Real Estate Investments

A recent Saturday edition of the Economic Times carried an article about Real Estate investments and the author asserted that real estate investors are ‘always’ better off. That’s quite an assertion.

I have been a real estate bear always, for reasons other than pure economics. Faced with the rather strong argument in the article, I decided to shun my negative bias and do some objective research on real estate investments.

Before I proceed further, let me make it clear that when I talk of investing in real estate, I am not going into the merits and demerits of owning the primary residence. That’s an emotional/sentimental issue for many.

Real estate investments would mean – for most of us - investments in land, a house or an apartment. I think there is a sea of difference between investing in land and investing in apartments or a house.

Let’s look at investments in a house or an apartment. My main grouse is that the rental yield from a property is significantly lesser than the opportunity cost of funds that go into funding the property. Let’s look at an investor that owns a house worth, say 50 lakhs and rents the same out at say 20K. The yield works out to 4.8%, calculated as 20K*12/50L. Now, the opportunity cost of funds is, usually, higher than that. So, for an investor to make money, there needs to be capital appreciation. If the rentals don’t go up– and they have actually gone down in the area I stay in – the disparity between the rental yield and the opportunity cost of funds only worsens as a result of the capital appreciation.

There are a few real estate cash flow calculators that illustrate what I am trying to say fairly well. One of the better ones is available at http://www.deepakshenoy.com/articles/realestate/realestatecf.htm. With the fairly liberal assumptions that the author has made, it turns out that the cash flows from a real estate investment are nothing to get excited about. If you consider the fact that the rentals have not been going up for a while – as against the author’s assumption that rentals move up by 6% a year, on average, the cash flows get worse.

An investment in land is a different ball game. Yes, they are not making any more land and there is demand for the same. It is fair to expect that the demand will increase – at least over the foreseeable future. But investments in land come with their own issues. In many cases, it is a pain to verify the title. Sellers expect to be paid in cash, etc.

SEBI has approved the setting up of Real Estate Mutual funds. Investors could look at taking an exposure to the real estate space thru such funds. My sense is that most of the value in the real estate value chain is captured by the developers. An REMF can invest in properties under development and as such should help individual investors capture the value creation there

Another option is investment into a real estate stocks. This, of course, brings with it huge volatility. But given where the real estate stocks are now, investment into companies that are well positioned to benefit from the turnaround in the real estate market – whenever that comes – should help.

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