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.

Disclaimer

Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

Please be advised that it is your sole responsibility to authenticate, verify and evaluate or take professional advice on the accuracy and completeness of all information, statements, opinions and other materials contained, provided, posted or expressed here or on any website with which this blog is linked. 

Alternate Investments with fixed income features

Alternate Fixed Income Investments

In the previous blog post I spoke of options available for fixed investments. Some of the questions that a few people came back with were, ‘why does one need to look at the various options? How much difference – in terms of returns – can one seek to achieve? Is spending the time to understand the options worth the trouble at all?

Even a 0.5% annualized improvement in annualized returns can bring about a meaningful improvement in the investment income over time. Let me elaborate. Consider someone – let’s call her Richa- with a crore of investments in fixed income securities. Let’s assume Richa has no other income streams and intends to live on the returns from the investments and the draw down from the investments. Let’s further assume that she expects to be around for fifty years and wants the investment to support her for that period. Let’s assume that inflation will be at 5.5% over this period. The following table shows the monthly spend she can afford, at different rates of return

6%                   Rs 19,500, approximately

6.5%                Rs 21.800, approximately

7%                   Rs 24,350 approximately

As can be seen, a 1% annualized improvement in returns can support a close to 25% improvement in the spend Richa can afford, implying a better lifestyle! Another way of looking at this is that to afford the same kind of spend – Rs 24.35K- at 6%, Richa would need a sum of Rs 1.25 crores.

That should settle the need for looking for investment options that offer potentially better returns that the popular options.

Alternate Fixed Income Options

There are a few ‘fixed income like’ options that have characteristics very similar to fixed income investments. I discuss a couple of those here.

Equity arbitrage funds: These are funds that try to take advantage of the arbitrage opportunities available in the stock market, primarily the arbitrage between the cash and futures markets. To illustrate, consider a stock quoting at Rs 102 in the cash market and Rs 100 in the futures market. An arbitrage fund sells the stock in the spot market and buys futures (or vice versa), pocketing the difference. Of course there are costs here, like the cost of carrying the futures position, the cost of executing the trades etc. These funds make money as long as the arbitrage is large enough to cover the costs and more, failing which one could expect them to deliver liquid fund kind of returns over time.

The arbitrage funds have delivered well over the last two years, both in the bull market of 2007 and the bear market of 2008. The returns have been in the range of 8-9% annualized. The fun thing is that these are classified as equity funds and as such there is no long term capital gains tax here. The short term gains are taxed at the applicable rate. It gets even more interesting if one were to opt for the dividend option with these funds. The funds don’t pay out any dividend distribution taxes and the dividends are free in the hands of the investors as well. Potentially all the gains could be had – completely tax free- in the form of dividends! In such a scenario, the 8-9% post tax return translates to a 12-13.5% pre tax return, approximately. That beats all the bank deposits, etc, hands down.

A word of caution here. There have been months when the returns from the arbitrage funds have been bad, of the order of 1-2% annualized. There have been months when the returns have been far better, with the result that the performance over a year has been good. So, if you have a tenure of a year or more, you may want to consider the equity arbitrage funds.

Structured bonds: Certain banks offer structured notes – which offer capital protection and a guaranteed coupon (interest rate) – while allowing the investor to participate in the upside offered by the equity markets. A structure that I recently came across worked as follows

• Capital protection -100%
• Coupon – 8% annualized
• Market participation – 40%
• Knockout – 35%, which means that if the stock market rose by more than 35% during the tenure of the note, the investor would get only the capital and the guaranteed coupon
• Tenure – 18 months

The returns would occur in the form of capital gains, making the structure reasonably tax efficient.

These bonds are not for everyone, as the investors are exposed to counterparty risk here. If the note issuing institution goes bankrupt, the investor could lose everything. Also, there is the issue of locking up of one's funds for 18 months.

Having said the above, the institutions that issue such notes are, usually, on fairly sound footing as per my reckoning, with decent credit ratings. So, one is not talking junk bonds here.

I think these notes would make sense to an investor who understands and is comfortable with the counterparty risk, is willing to forego the liquidity, to participate in the upside of the equity markets, while protecting one's capital and a base minimum return on one's funds.

Closing note

My attempt through this blog has been to bring to the notice of readers, the things they need to do to succeed in their quest for financial freedom. I have touched upon the need for asset allocation, the way to go about the same, the importance of insurance and some of the asset classes. I intend to discuss the riskier asset classes, real estate and equities, going forward.

Disclaimer

Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

Please be advised that it is your sole responsibility to authenticate, verify and evaluate or take professional advice on the accuracy and completeness of all information, statements, opinions and other materials contained, provided, posted or expressed here or on any website with which this blog is linked. 

 

 

 

Fixed income investments

The asset classes – Debt or fixed income investments

I have earlier discussed the importance of asset allocation and the asset classes that typically form a part of an individual’s asset allocation plan, viz. stocks, real estate, debt and gold.

Debt

Debt is an asset class that lets one earn steady – and usually low- returns with little or no risk surrounding wither the capital or the returns. In an ideal world, debt returns would show little volatility too.

All sources that talk of debt investments talk of a few common things like the importance of retiring all high cost liabilities, like credit card loans and personal loans, the importance of having 3-6 months of expenses set aside in a liquid fund, so that one can draw the same down in case of an emergency, etc. All of that advice is well meant and one will do well to follow the same.

Risks

Contrary to what most of us assume, almost no investment option is completely risk free.

Interest rate risk

Even the safest option available to an individual investor, which is investment in government securities, suffers from interest rate risk. The value of a government security – or a GSec – tends to fall when interest rates rise and vice versa. So, there is risk of capital loss associated with investment in government securities, if the same are not held till maturity.

Credit risk

Investments like bank fixed deposits have what is called the credit risk associated with them. Credit risk is the possibility that the bank may go bust and one may not get ones money back.

Liquidity risk

Investments like post office deposits carry little credit risk as they are backed by the government, but suck away liquidity. One may not be able to withdraw the money when one wants, or may be able to do that, by paying a penalty that may be associated with premature withdrawal.

Reinvestment risk

There is also the reinvestment risk which means that one may not be able to reinvest the proceeds from ones investments – on maturity – in an avenue that gives the desired returns, if interest rates decrease.

Each one of the common products that one looks at suffers from one or more of the above. For instance, a bank fixed deposit, carries with it the credit risk, liquidity risk and reinvestment risk, while a post office deposit carries liquidity risk and reinvestment risk. Liquid mutual fund investments suffer from reinvestment risks while debt mutual fund investments suffer from most of the above mentioned risks.

There is no way one can remove all the risks and the best one can do will be to understand ones objectives and decide which of the risks one would be comfortable assuming.

Investment avenues

I classify the fixed income products available to on into two classes

The traditional products – like bank fixed deposits, government small savings schemes, debt/liquid mutual fund investments, etc. These are highly popular avenues. There are many websites that compare and contrast these avenues and as such I don’t intend to discuss those here. 

Outside of the above mentioned products, there are avenues like the equity arbitrage mutual funds and structured notes offered by some banks. These have characteristics similar to some of the traditional products and throw open the possibility of improving ones fixed income returns.

For instance, the equity arbitrage funds – which do not have the risk associated with equity markets, in spite of their name- have delivered 8-10% returns over the past couple of years. Given the fact that these are considered equity funds, they offer a tax arbitrage that is not available with traditional fixed income products.

I have recently come across structured products that promise the safety of capital and also guarantee a coupon – i.e. a fixed interest – while allowing one to participate in the upside offered by the equity markets, subject to certain conditions. Ofcourse there is no free lunch and one assumes the credit risk associated with the counterparty, which is a highly rated NBFC in the product I came across recently.

I will discuss these two options in greater detail, in a subsequent blog, as i believe they can help one improve on ones returns from fixed income investments significantly.

Return optimization

I think it’s very important that one seeks to optimize returns from fixed income investments, without assuming undue risks. Even a 1% annualized improvement in fixed income returns can help one get to ones financial objectives that much quicker. To achieve this one needs to be nimble. So, please dont convince yourself that you cannot do much with the returns from your fixed income investments. You will do well to ask your financial planner for his/her outlook on the debt markets on a periodic, say quarterly, basis and see if that warrants you to do anything with your investments. I know of people who moved into income funds around August/September and ended up with a 20-25% absolute return in 3-4 months time. While we may not be able to do this all the while, keeping ones eyes and ears open for opportunities like that doesn’t hurt.

Disclaimer

Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

Please be advised that it is your sole responsibility to authenticate, verify and evaluate or take professional advice on the accuracy and completeness of all information, statements, opinions and other materials contained, provided, posted or expressed here or on any website with which this blog is linked. 

Role of insurance in financial planning

In my previous blog post, I discussed the importance of having a well drafted financial plan and sticking to the defined asset allocation pattern in achieving ones financial objectives. But one’s best laid out plans could go awry if one’s insurance cover – be it life, health or any other type of insurance- is not sufficient.  

As I discussed the last time, insurance is a cost. So, overdoing insurance is seldom a good idea. There needs to be a fine balance. The amount of insurance should be such that you and/or your loved ones are not left with less than what you/they would need, in case of unforeseen eventualities. At the same time, you need to ensure that you don’t spend more on insurance than you absolutely need to. Remember that there is always the opportunity cost associated with the funds that go into buying insurance; the returns you would be able to generate by investing that money elsewhere.

What kinds of insurance

The way I look at things, one needs the following insurance covers

• Life insurance
• Health insurance, AKA mediclaim
• Personal Accident insurance and
• Asset insurance
• Allowance for kids’ education

Life insurance

Calculating how much life insurance you need is fairly simple.  Calculate what amount of money your family needs to qualify for financial freedom, in your absence (Say A). Take an inventory of your assets and liabilities (say B and C). In simple terms, you need to plug the gap. The amount of insurance you need is A-(B-C), to ensure that your family is adequately provided for.

This may need to be adjusted, however, for the kind of assets you have. If you have a substantial portion of your money in risky assets like equity or real estate, you may need more insurance. Things can go wrong at bad times and the markets could crash just when your family needs to encash your equity investments. Providing a 25% haircut to your risky assets may be a good idea. Also, make allowance for the taxes that would have to be paid, if your investments are encashed. Finally, subtract the amount of insurance you already have to arrive at the amount of additional insurance you need.

Illustration

A.         Amount needed by the family – Rs 20,000,000

B.         Assets – 12,000,00 of which equity is Rs 6,000,000

C.         Liabilities – Rs 2,000,000

 

Adjustments

D.        Possible diminution of value of risky assets, in case of a fire sale – 25% of 6,000,000 = 1,500,000

E.         Taxes on sale of assets –Rs 500,000 (assumption)

F          Existing insurance cover – Rs 5,000,00

Adjusted value of insurance needed = A-(B-C) +D+E-F= Rs 7,000,000

The amount off insurance you will need will, however, come down if your spouse is working. That adjustment should ideally be made in your math used in arriving at the amount of money your family needs. Of course, your spouse needs to go through an exercise similar to what’s described here to determine her/his insurance needs.

There are many websites that try to help you with calculating the amount of insurance you need. Do a search for a ‘human life value calculator’ and you should be able to find one of those.

What form

Having decided on the amount of life insurance, you need to decide on how you are going to get the same. Go for the option that comes with the least cost. Usually, term insurance is the way to go. All other forms – be it ULIPs, endowment plans, etc- tend to result in less than optimal allocation of capital. There is sufficient material available on the web to tell you why term insurance makes sense. Read that and make sure that you ask the right questions the next time an insurance salesman approaches you, trying to sell insurance to you.

Term insurance is an arrangement wherein you pay the premium and get nothing back if you outlive the term of cover. In other words, you money is spent on just buying mortality cover, which is how it should be. Term insurance costs a fraction of what other types of insurance cost. By investing the money you save – by virtue of the lower premium payouts – you should expect to more than make up for the returns you would have had from your insurance policy, had you opted for other types of insurance. Always bear in mind that mixing insurance and investments is seldom - if ever- a good idea.

Health insurance, AKA mediclaim

Whenever I have spoken to people about the need for health insurance, I hear the refrain that their employers provide health insurance and so they do not need to spend money on that. That’s a risky approach to take.

For one, jobs are not secure – as many of us have painfully realized- and the health insurance provided by your employer protects you only as long as you are on the job, in most cases. God forbid, you lose your job and you or a dependant falls ill when you are unemployed, you would be in trouble. So, having health insurance cover funded by you, protecting yourself and your family, makes eminent sense.

There are other benefits too. You build a track record with the insurer, which comes in extremely handy when you don’t have the protection of the employer provided cover. Also, if you have bought insurance cover for a certain number of years, you would not have to worry about your claims being rejected on the excuse that the claims corresponded to ‘pre-existing’ illnesses. Also, as of now, the government provides tax breaks on the cost of buying health insurance, subject to certain limits.

Private healthcare, though expensive, is not fully out off reach for many of us, as things stand now. But the costs of healthcare – and education – tend to increase at a much faster rate as compared to general inflation. We could well end up like the US, where private healthcare is almost out of reach of those that are not insured. While I hope that we – as a nation – don’t get there, you don’t want to be taking chances!

Personal accident insurance

Imagine a situation where one meets with an accident, is permanently disabled and cannot be gainfully employed. There is a loss of income, and any amount of life insurance does not help. A scary situation!

This is where personal accident insurance comes in. As with health insurance, most employers provide personal accident insurance, but you may need to see if the amount is sufficient. Your employer typically provides a cover that’s 3-6 times your annual gross salary. Using calculations similar to those used in calculating the amount of life insurance you would need, you can see if the amount of personal accident insurance provided by your employer is sufficient. If it is not, go ahead and buy additional cover. It comes cheap.

Asset insurance

Most of us have vehicle insurance because it’s mandated by law. My guess is that very few of us have asset insurance, insurance covering the house and other valuables. Asset insurance can come into play in cases of natural calamities, theft, etc. I know most of us would feel such things don’t happen to us. But when you are planning for financial freedom, it makes sense to be ready for as many eventualities as possible. Remember that things do go wrong.

Allowance for kids’ education

Kids’ education is something all of us want to provide for, to the best off our ability. Given the importance attached to this, it makes eminent sense to make sure that the amount you want to be available for your kids’ education is available when needed, no matter what. So, to me, this is an apt case for buying protection to ensure the desired outcome.

There are many ways of doing this. One is ULIPs, but again the cost structure associated with ULIPs make them the least preferred option. The other way which was available for a brief while, was the insurance protected SIP investments in mutual funds from certain fund houses. This had its own issues too.

My approach has been to estimate the amount of money my kids would need, the time of such need and set aside sums of money, which would grow into the required amounts, at the times of need. If you don’t want to set the money aside today, and want to fund the same as you go along, calculate the amount you would have had to set aside today. Then buy additional life and personal accident insurance for that amount. This way, you can make sure that your kids’ education plans are always well funded