Publication: The Times Of India Mumbai; Date: Sep 16, 2008; Section: Your Money; Page: 21
A high net worth businessman is shocked to discover that his returns from realty are not up to the markMost Indians think of real estate as a safe investment. Just because daily quotes are not available, they think of real estate as safer investments. They subconsciously believe that not knowing the current price of an investment makes it less risky.
Rahul Mehra is one such business owner who believed that property is a much safer investment and the only way it can go is up. With this belief, he took exposure to real estate for the last five years. In some properties, he is still making some handsome money. But in properties bought during the last 17 months, he is still in the red from a pure valuation perspective.
He is worried about the real estate scenario considering that he is leveraged on four properties and has sizeable EMIs to pay. Also, one of his tenants had defaulted and he was finding it difficult to get the price he had in mind. On top of this, his business income had slowed down and there were some challenges on this front too.
We discussed the actual returns that he made in real estate over the last 20 years. He was just making some basic calculations and coming to a conclusion of 20% per annum. We then took into account every property bought and sold by Rahul in the last 20 years. This included properties where he not only made gains but also where he had substantial losses (like in 1996 and 1997), and took each and every expense into account.
He had missed out several key expenses like stamp duty (5% on every transaction); brokerage fees (1 to 2% based on the property); regular maintenance expenses (depends on a property but can be substantial—2 to 4% of property value); wear and tear—painting and other expenses; legal expenses like lawyer’s fees, drafting agreements and other advisory services, he also had a tenant who refused to move out and hence some litigation is underway, he is yet to recover some money from one of his older tenants; and taxes—long-term capital gains of 22.66%.
After accounting for all the above expenses and losses made in some properties, his net return worked out to around 7 to 8% post tax. He was shocked when we ran through the numbers. Some investors would have indeed done better at 10 to 12%.
The key point is that property prices always move in cycles and sizeable profits can be made if you buy: when the prices are affordable and interest rates low; buy properties that are foreclosed or distressed assets or; if you invest in the early stages of a project (at a discount). However, this is again subject to affordability of prices, economic situation, interest rate scenario and general income growth. Unlike popular perception, no asset class is free from risk. Every asset class is exposed to different kinds of risk and real estate is an asset class that is exposed to different types of risk—right from prices going down to legal and complex matters. Also, it’s a leveraged form of investment where people borrow to invest and are in deep trouble when the tide goes against them.
Mehras goals were as follows: expansion of Rahul’s business—he needs around Rs 2 crore; fund Gauri and Purav’s education with about Rs 50 lakh each in the next 10-12 years; have sufficient funds to the tune of Rs 1 crore for their marriage; buy a property abroad for around Rs 2 crore; generate 15 to 20% per year from his investments; and post retirement income of Rs 2 lakh per month.
A detailed assessment of their goals, cash flow and net worth statements, insurance policies, investments and tax returns revealed the following:
Most of his properties were leveraged and on floating rate interest rates. To save 1%, he opted for a floating rate when interest rates where around 7%. Now, his interest rates have gone up to 12.25% and the equated monthly instalment (EMI) payments have gone up substantially. Majority of his is tied to his real estate. Though he is generating decent rent, the EMI payments are substantial and almost two times his rental income. Hence, the cash flow was negative on these real estate investments and there was substantial outflow going from his pocket.
There is a strong likelihood that his income might go down by 30% and this is one of the key risks to his situation. Also, if property prices correct by 25%, banks will almost certainly ask for more collateral from him. However, most of his investments, except for the savings account and mutual fund amounts, are illiquid. Some of his mutual fund investments are also down. This has created a situation where if the banks ask further margin money, he might not be left with any money even if he liquidates the mutual fund investments. This is a very unpleasant situation to be in even if the individual’s net worth is very high. He had anchored himself to a certain price and was expecting a particular price from his investments. This is one of the reasons why he was finding it difficult to sell his property.
Also, though he was paying very high premiums, the cover was around Rs 2.5 crore. He had not covered all his liabilities and thus was also exposed to this risk. His debt-to-take-home income ratio was around 58% which was extremely high. This should have been restricted to around 35% of his take-home income. And the real estate exposure should be limited to a maximum of 30% of the overall asset allocation.
We created a comprehensive financial strategy for them, parts of which are reproduced below:
We first found out prices for similar properties in the area which were around 10 to 15% less than Rahul’s expectations. I told him it’s always not possible to get the expected price. I reminded him of his experience in 1995 when he had to sell one of his properties at a sizeable loss. We decided to sell two properties (at prevailing prices or 5 to 7% lower and it took us three months to sell them) for around Rs 4 crore and pay off 80% of the loan.
This ensured that the loan was now restricted to a single property and the EMIs would be around Rs 12 lakh. This was absolutely comfortable and this property was rented as well. It was generating a rent that could be used to pay off a sizeable portion of the EMI. This was the property that he had bought in 2004 and thus the rental yield as per current market prices was very attractive.
Hence, we decided to retain this property and sell the others. This action improved his cash flows to comfortable levels and ensured that he had a sizeable surplus every month.
We then surrendered some of his life insurance policies and brought down the overall premium payments to around Rs 5 lakh. At the same time, we scaled up his life insurance cover so that he had some meaningful cover. This once again improved his cash flows dramatically. We also took a Key Man policy for him and some of his key team members to address the risk of his death or his team members on the business.
We also looked at the requirements of his business, expansion needs and then created a business plan that clearly outlined his strategy and outlook. We utilised Rs 2 crore, needed for his business expansion, from the balance funds left after paying Rs 4 crore of home loan. This ensured that his expansion was timely and he is looking forward to break even in the next 18 months.
Amar Pandit is a Certified Financial Planner and Director, My Financial Advisor
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