The Hindu Business Line : A tough nut to crack

Compared to investing in a commercial property, the risks associated with residential properties are relatively lower. But your returns will be lower too.

Those who invested in real estate in the 1970s and 1980s will have an enthralling story to relate. Deals made during that time provided an annual return of about 20 to 25 per cent over a 15- to 25-year period. Mouth watering, aren't they?

However, in the coming years, similar to other asset classes, real estate investment too is likely to offer lower returns compared to the past. And yet real estate continues to be among the most popular alternative investment option for investors. For conservative investors, investment in residential land and houses is worth considering.

Staid investment

Residential properties are a sub-sect of real estate investment, which encompasses commercial properties also. Commercial properties are similar to equity investment characterised by high returns and risks. In contrast, investing in residential property will appear almost staid. However, it is a worthy option for the conservative minded.

Compared to investing in a commercial property, the risks associated with investing in residential properties are relatively lower. However, the returns are also lower.

For instance, estimates of gross yield on a commercial investment works out to about 10 per cent or even higher for a commercial property. Gross yield is the rent income as a proportion of amount invested in a property. That is, investment of Rs 50 lakh in a commercial property could fetch you rental income of about Rs 5 lakh per annum.

For a residential property, the gross yield is lower at between 4 and 6 per cent. In addition, when you sell the property after a few years, the total return on an investment in a residential property is expected to be between 8 and 10 per cent. In contrast, commercial properties could fetch returns of between 12 and 15 per cent over a long period.

Notwithstanding the nominal returns of only about 8 to 10 per cent that a residential property offers, it is still attractive because of a few factors. One, the returns on residential properties is expected to out perform debt investment. In addition, even as residential property investment is expected to under perform stocks, the fluctuation in their sale value, a measure of risk, is expected to be lower than that of stocks. This makes them worthy of inclusion in a conservative investor's portfolio.

Single homes

Investors in a single residential property may not consider themselves as investors in real estate at all. However, more than investors in a number of properties, it is this class of investors who need to ensure that their residential property deal works out to be a paying proposition. This is because the stakes are much higher for these investors. Typically, these investors shell out between 25 and 60 per cent of their net monthly income to repay the loan taken to finance their property purchase. This means that over a 10-year time frame, the value of their real estate investment could prove to be a substantial proportion of their total wealth. In this context, if the value of their property declines or performs poorly, they may end up compromising on old-age security.

Single home investors also need to consider the impact of leverage. For the property to be remunerative, the total return for the investor has to be higher than the rate of borrowing. For instance, if you are borrowing at the rate of 8 per cent, the total return has to be more than 8 per cent. The total return here includes tax savings and savings in rent but is predominantly dependent on expected change in property value. So, the price at which you purchase the property and the potential for appreciation are critical. For instance, apartments in suburbs may be unattractive for most single homeowners, since the potential for appreciation is limited.

Caution advised

There are a few caveats, though. In India, investing in real estate has remained a nightmare. Lack of availability of reliable information on market prices and deals undergone in the market, have ensured that investing in real estate still remains more of an art than a science. Market idiosyncrasies such as different values for the actual deal and for the purposes of registration enhance risks. In addition, the minimum investment size is quite high. Some suggest that to hold a portfolio of worthy real estate investment opportunities, a corpus of at least about Rs 1 crore is necessary.

Investors also need to be cautious about the prices of property. The home-loan borrowing binge of the last 24 months has led to a rise in property prices across the country. According to analysts tracking the real estate market, prices are now at levels closer to what they were in 1996, asignificantly high level.

In this context, thorough groundwork is essential to find out if the acquisition prices are reasonable and capable of delivering returns.

Another factor is interest rates. Typically, real estate values offer a hedge against interest rate decline. However, interest rates have already declined substantially. So, real estate prices may fall if interest rates rise over the next few years. If you have borrowed to finance your property acquisition, it could put you in a fix if interest rates rise since it could lead to decline in property prices as well.

Worthy option

Such obstacles, though, need not deter investors. Usually, the market for every asset class has several constraints within which investors have to operate. The real estate market is no different. The most important factor is the need to ensure that the price paid for a property is as reasonable as possible.

Besides, young investors can test the market with smaller sums and start building a portfolio over a decade. Over this period, investors can also utilise the time to get to know more about the real estate market. It is a tough market to understand and the trends in prices, rent and other relevant matters are difficult to grasp. Since real estate is a long-term investment proposition, time spent in understanding this market will be worth its weight in gold.

Picture by Shaju John

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