For a lot of investors, at least in the Indian context, physical assets like real estate and gold have traditionally held much significance. And the sharp run up in their prices has further ignited interest in these avenues. While having real estate and gold (among other assets) in your investment portfolio is critical, this must not be dictated only by the prospects of making a gain. Rather, how much real estate you must own (which is the subject of this note) must be governed by factors that are unrelated to its price.
So why and when should you buy real estate? Before we answer these very critical questions let's first understand some very basic points about investing.
Asset allocation
Any discussion on investing must begin with what is known as a portfolio. An investment portfolio (since it's related to your investments) is a list of assets that you own in a certain proportion (referred to as allocation). So all assets put together in a particular allocation are referred to as asset allocation.
A typical portfolio must include equities, debt, real estate, gold and cash in a particular proportion. Notice that real estate does form part of the asset allocation, but it features alongside other assets like equities, debt, gold and cash. There are reasons why there are several assets in your portfolio. Once you appreciate these reasons, it will become clear why owning real estate is important but owning it alongside other assets is even more so.
Every asset, like equity/debt, is governed by different factors, which have an impact on its price performance over the long-term. To understand this better consider debt (like corporate bonds, government securities, debt funds), which is closely linked to interest rates, inflation and the economic health of the country among other factors. Then consider equities, which are governed by, apart from the abovementioned factors, performance of corporates/companies.
Notice that although there is an overlap to some extent between the factors that govern the performances of debt and equities, there are also factors that are exclusive to each asset. On the same lines, real estate has factors that are exclusive to its performance. Over the long-term, the exclusive factors set apart the performance of one asset from another.
What is an asset cycle and how it works
The domestic and global economies are dynamic and are constantly witnessing changes. These changes trigger a factor, which in turn impacts the price performance of a particular asset. If this impact is sustained, it will give rise to a cycle in that asset. If the change is positive it will lead to an upturn in the price of the asset; on the other hand if the change is adverse, it will lead to a downturn. Since there are several factors at play at the same time, various assets are under different stages in their cycles.
This explains why at times equities are on a high, but gold isn't or why being invested in debt is more profitable than being invested in equities or why real estate prices are on upswing but equity markets are depressed. While in theory at least, it is possible that all asset classes are witnessing the same cycle at the same time, in practice this is a rare phenomenon (surprisingly, that rare phenomenon is what we have been witnessing over the last few years!).
Why asset allocation helps
Now consider an investor who does not understand how asset cycles work, which is why he is invested heavily in real estate with only limited investments in other assets. At a time when real estate prices are on an upturn and other assets are on a downturn, the investor will benefit. But when the trend reverses (i.e. real estate prices decline and prices of some of the other assets rise), he will not only part with the gains he made on his real estate investments but will also forfeit the opportunity to earn returns on other assets.
That is why it pays to be invested across various assets in a defined allocation to benefit from the various asset cycles. Since you do not know beforehand which asset is going to be in which stage of its cycle, it is futile trying to time your entry from one asset to another based on the asset cycles; this rarely works and in any case is too time consuming (you also need very accurate research to tell you beforehand which asset will see a downturn and which one will witness an upturn). It is more preferable to be invested in several assets in a pre-determined allocation so that no matter which asset is in which stage of its cycle, as an investor you are well-placed to clock a return in line with your risk profile and in tune with your long-term investment objectives. This is like placing your eggs in various baskets or as it is referred to in investing parlance - diversification
As an investor if you have a preference for real estate then its time to 'change' your bias in light of this note. Rather, you should remove all biases for any asset. On the contrary invest in various assets according to a pre-determined plan/allocation.
At Personalfn, we maintain that you must have enough real estate/property for:
- your own residence and business, if any, and,
to give away as inheritance (which for someone of your age is quite some time away)
Typically, for most individuals property must account for roughly 50% of assets. Owning anything significantly higher than that can prove self-defeating, as it will expose you to the uncertainties of real estate without adequate backup (in the form of other assets like equities, debt and gold).
Real estate: A case study
To give you an idea, let us consider Kumar, a 26-Yr male, unmarried, who is in his first job. According to the Personalfn's Asset Allocation Review, this is how his asset allocation should appear:
Kumar is unmarried now, but in time plans to get married, he must therefore consider buying a property on priority. Personalfn's Asset Allocation Review recommends that Kumar must aim at having 50% of his money in real estate. He should invest in stocks/equity funds (30% of assets) as equities can add considerable value to a portfolio over the long-term. He must invest in fixed deposits/bonds (10%) for stability; in gold (5%) mainly for diversification (and not for generating above-average returns as many investors are tempted to do now when gold is at a high). He must maintain 5% in a savings bank account for emergencies.
While this is our estimate for Kumar, it is not too different for other individuals. For instance an individual (in the 45-55 year old age group) who is married with children must also aim to have no more than 50% of his assets in property.
It is however important to note that in present times when one buys a property, it is very likely that it will account for a lot more than 50% of the total value of one's assets. In such instances it does not mean that you do not buy your first residential property because you will exceed the 50% mark; what the Allocator tells you is the ideal allocation for you is this and that over time you must reach it. So, when you buy a property in Mumbai, probably property will account, for let's say, 80% of your assets. In such instances the incremental monies you invest should be in other assets (equity, debt, gold) so that over time their share increases and you reach your ideal allocation.
Buying property on a home loan
Since it's likely that you are in an early stage of your career, your salary is probably not enough (add to this the prohibitive property prices) for you to purchase a property outright. Fortunately you do not have to rule out buying a property for this reason. For salaried individuals in particular there is help in the form of home loans.
Many banks offer home loans and salaried individuals stand a good chance of qualifying for one. This is because most banks prefer the steady income of a salaried individual to the irregular cash flow of a businessman, for instance. And if you are working in a reputed company (as defined by the bank) then your chances of getting the loan are enhanced. Of course, there are various parameters on which home loans are approved, being salaried and working in a reputed company are just two of them. Various banks have various parameters with varying importance accorded to each parameter. It's best to check with the banks while applying for the loan.
Individuals who are looking at buying property on a home loan have another reason to be pleased. Home loans are eligible for tax benefits:
Interest on home loans is deductible from income upto Rs 150,000 under Section 24 (b).
Principal amount of upto Rs 100,000 is eligible for deduction under Section 80C.
If all this sounds very confusing, consider taking advice from your chartered accountant or tax advisor. He can help you with the details particularly while filing returns when your home loan breakup (in interest and principal) must be defined.
So while it is pertinent to invest in real estate, individuals must curb their enthusiasm for it to ensure that their investments in real estate are always aligned to a well-defined and well-balanced asset allocation plan.
Of course, drawing up an asset allocation plan is not that simple. This is where an honest and competent financial planner comes into the picture. At Personalfn, we always urge investors to hire the services of a professional financial planner who can help them devise a well-balanced asset allocation plan with a defined allocation for real estate across various life stages.
No comments:
Post a Comment