Privacy, market decoupling and REITs

Real estate market in India is currently claimed to be in bubble territory. Certainly, the price increase during the boom period of 2004-2015 is unprecedented. While it has been a wonderful time for people who got on board before or in the initial stages of the boom, for people who did not purchase a house, it seems pretty hard. Worse, these are the people who are most likely to buy property at the worst possible time - just before the bubble explodes.

Privacy and market decoupling

So what has this got to do with privacy? Well, as per the original definition, a private citizen was one who took no interest in the affairs of the society. Given that most of the functions of a society are performed by markets today, I would call privacy as the degree to which a person is decoupled from markets.

When a person rents a house on a one year lease and license agreement, he or she is highly coupled with the market. Price changes would affect him greatly. The coupling decreases as the lease term increases and price stability is built in; however, often the "price stability" assumes other factors to remain constant. For instance, a 10% escalation clause would be fine in high inflation (and high salary rise) era but if inflation drops to 2% and salary increases follow suit then again issues arise.

Owning the house you live in significantly reduces the risk. You become much more disinterested in what happens to property prices.

Ticket size and Timing risk

Unfortunately, while owning a house reduces the risk associated with market movement, the process of owning a house increases it. In other words, if you purchase a house when the prices are high, you are significantly worse off. The real issue is that you can never be sure when the prices are high or low and since you must purchase the house at one go, you need to take up this one time risk

REITs

It is easy to see where all this leads to. REITs are a mechanism to "buy a house one square foot at a time". Basically a REIT (real estate investment trust) is a large corpus of funds that is invested in real estate. The investment into this corpus can be bought and sold in "small quantities". Sure, this costs money and my sense is that for REITs, the costs for managing REITs are likely to be 2-3% which will probably be of the same order as rents so your returns will be substantially lower than if you had bought a property. However, the benefits of diversification and small ticket size are significant since for many people there will be no other option.

In other words, once well managed REITs are available, you can invest in them in small amounts. They will allow systematic investment in property. For a person who has just started a job and would like to buy a house in 5-6 years, REITs would give an alternate mechanism to "decouple from the market". By investing a fixed amount every month, one can get rid of the fear of "what if property prices increase substantially". When one is ready to purchase property, one can just sell the investment in the investment in REITs and purchase the property.

For people who dislike paying interest and / or are not certain where they want to live in (probably because they are considering changing their job, career or city), these will be a boon and an alternative to purchasing a house on EMI.

Budgeting for your house

In this second post on a series on buying a house, I look at deciding the budget for a house. I assume here that the house is being bought for personal usage and not for investment. I look at a number of rules of thumb and show how they result in similar values.

Thumb Rules

1. The value of the house should not exceed 3-5x of your annual post tax income.
2. The EMI should not exceed 40% of your monthly post tax income.
3. After EMIs and expenses you should be able to save 15-25% of your post tax income.
4. The EMI should be twice the rent.
5. You should be able to make the down payment with 2-3 years of savings.

Justification

Much of the justification for the above come from models of expenses. For a family earning 1,00,000 Rs monthly after tax, the following seem reasonable.

• 30% (Rs 30,000) in monthly living expenses. This includes expenses on food / groceries, fuel, utilities, clothes, health, education, entertainment and other expenses.
• 30% (Rs 30,000) in rent and depreciation of major capital items like furniture, appliances and car. Of this, roughly two-thirds (Rs 20,000) will go for rent, one-sixth (Rs 5,000) will go as depreciation for car and remaining (Rs 5,000) will go as depreciation for appliances and furniture. The depreciation would roughly be the case if you have a car worth 3-4 Lakhs and total value of furniture and appliances worth roughly the same.
• 20% (Rs 20,000) savings for major financial goals other than retirement.
• 20% (Rs 20,000) savings for retirement. Half of this will usually come from mandatory savings (EPF etc) and the remaining half should be invested in equity via mutual funds etc.

 The ratios usually hold out over significant income range (say 25,000 per month to 4 lakh per month).

From the above we see that the rent is 20% of income so rules 2 and 4 become the same. Similarly after deducting the EMI of 40% of monthly income, the family would still be able to save 20% so rule 2 and 3 also become the same. 

Lastly, at current interest rates (10%), a 25 year EMI comes to around 1% of the house value. So if the house is 3.3 times your annual pay, the EMI will be (3.3*12*0.01) 40% of your monthly pay. Similarly, if the interest rates are 6% and the house is 5 times the annual pay, the EMI again will be 40% your monthly pay. So rules 1 and 2 again become the same.

Lastly, if you use all your savings (25-30%), in 2-3 years you will have around 75% of your annual pay which will be sufficient for 20% of a house that costs 3.5 times your annual pay. So rules 5 and 2 also become the same.

Together, these imply that with a monthly income of Rs 1 Lakh, you can buy a house worth 40 Lakhs.

But this is too low

This would be your first reaction, especially if you are actually living in a house with a rental of 20,000. Generally, such houses would sell for around Rs 1 crore. Please note the following caveats which shows that the above is not really an underestimate - 

1. We have not considered property taxes and maintenance expenditure on the house.
2. The above assumes that you are buying a ready to move in house. If it is still under construction, the EMI that you can afford goes down - almost by half.
3. The above also assumes that all the money for your other financial goals will come only from increase in income. So do not assume future increments for a higher value of the house that you can afford.

So the end result is that you really cannot actually afford a more expensive house.

Options

 You are then left with the following options

1. Buy a smaller house or in a less desirable location and downgrade your lifestyle.
2. Save more money from expenses and retirement savings to fund a larger house.
3. Buy a house or land in another city as an "investment".
4. Continue living on rent.
5. Unconventional ways to significantly reducing expenses (living with your parents, delaying / not having kids, extremely frugal living)

 Of course, none of these options are easy. You need to ask your why you want to own a house to really decide between them.

For people who have not yet married or are just married, my recommendation would be a combination of 4 and 5. Frugal living on rent will allow you to save a good amount of money; 70% of your after tax income is actually doable. 4-5 years of savings of that nature can easily result in a situation where you have saved 3-4 times of annual income. Such a corpus could open up a large number of opportunities.

Buying a House

Buying a house is one of the first things on your mind after you get a job. Part of the reason is that a house is a major source of security, stability and status. This is probably the biggest financial decision taken by most people. Yet, as the housing crises all over the world shows, this is a decision that is easy to get wrong.

Emotional Factors

Many of the mistakes that are made while people are buying a house are because of "emotional" factors associated with it. So I will address those first.

1. Status Symbol: Owning a house certainly is a status symbol. But you need to ask yourself how much are you willing to pay for purely the status part of it as a fraction of your salary. While the number will vary for different people, it should not be more that 10-15% of your take home salary. In any case, asking yourself this question and writing down a number will help you take much better decisions.
2. Convenience: Sure, it is much more convenient to not have to change a house every year or two. Further, you can decorate / customize your own house to an extent that nobody will allow someone staying on rent to. But you need to ask yourself when will these important enough - before marriage, after marriage or after having kids. On the other hand, do remind yourself that buying a house reduces a lot of flexibility. I know a number of people who bought a house and then in a few years switched cities because of their job. Many wasted several months in a dead end job because they did not want to change cities / the new offer was too far off. As a rule of thumb, you should buy a house only if there are a large number of opportunities nearby or if you plan to stay in your current job for 3-4 years.
3. Marriage: Few people openly talk about it but that fact is that in arranged marriages (and increasingly otherwise as well) owning a house is a big plus point. To be sure, a house is a sign of stability - and it is relatively more polite to ask if the prospective groom has his own house (and ask to see it) rather than asking what is net worth is. I would like to emphasize that one should concentrate on education, job, basic savings and house in that order and that you are probably better off not marrying someone whose priorities are significantly different.
4. Pressure: A number of people, especially bachelors buy houses not because they see any major benefit but just because their parents of relatives pressure them to. Spending a few hours trying to figure out your life plans will help a lot. If you have just got a job then typically you will not know what you want to do with your life; purchasing a house will be a major decrease in flexibility.

Financial myths

I now look at a few common misconceptions regarding housing.

1.  House prices never decrease. Not true. They decreased in Mumbai in the 1995-2003 period. Search on the internet for proof.
2. If you want to buy a house for self use anytime is a good time. Again not true. It should be common sense that if a decision does not make sense for one class of customers (i.e. the investor), it will not make sense for another class (i.e. the end user).
   This myth is probably spread to get more end users to buy in the current slow market. The justification probably derives from the efficient market hypothesis which says that a market cannot be timed (i.e. you cant be sure that if you wait prices will fall, no matter how insane they appear). Unfortunately, housing market in India is very far from being efficient. Besides, even if a market is efficient, the ideal way to invest is systematically (i.e. a small amount every month) so that temporal risk (i.e. the risk that price will suddenly change in a small period of time) is avoided. Unfortunately, that is not an option in India currently.
3. Rent is wasted money; it is better to pay EMIs. It is a surprisingly common myth that I have seen. Somehow people forget that the interest that you pay is as much a waste.
4. Returns on property are high, especially if you take a loan. This is partly correct to the extent that there are tax benefits on interest repayment. However, the bulk of high return is due to leverage - the fact that you are borrowing money to invest. As long as price appreciation (+ rent) is above interest rates, leverage will magnify returns; however if prices remain event flat for some time, returns will become significantly negative. Basically increasing leverage increases risk so the returns should not be directly compared.

In my next post, I will talk about setting a budget to buy a house.