One of the most notable trends we’ve noticed as financial planners is that the vast majority of individuals’ portfolios are either already heavily weighted in real estate or that one of their top priorities is to invest in more homes.
Investing in a home purchase? Here are the risks that you must take into account.
No one should be surprised by the fact that, as of 2017, real estate accounted for an astounding 84 percent of the total amount of household investment assets in India (RBI Household Finance Committee Report, 2017). Beautiful gated communities and lavishly constructed residences attract the average Indian investor in much the same way that Bollywood seductresses do.
You recently purchased a home and are just beginning to pay off the loan’s principal when a fresh upgrade comes on the market catches your eyes, do with the extra half-bedroom you forgot you needed and the tennis court your current apartment complex urgently needs but doesn’t have.
This is becoming more and more visible as things return to their regular state prior to COVID and as the economy picks up speed. In a conversation I had last week with a group of friends, one of which works in the construction industry confirmed that there are currently over 100 redevelopment projects taking place just in their small Mumbai suburb, with a similar number expected to be added over the next three to four months. The demand for this supply is obviously being driven by purchasers in the market, and it is only increasing. In other words, investing in real estate is looking attractive right now.
Given that many of you who are reading this are probably among those who are thinking of investing in a house right now, it might be an intelligent decision to stop and think about some of the investment dangers related to this asset class. This list is not all-inclusive, but each risk has the potential for severe damage to your financial independence.
Concentration
One of our customers had all of his disposable funds and approximately 70% of his net worth invested in real estate when he first approached us. Overall, he was in excellent financial position and well on the way towards becoming financially independent when we prepared his financial plan. But he had put all his eggs in one basket.
In actuality, it was the lengthy recession in the real estate market during the last ten years that prompted him to seek the advice of a financial planner. He realized that several of his long-term goals were harder to achieve than he had thought since his efforts to enhance his overall wealth had suffered greatly.
Therefore, it should go without saying that too much concentration in a single asset class can cause a portfolio’s overall performance to suffer, with sometimes huge overall wealth erosion. You should exercise caution if your real estate holdings represent more than 20 to 25 percent of your net worth.
Liquidity
In addition to concentration, liquidity is another more well-known worries. Although most people are aware of this risk, they won’t actually feel its effects until they do so under unfavorable conditions.
We’ll stick with the first illustration. On paper, the financial situation and trip appeared to be in good shape, but when it comes to execution and implementation, this risk became visible. One of the customer’s financial objectives—paying for a child’s international education—was already met off for fulfillment last year. The client had chosen a property that would be sold in order to raise money for the child’s education in order to achieve that goal. The home has been put for sale for several of months now, and despite inquiries—some of which were serious ones—it has not yet been purchased.
Make sure you have thought about that it is possible that a real estate asset (such as an apartment, house, land, shop, etc.) will not be liquidated within your timescales and that a plan B may therefore be required if you have such an asset.
The risks listed above are “obvious,” but based on experience, the next three are not.
Value Discovery
Value Discovery is a danger that comes after Liquidity. Real estate assets can only be valued based on other recent transactions in the same area or by forecasting over time, unlike market-linked assets where value discovery is fast and daily. Therefore, this estimate could be drastically incorrect, causing both value erosion and a financial delay to the attached goals.
In a recent instance, one of our customers had to liquidate her home in order to achieve a retirement goal. Since there hadn’t been a transaction in her neighborhood for a very long period, the valuation was based on benchmarking against other nearby buildings as well as extrapolation. Unfortunately, when it came time to sell, the proposed price was only around 70% of what was initially thought to be worth! Despite the best of efforts, there was barely any rise in the final transaction value. As you can expect, this dramatically complicated her retirement plans.
The problem is made worse by the fact that valuations cannot be directly compared or estimated over time because real estate market cycles can be vicious and lengthy. In a report we prepared for many of our clients, we found that, in the majority of cases, real estate assets held over the previous ten years had actually produced a capital loss post-indexation, i.e., they had not even beaten inflation.
Obsolescence
Although buildings age, it happens gradually. Perhaps a decade ago, there was no reason to be concerned about a 15 or 20-year-old structure built by a reputable contractor. The situation has changed, however. Liquidity and Value Discovery have grown to be a source of concern mainly because, while the real estate market cycle has an its impact, the product cycle adds a new dimension.A launch in 2021 will include amenities and characteristics that are considerably different from those of a launch in 2011. Therefore, even a high-quality property that is ten years old no longer qualifies for consideration. And if there is a sufficient supply of new construction nearby, even your excellent flat, which is 10 to 15 years old, loses its appeal to potential purchasers.
Obsolescence has a negative impact on the housing market due to a decline in demand, the supply of older homes for sale keeps on increasing.
Hidden expenses
Last but not least, hidden costs are a risk that most people do not consider, even if you are able to identify a house as an investment that is immune to the above four risks. People are aware of the costs associated in maintaining society, but there are other costs that are overlooked, particularly when making an investment.
Income taxes, periodic repairs (even if you change tenants every three years, you need to spend a good sum on getting the house repainted every time), brokerages (payable each time you have a new tenant), and non-occupancy (even a few months of a delay in finding a tenant means no income) are a few examples of these hidden costs. Last but not least, during the past few years, even the inflation hedge that rents offered due to the annual escalation has vanished, with rentals actually declining throughout the COVID period.
Hidden expenses have a major negative impact on already low rental yields and can reduce the yield by up to 50%. And when calculating investment returns, the majority of people fail to take this into consideration.
Conclusion
Any intelligent investor will assess a new investment based on two key criteria: the returns that the investment will probably provide over a specific period of time, and the risk that must be assumed in order to obtain that likely return. The second is far more important than the former because risks identify all of the different situations that might have an impact on the expected return on investment.
While purchasing a property as an investment may sound rather glamorous, there are a number of important considerations that any serious investor must take into account if they want to ensure that their investment does not turn out to be a waste of money in the future