Why big numbers don't mean big returns in real estate

“You know V,” she said, “I think you may have been wrong about real estate”.

“Like how?” I asked.

“So, I ran into this long-lost friend of mine...”

“And?”

“She was telling me about how her real estate investment had made so much money.”

“Like how much?”

“She had bought this one BHK in 2004 at Rs 26 lakh. It’s now worth Rs 1.2 crore.”

“Hmmm.”

“Isn’t that fabulous?”

“This is what I call the fallacy of mistaking a big number for a big return.”

“As in?”

“How much do you think the per year return on this investment works out to be?”

“Well, if I could do these calculations mentally, I would be a human computer,” she said.

“Let me make things easy for you,” I replied, as I got hold of my phone to carry out the calculation.

“The return works out to around 11.5% per year,” I said.

“Oh. That’s about it?” she asked.

“And this is without taking into account monthly maintenance charges that would have to be paid to the society, the annual property tax to the government, the interest on the home loan, and the general headache that comes with owning and maintaining any property. Of course, she would have got a tax deduction on the interest on the home loan and some rent, if she chose to put it out on rent.”

“No, she didn’t put it out on rent. She was afraid that the tenant won’t leave.”

“Hmmm. Good that you brought this up. There is an interesting lesson in this.”

“Like what?” she asked.

“Property prices in Mumbai have sort of stagnated over the last few years. My guess is that the price of your friend’s home went up rapidly between 2004 and 2011, then went up a little more between 2011 and 2013, and has, stagnated since then.”

“I wouldn’t know. Let me call her.”

I went back to my book and cup of coffee, till she made that call. She was back 10 minutes later.

“Yes, you are right V. So, what does that mean?”

“For the last five years, the price of her home has stagnated at Rs 1.2 crore. This means that if she had tried to sell it in 2013, she would have got Rs 1.2 crore for it.”

“Yes.”

“What do you think the per year return would have been in this case?”

“You tell me.”

“Around 18.5% per year, which is a huge improvement over 11.5% per year, she is likely to get now.”

“Oh. Wow.”

“Now, the prices between 2011 and 2013, went up at a very slow pace. In 2011, the price was already at Rs 1.1 crore. What if she had sold it back then?”

“Yes, what if?”

“Her return would have worked out to 22.9% per year, which would be much better than 11.5% per year.”

“So, what is the learning here?” she asked.

“That making money through real estate investment is all about timing. Your friend got one side of the equation right. She bought a home when prices were down. But she kept sitting on it for too long.”

“Why?”

“I guess simply because she expected the prices to keep going up, which they did for a while and then they didn’t.”

“Yes. And now she is stuck with it.”

“There is a very interesting thumb rule one can work with in real estate.”

“Which is what?”

“Over a longish period of time, say a decade or more, the per year return on a real estate investment is likely to be around the economic growth per year not adjusted for inflation. If the return is beyond that, it’s unsustainable.”

“How does it look in the Indian case?”

“Between 2004-2005 and 2017-2018, the Indian economy has grown at the rate of 13.6% per year, not adjusted for inflation.”

“And the real estate return of my friend has been 11.5% per year.”

“Yes. I mean this is a quick and a dirty method of looking at things.”

“But an interesting one nonetheless.”

“Yes.”

“Why do you have pull down everything V?” she asked.

I guess some dreams are best left un-shattered.

(The example is hypothetical)

Vivek Kaul is the author of the Easy Money trilogy