Property can generally be classified into two separate categories: residential property and commercial property. A residential property can be bought to let out with the rental income acting as the basis for an income stream to the investor.
Likewise a commercial property (an office, factory, warehouse etc.) can be bought and owned in the same way, with the rental being paid by the tenant (the business that rents/leases the property) being collected as an income.
Before discussing whether having many properties helps achieve one’s goals, we shall first see what are the common financial goals(long term) for an individual with regular income. It could be:
- Income generation (people here buy rental property and put it on rent to obtain regular income), for retirement planning.
- Secure future (you may think of buying a property at present and sell it in the future at higher price and make some big money) to fund a particular goal
- Capital appreciation (if your objective is capital appreciation, then you opt for buying a promising piece of property in a neighborhood with great potential.)
And the objectives could be tax minimization and liquidity.
In order to pursue the above objectives and goals generally people opt for real estate or owning many properties as their ultimate and only investment option. It is very tough to talk a household out of buying more property, even though there are significant risks involved, since property and gold have been the favorites of traditional households for many years. Property taxes, maintenance expenses and repair costs are just some of the costs of holding the asset. Furthermore, real estate is considered to be very illiquid – it can sometimes be hard to find a buyer if you need to sell the property quickly.
For most households, this asset is the largest and most expensive one they would hold on their portfolio.
Let’s look at the challenges coming with rental properties which could be the causes of failures of rental properties:
- Negative cash flows: When a property consumes more money than it produces, it is said to be in a state of negative cash flow. Negative cash flow makes you have to look at other sources for paying off the mortgage, taxes, maintenance and repair costs, etc. Needless to say, it can be hard to hold on to negative cash flow property for long, unless one has significant savings or income from other sources (like rental income from other properties).
- Vacancies: The more the vacancies, the lesser the rental income – this has a direct effect on cash flow. Many landlords have trouble attracting tenants and/or retaining good tenants. Whenever a tenant vacates, it can be hard to find a new tenant soon – even a month or two of the property lying vacant means lost rental income. The secret to successful rental properties is good long-term tenants. Such tenants pay the rent on time and take good care of the property.
- Tenant dissatisfaction: As a landlord, tenants expect you to carry out regular maintenance as well as prompt repairs. It may be inconvenient for you to attend to problems whenever they occur. If you are unable to do so you’ll have a hard time retaining tenants.
- Tenants who pay the rent late (if at all): One should have an efficient tenant screening procedure in place to let in only financially stable tenants and those with a track record of regular rental payments.
- Leniency: one should separate emotion from business and be firm with late- or non-paying tenants and impose penalties and evict tenants if required, without hesitation.
- Low-quality properties: Low quality properties come with issues like structural problems and faulty electrical systems. Needless to say, this is a serious threat to the safety of the tenants, and if any unfortunate accident involving structural issues were to occur, you could face legal action.Costs to maintain a property are quite high- When buying a home, most people probably first think of the financial responsibility. And don’t often consider the time and labor that home ownership requires. Home maintenance includes everything from regular cleaning to repairs and replacements
- In case of rental property, before handing over the house keys to tenants, a home owner needs to ensure that the property looks well maintained. For that he needs to undertake cleaning of the property, painting (if required), a check on all pipes and fixtures by plumbing professionals (including water outlets, drains etc.), check on all the electrical connections and switches etc
Drawbacks of a property in earning capital gains:
Most of the times property is not really an investment. We do not understand the impact of compounding and end up overestimating our gains.
Let us see an illustration. Mr. Ashok bought a property in Bangalore, for a total cost of around Rs. 20 lakh in 2000. Today, brokers tell him, he can get Rs 1 crore for it if he sells. Wow! more than a six-fold return, you will say. But if you calculate compound interest and did the math, the rise in property value from Rs 20 lakh to Rs 1 crore means he got a compound annual growth rate (CAGR) of 11.33 percent. Nothing earth-shattering!
What is CAGR?
The CAGR represents the growth rate of an initial investment assuming it is compounding by the period of time specified. The concept of CAGR is relatively straightforward and requires only three primary inputs: an investment’s beginning value, ending value, and the time period.
Specifically, the formula is:
Remember, through most of this time he could have received risk-free fixed deposit returns of 9 percent-plus with banks. Or more with company fixed deposits.
Now, consider the cons of real estate investing, especially when you borrow to buy expensive property. When Mr. Ashok bought his property, the interest rate was upwards of 14 percent. The CAGR the property may give is 11.33 percent.
Symbolically, Cost of investment (14%) > return on investment (11.33%)
Though interest rates had fallen a few years later, he would probably have paid close to the rates of return the property gave him during the 15years. An investment that does not give you more than the cost of money is not considered an investment, but a liability.
Now moving further to see how other asset classes can be a good source to achieve your goals,let’s consider the four major assets like cash, gold, debt (income funds) and equity.
- Cash: The cash discussed here under is the cash that one holds in his/her savings account.
- Gold: Surplus money is also invested to buy gold which is ever appreciating in value.
- Debt (income funds):Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest. The examples of debt funds are Dynamic bond funds, Gilt funds and Long-term debt funds. Debt Mutual Funds offer several benefits. Debt Funds can give better returns than your Savings Bank Account & Bank deposits. Safety of capital and risk involved is almost the same with both the options (Debt MFs & FDs). FDs may offer you assured returns but Debt funds can offer you higher post-tax returns. The returns from Debt funds are mainly dependent on the ‘interest rate’ scenario that is prevailing in the economy. If interest rates are in a downward trend, most of the long-term or dynamic debt mutual funds can give better returns than bank fixed deposits.
- Equity: In simple, this means investing your money in company’s equity shares. This is mainly for people who can take risk with their money. Higher the risk, higher are the returns. It is a very volatile investment.
Let’s have a look at the following chart:
Every year a different asset class outperforms in terms of returns. That is why there is a need to have a diversified portfolio, not real estate alone.
The average annual returns of the major assets over the years also provides a good insight into other investment options.
Therefore for any individual, owning a house to reside in is a must (after deciding to settle down in a particular place). Owning a second house if affordable comfortably, as a rental property to generate regular rental income has proved to be a good investment with proper calculations. But going on to invest further more into similar properties either for rental income or capital appreciation proves to be a bad idea in the long run. That is because there are various other more profitable investment options for us as discussed in the chart above.
Here’s a brief comparison of the pros and cons of the three major asset classes, equity, gold and property.
Content writer – Dilzer Consultants Pvt. Ltd