Is your property a home or an investment?
Sharing a room with the extended family while growing up in a small Indian town, one of my biggest dreams was to buy my own house one day. I shared this dream with many others around the world, not just in India. It’s typically the biggest purchase for a middle class family. So the question is, what should you look for when buying a house?
You obviously want your home to be a great space, well-served by amenities and conveniently located. Some of these are intangible qualities. So once you find them, how do you value them? How do you decide what to pay for these features?
Like any other investment or asset, capital growth reflects future income
Your house is not like any other purchase such as clothes, gadgets, cars, etc. The big difference is that your house can generate income. Anything that can generate income is an asset, and assets usually go up in value over time because the income is likely to keep increasing with inflation. So if you were to estimate the income over the long term, say 10-15 years, and ‘discount’ it in today’s terms by comparing it to what you could have earned in the bank, you can calculate a fair value of what you should pay for it today.
If you borrow money from the bank at an interest rate that’s less than the current or future rent, you are ‘leveraging,’ which could enhance the returns. And if you happen to pick a location where demand is growing and supply is limited, property can be a very good investment.
While this calculation sounds simple enough, of course in reality, it’s a bit more complicated. You don’t know exactly what the future income will be because the demand and supply of properties in the area could change. Similarly, the interest you could earn in the bank could change. And so on.
But this sort of complicated calculation is what professionals get paid for. So if only professionals were buying and selling properties, valuations could fluctuate a bit but tend to go back to fair valuation pretty quickly.
Real estate is prone to bubbles because homeowners don’t know it’s also an asset class
However, when normal people buy and sell properties, they don’t calculate the fair value but go by non-financial or emotional factors. So I may buy a place at a much higher cost than fair value because I want to live next to my family. Or I may not want to sell a place because I grew up in it.
However, if I get a loan from a bank, there should be a limit to the effect of my emotional, irrational behavior. The bank doesn’t have any emotional attachment, so it would value the property at fair value and only lend to me accordingly, after keeping a margin of safety. But there are plenty of people who don’t borrow to buy homes. And in India, there is also plenty of “black money,” i.e. illegal cash used to buy property. So valuation of homes, i.e. residential property, gets out of whack more easily than other asset classes.
Rent or buy?
In addition to the issue of fair value, there are many other factors to consider when deciding to buy a house. Firstly, there are significant costs to buying and selling property. The maintenance cost is also something people tend to forget. Secondly, the cost of borrowing is crucial when deciding to buy. If the interest cost is higher than what you can rent the property for, you should worry.
Given these costs, buying property is definitely a long-term decision, and I would encourage people to rent in the early years. Renting allows you to figure out which locality, or even which city or country you might want to live in long term. You can invest any savings in investments such as equities to accumulate a large enough portfolio, which you can then use as a deposit when the valuations are right.