to about Rs. 59.6 lakhs or Rs. 4,946 per sf.

Similarly the rents table shows what rent I was able to get for the property. Currently the rent is Rs. 20,500 per month with a built-in bump of 5% per year. The Yield table show what rental yields I am making on my investment. For e.g for the 1st year I am making a 3.5% yield. This is the annual rent (minus maintenance and property taxes) divided by total cost (Rs. 59.6 lakhs). This goes up to 4.1% by year-4 because of the bumps.

The Sources and Uses table lays out how I have financed this purchase. I have taken a 40 lakh loan from Citibank at 8.5% (fixed for 3 years). I have assumed that I will sell this property after 4 years at Rs. 6,000 per sf – 20% more than what I paid for. Each one of you is the best judge of what this number should be for your own investment. I am pretty confident of this number for Koramangala.

There are also some savings in income tax, which is the benefit you get (in the form of higher monthly take home salary) from taking a home loan. (Refer to the last section for more). In my case the savings are about Rs. 4,500 per month. The EMI on my loan is Rs 34,700. So, the net gap I need to fund every month is Rs. 34,700 - Rs. 4,500 – Rs. 20,500 = Rs. 9,700. The table below lays out these calculations.

There is an interesting point to note here. The monthly interest on my loan is about Rs. 28,000. The total rent and savings in income tax is Rs. 25,000 (Rs. 20,500 + Rs. 4,500). That’s a gap of Rs. 3,000 per month. So of the Rs. 9,700 that I pay, around 30% is interest and the rest is principal repayment. Ideally, 100% of what I am paying from my pocket should have gone towards the loan with the tenant and the government funding the interest (and that’s my immediate plan) because otherwise it would mean that I am making my money work not for me but for the bank. Of course, this % totally depends on what % of the house you are funding with your own equity. In my case it was 33%. Had it been more this gap would have been lower.

Looking at it in this way the cash flows very closely resemble that of a Systematic Investment Plan (read my earlier blog). In a way this is nothing but an SIP on real estate. The only difference is that this SIP is on ONE asset with the price being fixed upfront. However, it is an asset that you fully understand and have thoroughly researched. I think the risks are a lot lower when you understand what you are getting into. According to me, this is one of the best ways to invest monthly on a real asset.

Coming back to the model, if I sell the property after 4 years for Rs. 6,000 psf (Rs. 72.3 lakhs) and repay the loan, I stand to make about 12% per annum and 1.5x my initial capital. This seems a reasonable rate of return for an asset that is comparatively less risky.

A sensitivity table on the right shows how the returns would vary if I were able to sell at higher or lower prices. For e.g. If I sell for Rs. 6,500 psf I make 17% and 1.8x my capital. At Rs. 7,000 psf I make 21.2% and 2.0x my capital and so on. I am confident that my returns here will be between 12.0 and 20.0%. Even if I am not able to sell at my price, the investment always gives me the option to hold it for a longer period of time and keep earning rental income. Perhaps, I may even want to stay there in the future. This flexibility is an added advantage of a residential real estate investment.

Now that we’re done with the numbers, I want to spend some time to understand why I think real estate is a good investment today.

The biggest drivers of my real estate investment were

1. Inflation
2. Capital Appreciation
3. Regular Income / Retirement Planning
4. Other Ancillary Benefits

Lets look at all these reasons one by one.

1. Inflation

Inflation scares me. Period.

Prices of food, petrol, travel etc are going up rapidly every year. It used to cost me Rs. 18 to travel from my house in Colaba to my office in Nariman Point in 2007. In 2008 it rose to Rs. 22. Today the same journey costs me Rs. 27. That’s a 50% increase in 3 years. On 16th July, Mint published an article on inflation which compared the cost of ordinary household groceries in 2000 and 2010. The results were the following:

The story is the same for all vegetables, grocery items, meat products etc. Newspapers give us a variety of reasons for this - bad monsoons, high government debt, rising nominal incomes, higher money supply, demand pull, supply push and so on and on. Whatever the reasons may be, as investors we cannot let external factors affect our investments and returns. We must do all we can to protect our investments.

My own opinion is that inflation is not going to go away any time soon, especially in a developing “growth” country like India. Our country has a large fiscal deficit that keeps growing every year due to oil and farm subsidies, infrastructure spending, rural development etc. The government borrows to fund this deficit every year. There are 4 primary ways to deal with this debt:

1. Default
2. Reduce expenditure
3. Print more money to pay off the debt
4. Borrow more

Of the 4 options, option 2 is the most difficult to execute. It’s political suicide. It makes the government instantly unpopular. Just look at the furore the recent oil price rise created in India or the protests on the streets of Greece when the prime minister announced budget cuts.

Option 1 junks your debt rating, currency and everything else you hold sacred and should be a last resort. Options 3 and 4 are the most likely ways to deal with this problem. However, with option 4 you are only postponing the problem. It’s like paying your debt with a credit card. It will end up becoming a much bigger problem later and you will again be faced with the remaining 3 choices.

Option 3 seems like the least harmful way to deal with this problem. Option 3 means more paper money in the system means more inflation means real assets will become more valuable. This is one of the main reasons why gold prices have shot through the roof in the last year. With European countries defaulting on their debt, investors are seeking the safer haven of real assets like gold.

Gold has already gone up 3x in the last 5 years and is at peak valuations right now. Maybe gold is still a very good investment. I frankly don’t know because gold prices have no fundamentals. I have always maintained that an SIP is the best way to invest in Gold.

I think right now the best REAL ASSET to invest in is property. It is affordable (you can easily get a loan), interest rates are low, it is fairly liquid and prices in most cities are below the 2008 peak levels.

My thesis for investing in real estate is that returns from real estate are closely linked to inflation. Rents go up every year almost in line with general price rise. When I started out in 2007 I used to pay Rs. 37,000 rent for my apartment in Colaba. The following year (which was the boom year), my landlord increased the rent to Rs. 49,000 (33% more). Last year (recession year) I renegotiated my rent down to 42,000 (down 14%).

My point is that rents move pretty closely with general economic conditions and is a good way to hedge against inflation. I think the basket of goods that a particular rent buys today will be more or less the same 10 years from now. Also, the cost of construction (steel, cement etc) will continue to go up and the cost of building the same house or apartment will always increase over time. This is why I like owning this asset class and this was one of the main motivations for purchasing the property.

2. Capital Appreciation

More often than not, this is the main driver for real estate investment in India. Historically property has been seen as a ‘safe investment’ that appreciates over time. This has held true in most cases. With increasing urbanization (more people moving to the cities), scarcity of land, improving infrastructure and rising incomes property prices have rapidly increased in almost every part of the country.

In Koramangala (Bangalore) itself prices have risen from Rs. 2,000 per sf in 2000 to 5,500 per sf today. I think, as long as the property is well located, the purchase prices is reasonable and the rental yield is healthy, this trend of rising home prices will continue for some more years.

3. Regular Income / Retirement

Retirement is something all of us think about. People plan their retirement by investing in insurance, provident funds, fixed deposits, post office schemes and equities but other than equities all these asset classes get their returns eaten away by inflation. I think good real estate is one of the best ways to invest in your retirement. There is no better way to get monthly inflation-adjusted “cash” returns month-on-month than rent. What’s more you can always enter into a reverse mortgage with a bank to get EMIs paid to you once you are retired.

A rented property today yields about 3.5-4.0% per annum, meaning total rent divided by total cost of apartment is around 4%. Like I pointed out earlier, the property I purchased is giving me a yield of 3.5%. However, this 3.5% grows by ~5% every year. In 10 years the property will probably yield around 3.5*(1.05)^10 = 5.7% and in 20 years around 9.3%. If you were to invest one crore in an apartment today (and pay off the debt in 20 years) the yield will be around Rs. 9,30,000 per year in 20 years, that’s Rs. 77,500 per month. Bear in mind that this does not factor capital appreciation.

4. Other Ancillary Benefits

Real estate investing has other ancillary benefits too. I can think of the following:

i) Tax benefits – If the property is “let out” (like mine is) the entire interest (minus the rent) can be set off against your taxable income reducing your tax. If the property is self-occupied you can set off up to Rs. 150,000 per year from your salary. So if you’re in the 30% tax bracket, you will save around Rs. 45,000 per year (Rs. 3,750 per month). The top right hand side of the model provides detailed calculation of how the tax benefit is calculated.

ii) Safety / Stability – Buying a house gives you that feeling of security. If nothing else, you can always stay in the house yourself with your family.

If you’re worried about inflation like I am and want to plan your retirement and have your own little cash flow stream other than your primary income, there is no better way than investing in good quality real estate.