Real Estate Investment – Part 7 of How to invest into anything?

SR07 - Title-Real Estate - Land

Ref: 09-034A of 1st November, 2009      Scribd PDF Download

I am skipping three important chapters on Bonds – Treasury, Municipal and Corporate (Fixed Income and Convertible Bonds) which are really useful to practical investors, especially wealthy ones who do not have risk appetite after a few years, and would settle for more secured yet reasonable returns. I am postponing, not skipping them because there has been demand from retail investors in popular column of this blog Confused Mind, Clear Answers.

REAL ESTATE – the name conveys it all. It is “real” that is touchable, feel able (Indian English) and enjoyable on day to day basis. It is “physical”., not paper assets except its derivatives that destroyed America such as CDO (Collateralized Debt Obligations), CDS (Credit Default Swaps), REIT (Real Estate Investment Trusts), Mortgage Pool, Warrants of shares of Real Estate Companies etc.

Howsoever the high may be the price; the Investor in Real Estate has one consolation – which the investment will never go to zero (except in derivatives as above). It can be held for long term, for passing heritage from one person in the family to the other descendants. He is often wrong, especially when he leverages his investment by borrowing from the banks, relatives, home financiers, moneylenders and friends.

Gone are the days when the people used to invest into Real Estate only from own savings. Today, Opium (or Other People’s Money) or others’ lending becomes our capital. We have come to a stage when one can comfortably say “If I earn, it’s all mine; If I lose, it’s all yours”.

The World’s riches men have made major fortune in real estate. AND the world’s leading bankrupt persons lost everything in real estate. The Real Estate therefore makes or breaks anyone anywhere.

GIF AnimationIt is therefore important that we know the every little thing behind the real estate to make us rich and richer, not poor and poorer. Any investment made carefully has chance of making money in 70% of the cases. An ordinary investor is never in command of external factors, that takes away 30% what we call risk.

Any long term investment in good assets of whatever kind always makes money, is another rule of investment. The real estate automatically become long term investment because it can not be bought and sold like a stock or in day trading exercise EXCEPT in a city like Hong Kong, my city, where the Chinese people eat, drink, lunch, dine or breath only real estate and race course.

Following are the most important long term investment, some physical or real and others abstract.

  1. Own Education – Abstract
  2. Family – Parents, brothers, sisters etc – until one marries (Abstract)
  3. Family – Wife or husband, Children – after one’s marriage until Children marry(Abstract)
  4. Family – Wife or Husband after the marriage of the children (they get separated or what we call in stock market language – Spin Off – Abstract yet Real
  5. Job or Business – Real
  6. Home, Office, Land – Real
  7. Car or Scooters, Motorbike – Real
  8. Bank Deposits (3 years and above) – Real
  9. Bonds – Real
  10. Stocks of really good companies bought at market crash time. – Real

In short, after one’s own education, only Spouse (wife or husband) become real long term investment that comes to help at any time even when a person loses everything or at deathbed. It is important therefore to choose the career carefully (while educating) or while selecting a life partner.

Second Best is “Real Estate” – our Home. Owning a home is a dream of everyone in every country– in America, it is known as “American Dream” that went sour of late. Even one has gone on a costly holiday and stayed at best hotels, he feels comfortable when he returns home – Home, my Sweet Home. There is no pleasure like coming back to one’s own home from wherever he was.

How to Buy Real Estate? Where to start? Residential Home

Its a million dollar question. The answer is very simple. Start from buying Home for self use. Never try to buy own home for investment purpose but for real self use. When one buys his own home for dwelling purpose, to marry and then build family, he develops tremendous attachment to that asset, and never feels like selling unless there are very compelling reasons to do so. It automatically becomes a long term investment. Following are the basic rules to follow while buying own home.

  1. Type of Usage
    1. Commercial Property:
      1. As a rule, commercial property rise much faster than residential or agricultural assets. They also tend to fall last. The reason is; the commercial property is meant for business which has earning power. The owner can afford to pay more if the business is good.
      2. Residential Property is of following types with features:
        1. Luxury Property – always on rise for several years. They are relatively stable because the owner has holding capacity in the event of downturn of overall property market. Prime properties are always best to invest. If your purpose is an investment, and fairly for large value (Over USD 500,000 or more) and not necessarily own personal use, prefer prime property. They are liquid, rise fast in value, fall slowly and give the owner a unique status.
        2. Upper Middle Class Property: They have more liquidity. Most of the owners are high salary earners from executive or semi executive cadre. Or they could be middle order businessmen.
        3. Lower Middle Class Property: These are generally Mass Housing Projects. They look good for first few years but then begin to crumble due to poor maintenance. In country like India, where the concept of “cooperative society” is popular, the property is managed by the group of owners who are always cost conscious. The owners generally do not contribute much to the proper maintenance. There are always differences or squabbles. As result, the property deteriorates fast. They fall fast in bad times but rise slowly even in good times.
      3. Agricultural Property:
        1. Very few are interested in this property. The farmers everywhere are poor, so the value of the property rises at slowest pace.
        2. However, one has to read the farm produce prices and its trend for next few years. Of late, the food prices are seeing strong upswing with the result that the yield rises very fast. The value also rises at fastest pace.
        3. In such property, the presence of Water and suitability of land for tilling purpose are most important factors for selection. No water, no value for such property. However, little imagination could bring in stupendous profits. More on this later.
        4. Location
          1. Country: Buy where you are going to live for at least 10 years.
          2. City: Buy in that city where you will be living
          3. Suburb: Buy where you have place of business or job (even if it is transferable).
          4. Select the location between two cities or two districts of same city, which are expanding outwards. For instance, if the district or city is expanding north, and neighboring district/city is developing south, it is preferable to buy somewhere in between, provided the location is within same municipal limits.
          5. If the nearby road is less than 30’ wide, better buy the unit one block inside. It often happens that when the city start developing, the roads are widened. If you have bought unit just touching the road (what they call “road touch property”), it may be subject to compulsory acquisition by at least 10 feet to 25 feet. If you have bought the unit one block inside, it will automatically become “road touch” with the result that its valuation will improve instantly whereas older one will lose.
            1. Real life example: I bought one large piece of land (5.5 acres) about 500 feet inside the main road, Due to expansion of new Airport, the main road is now truncated and the inside road touching my land will be developed into a High Way. I will lose about 10’ to 15’ – about 0.125 acre, but I will be compensated @Rs 500,000 when my acquisition price only a year ago was Rs 245,000.
            2. The adjacent plot was just sold for Rs 900,000/acre for some industry. In other words, my investments will more than treble in less than 18 months.
        5. Locality
          1. Select safe, secure and developing locality. Avoid mature locality which has no room for growth. Newer localities are better planned and have room for growth, so your investment has chance of growth.
          2. Ensure that there is enough power, water and other sanitary facilities.
          3. Ensure that there are banks, post offices, telephone facilities and most importantly School and colleges facilities. (Real life example: In NRE Complex in Navi Mumbai, India, the prices never rose for 7 years, in fact they fell. When the prestigious school Delhi Public School opened near its front gate, the home prices started climbing, rising nearly 5 times (500%) in 7 years from all time low)
          4. d. Ensure that there are some industrial estates in less than 20 kilometers (10 miles) peripheral area.
            1. The industries bring in prosperity. They create jobs or income, and also increase the travelling population. The people from other towns or suburbs travel to this city for job or other gainful employments.
            2. A city with real industries (with employable labors, not automatic plants relying on less labor and more on automated machines) enables greater rise in capital value than others. (Real life example: The prices in city like Surat rose faster than Baroda in Gujarat, India because Surat was having labor oriented industries such as Textiles and Diamond, whereas Baroda was having automated plants like Petrochemicals – IPCL).
            3. This is often a difficult proposition to follow, because 1 out of 50 cities have industrial estate.
            4. Use this rule as last but avoidable requirement.
        6. New Constructions
          1. Prefer new constructions to old one, because the priorities of people have of late changed. The people ask for more telephones, broadband, piped gas, lifts and recreational facilities etc. Old ones have no infrastructural support to adopt the newly demanded facilities. Further, residential complexes have better appeal than others.
          2. Swimming Pool and Club Houses are not must requirements. They merely increase the monthly maintenance charges and cause higher capital outlay (developers add these assets in Gross Built Up area in a country like India. The real utilizable area is often 35% less in high rise buildings.
          3. Older constructions with purely residential homes are acceptable if they are built in last 5 to 7 years. Still, they do not match the price performance of new constructions above.
          4. Prefer gated community (in country like USA) than independent homes for family security reasons. The crime rate in gated community is less (such as kidnapping, sex crimes, robbery or theft) than independent homes (unless there is private security arrangement). The people invariably buy homes for family security first.
        7. Car parking facilities
          1. As far as possible ensure that the Residential Home Estate has affordable car parking facilities.
          2. Car and other vehicles like Scooters, Motor bikes have become a necessity, not symbols of luxury. Those who buy home can afford to buy cars or other two wheelers.
          3. If there is no covered parking, make sure that the open parking facilities are available.
          4. In some estates, the cost of car parking facilities (say in Hong Kong) is almost 3 times the cost of the car itself. In India, it is almost equal to cost of car itself.
          5. This is avoidable proposition, if one intends to live in big city or suburb with ample public transports such as buses, trains, metros, auto and taxis and ferry. (Example: in a city like Hong Kong where I live, the public transportation facility is so efficient that one need not have expensive car unless it is a status symbol -in most cases)
        8. Valuation
          1. This is often very difficult part. This section applies to Residential and Commercial sector, not Agricultural where the preferences are different.
          2. An investor normally expects 6% yield on his investment. This has come down to almost 4% due to prolonged lower interest rates world over. I will stick to 6% as a general rule.
            1. If an investor expects 6% yield, it means that he expects to earn 6 on his investment of 100 (in any currency). That is if rental yield is 6% per annum, the capital value could be 100. In other words, if monthly rent is X, the annual rent will be 12X. If the yield is 6%, the capital value will be (100*12X )/(6) or 16.33 times the annual rental value (ARV). or say 16 times ARV
            2. If the market is super bullish, then the expected yield is 4% and in that case, the capital value could be 100/4 times or 25 times the annual rental value.
            3. If some one demands more than above as his Sale Price (your purchase price), then you would be overpaying.
            4. The best bargain, usually in bear market, is 12 times the Annual Rental Value. If it is 8 times, then you will never lose money (in 99% of cases)
            5. Say, you are able to get a monthly rent of 10,000, the Annual Rent will be 120,000. The possible capital value on 6% yield basis will be 16 x 120,000 = 1,920,000 on approximation basis. OR it will be 192 times of monthly rent. For simplicity sake, use 200 times the monthly rent.
            6. Often, the broker or seller quote overstated price for properties on sale,. You can not go to Architect to have valuation all the time – it costs money. How to find the nearest value in such cases? Here is the answer – check the monthly rent for similar property in same building or area with similar location. Multiply 200 times, and you get the rough numbers to start the negotiation. The reason for using Rental value is that the seller or his broker may inflate the sale price, but would be honest in telling you the correct rental value. An unwritten rule in real estate is that the “Rent Never Lies”‘. When you know the realistic rental value in the locality where you intend to buy the property, you will have nearly correct sales value based on above stated formula.
            7. If the location of said property is prime in that area with good view (mountain or sea view), you may add a few hundred thousands more.
            8. Exercise-1: You want to buy a home in good location. The seller is demanding 3,000,000 (3millions). The annual rental value for similar property is 12,000. The Fair value comes to 16 times Annual Rental or 200 times monthly rental or 2,304,000. If the interest rates are lower in your country, to say 3% to 4%, then the valuation will be 25 times Annual Rental Value or 300 times monthly rental or 3,600,000 which is well above offered price. But this is a top valuation model.
            9. Exercise -2: If you are an investor and not actual user, you can work out the possible future value based on expected interest rate in future. Based on those rates, work out the possible future value. If the rates go higher, the valuation goes down, and if the rates go lower, the valuation goes higher.
          3. These are the rough diamond tools. Once you use them frequently, the seller/broker would be surprised how you arrived at fairly good price of the offered property. Once they know that you are clever, they will sit down with serious negotiation if they want to sell.

        The next installment on this subject will be on 11th November, 2009.

        Please visit Scribd to have PDF downloadable version of this article.

        Anil Selarka (Kalidas)

        Hong Kong, 1st Nov, 2009 Article Ref No: 09-034A

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