04 May, 2013

Don't reallocate to property just because it is doing well today

There is a worrisome trend today. The trend is to take loans to acquire properties – not just their residential home, but investment in home & land. The current thinking with people is that property is the only asset that will give good returns and hence investors it. One may wonder - what is so worrisome about this?  The point is that they are going in for multiple properties, in many cases liquidating most of what they have and taking a loan for the rest.

What we need to understand is that, it is not just property loans alone that people may have. Most people also have vehicle loans. Some have personal loans, credit card EMIs, consumer durable loans etc.  Property loans go on for long periods and hence has to be properly thought through, before taking it up. Also, in case of floating rate loans, the EMIs can go up.  So, we find many people with multiple loans – their overall loan servicing burden goes as  high as even 80% of their income, in some cases. When most of the income is going to service the EMIs, even a small increase can be very difficult to service.

The second important point that we need to realize is that no asset class, including properties will perform forever. There is a school of thought that property prices can never come down. Some argue that even if it comes down, it can come down by 20-30% and not like equity shares. It is true that property prices may not come down by a huge percentage; but properties can remain stagnant for long periods thereby depressing returns, like it happened between 1995-2003. So, there are up and down cycles in properties as much as there are cycles in every other asset class. Gold is another favourite. About two years back the gold fever was at it’s peak. Again, there are those who believe Gold cannot come down at all. Gold has performed well in the past 10 years; but if you look at the past 30 years, the annualized returns would be in high single digits.  That too is not due to gold returns ; it is due to rupee depreciation!

The other aspect to consider is the return on investment in properties, in the holding period. For land, there is no return. For residential  properties, the gross returns as a percentage of the property value would be 3-4%. For commercial properties it can be double that. If one calculates the various outgoes like society charges, property taxes, income tax on the rent received, brokerage etc., the net in hand would only be between 50-60% of the rental income.  So, every year one is earning only about 2% on residential property and may be twice that for commercial properties.  One is potentially losing 5-6% in terms of returns, every year.  The capital returns on the property has to make it up.

The other cost not factored are the registration, stamp duty, brokerage & other incidentals, which adds to the cost, but does not reflect in the value of property. Also, during the period when one is holding the property, the property has to be maintained, which is over and above the costs discussed earlier. At the time of liquidating the property, one also has to pay capital gains tax. Else, one needs to invest in Capital gain bonds ( yielding 6% taxable return ) or buy another residence to save tax!

However, most talk of creating an asset on borrowed capital and tax savings. One is creating an asset using  borrowed capital but is also paying interest. Only for residential property the interest rate is benign at about 10.5% and the real cost of borrowing can be low, if it is a second home.  In case of commercial property, the cost of capital will be atleast 3% more than the residential home rate.

The loans taken to create such assets are longterm loans which means the loan taker is assuming significant risk. One is making a commitment for a long period like 20 years to acquire a property, which itself is a huge risk. What is working for property investors are not what they think. What works is 1) people hold property for the longterm. They don’t look at the property prices every second day 2) consistent investments into it for years.

But, this kind of commitment would have worked well for other asset classes as well!

What people are afraid of is volatility. They do not realize that what they should ultimately be concerned about is returns over their holding period. Volatility is one of the accepted parameters of measuring risk. But given a long time horizon, volatility is less and less significant. That is, risk goes down as time increases, as one will be able to capture both up and down cycles that way. It will be even better, if one is investing regularly over time, as this will further ensure that the investor participates at all levels of the markets.  Long term investment horizon reduces risk. This is an important fact to bear in mind while investing in assets prone to volatility & cycles. Most investors dread volatility & end up cashing in or out at the wrong time.

A portfolio is created to offer diversification, deliver returns after taking into account risk, liquidity, maturity profile and other considerations.  No asset class will perform at all times. Only FDs or such fixed income products can always provide a stable & positive return.  But that return, especially post-tax, will be miniscule.

 A good asset allocation should have equity, debt, property and other assets in the required proportion, based on the investor’s needs. Moving from one to the other, just because one asset is performing well, will skew the portfolio as well as create liquidity issues, tenure mismatches, tax inefficiency & other problems. Also, timing error will come in as we may not always be able to time correctly in terms of moving back and forth. Also, there will be costs involved and there could be other issues like liquidity, taxation, tenure etc.  

In essence, it is better to stay true to the desired asset allocation, save for any tactical calls of a minor nature.

Article by Suresh Sadagopan   Published in Business Standard 
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