Money Wise: Aam Aadmi's Guide to Wealth and Financial Freedom

by Sharath Komarraju

Real estate is illiquid. Liquidity is a measure of the ease with which an asset class can be sold for liquid cash. On this measure, real estate ranks the lowest. Just about any other asset class is quicker to sell than real estate. Even if you have a buyer ready to buy your house, it could take more than a month to complete the transaction.

we will look at some of the most common myths that people hold with respect to real estate. Myth 1: Land value never goes down. This is not true. Like any other market, there is speculation in the real estate market too. Say that you expected a software technology park to come up in your suburb, but for some reason the government did not give permission for it. Real estate prices will drop. There have been many real estate bubbles and crashes in history. Even within India, almost every day, there are corrections in some local market or the other. What is true is that land value will never go to zero. But it can – and does – certainly go down.

Myth 2: Land appreciates more than apartments. As we discussed before, real estate is made up of land and structure. Of these two, land is the immutable asset – which means it does not change with time, and therefore holds its value, whereas a structure is the mutable asset – which means it erodes and depreciates with time. No matter what kind of real estate you own, the ‘land’ part of it will appreciate and the ‘structure’ part of it will depreciate with time. Since in an apartment, you own more structure than land, the combined effect of appreciation and depreciation makes it seem as if it appreciates less than a piece of land. Also, land is often bought as a ‘capital gains’ asset, with an intention to sell after a period of time. Apartments are bought as a ‘cash flow

asset’, with the intention to rent out and procure regular returns.

The Two Faces of Leverage In case the word leverage confuses you, it’s just another way of saying ‘debt’. The most common way an investor buys a piece

of real estate is by taking a loan for a portion of the purchase price. Under the current 20 per cent rules, a buyer can borrow up to 80 per cent of a property’s worth. So if he wishes to buy a house worth 50 lakhs, then he pays 10 lakhs as down payment, while furnishing the remaining 40 lakhs with debt. In this case, he is said to be ‘leveraged’ four to one. Leverage can work both for and against you. Let us look at both scenarios with a simple example.

Face One: The friend Let us say that you buy a house for 50 lakhs with a loan of 40 lakhs, on which you pay 10 per cent interest. So at the end of the first year, you will have paid 4 lakhs in interest payments to your lender. But say in that one ye...

house for 60 lakhs, its current value, return the 40 lakhs to your lender to repay your loan, and keep the remaining 20 lakhs as your net revenue. Since you have paid 4 lakhs in interest payments in the one year, your total profit is 16 lakhs. In this example, notice how you’ve made more money because you were leveraged. If you had instead bought a house without leverage with your initial 10 lakhs, and if you had sold it a year later at a 20 per cent higher price, you would have made a profit of only 2 lakhs. Just by leveraging, you’ve increased y...

Face Two: The Enemy We will stick with the same example as before. You bought a house for 50 lakhs with a loan of 40 lak...

As before, in the first year, you have paid 4 lakhs in interest. But this time, after the first year, assume that your house has lost value by 10 per cent. So now it is worth only 45 lakhs. Now if you sell the house, your total revenue will be 45 lakhs. Since you have to repay your lender with 40 lakhs, at the end, you will be left with 5 lakhs, which is a 50 per cent loss on what you started with. Once again, notice how leverage has caused you to lose more money. If you had instead bought a house without leverage with your initial 10 lakhs, and if you had sold it later at a 10 per cent lower p...

depends on what the market does while you...

If the value of your house goes up at a higher rate than the rate of interest on your loan, you will make outsized gains. On the other hand, if it does not r...

we will compare renting and owning with respect to a few key factors.

Flexibility.

Liquidity.

Maintenance.

Security.

Finances.

There are quite a few ‘right answers’ to this question, depending on whom you ask. There are people who will advise you to spend no more than 20 per cent and no less than 10 per cent of your income on your house loan repayments.

The latter is to fund your longer trips, either out of state or country. Two points to note here: The percentages are arbitrary. Depending on what is important for you, you may wish to change some numbers. Feel free to do that,

but my recommendation is to keep your emergency fund contributions and your medium-term savings at 10 per cent of your income at the very least. Play with the rest as you wish. The items are also arbitrary. Some people like to budget at a minute level, and they break down these ten items into various sub-items. (For instance, ‘entertainment’ can be broken down into ‘movies, dining out, buying books and magazines’ and so on.) Others stick to a broad budget like this. Choose what works for you.

In most real-life budgets, the amount of money allocated to house loan payments falls in the range of 20-30 per cent. That doesn’t mean, though, that you’re forbidden from exceeding that range. It’s your money, after all,...

that in your eagerness to pay down the house loan, you’re not overlooking other important aspects ...

payment? The most sensible option is to pay down as much as you can over the lender’s minimum. For instance, right now, banks in India are insisting on at least 20 per cent as down payment. But it pays to remember that nothing

is preventing you from putting down 30 per cent if you can afford it. But in doing this, make sure that you’re not pushing yourself. Do your sums: if you have your emergency fund filled to the brim (six months’ family expenses), your saving plan running on autopilot, and if your job security is reasonably high, go ahead and put down more.

If, on the other hand, you believe that the real estate market in India is in a bubble, and that prices will even out over time, then you’re better off looking for other investments. It is the unfortunate truth of real estate investing that you must be a speculator. You cannot shy away from it and passively invest in it like you can with other asset classes. And the necessary consequence of speculation is that you will make money if you’re right, but if you’re wrong, you will find yourself out of pocket.

If the property is located at the right place – and that usually means as close to the busy commercial roads as possible – and if it is not too old and has been well maintained, commercial real estate could end up earning for you a lot more than residential properties. Current averages for rental yields in India for commercial real estate are around 9 per cent. The amount of maintenance that you need to do for

a commercial space is much less than what you would do for a residential apartment (because commercial structures require simpler plumbing and architecture), and the tenants generally lock in long-term leases that give you regular, secure income for much longer. You must be asking now (and if you aren’t, you should be) what the catch is. There are a few, but the main one is that when the economy turns for the worse, businesses are the first to be affected. No matter how bad the situation is, people still need to live, so your residential property will still find tenants, but the hardware shop that leased your commercial space may go out of business. Finding new tenants is another issue. Since businesses prefer to be in one location for a few years at least, they choose their premises very carefully, which means that once your hardware store tenant throws up his hands, finding another

tenant may take you longer than you realize. In contrast, people looking for a house to live in are much more flexible with their time-frames and choices: they know that they can move whenever they wish to another house and not much will change. This is the flip side of long-time leases and secure income; finding such tenants is not easy. One other downside is taxation. Commercial properties are taxed at higher rates than houses, and the rental income is taxed at a higher rate too. If you’re going down this route,...

Why do they fail, then, one might wonder. The simple reason is that people who issue fiat currencies do so with the intention of devaluing it. In 2008, the balance sheet of the Federal Reserve stood at 800 billion dollars. Today, in the Indian summer of 2014, it is upwards of 4 trillion dollars. So from the years 1913 to 2008, the Federal Reserve expanded the money supply by 800 billion dollars, and between 2008 to 2013, in five years, that money supply was inflated five

times. What do you suppose will happen when you inflate a currency at such rates? The value of each dollar in existence shrinks, and the more it shrinks, the more the policy-makers will inflate, and so on until the currency is not worth the paper on which it is printed. Today, every country in the world is debasing its currency. There isn’t a nation on the planet that is not indulging in inflationary policies. Amid all this, there is one form of money whose supply has changed very little in comparison: gold.

The amount of gold in the world increases year after year at a rate of around 1 per cent, which is the rate at which it is mined. So if you have the choice between a currency which will lose value by 9-10 per cent (if not more) like clockwork, and a metal which is guaranteed to hold value and preserve ...

bonds and fixed deposits) puts us all at the mercy of the central bankers. Owning gold will mitigate that risk, and if the last five thousand years are any indication, it will preserve our wealth and purchasing power far into the foreseeable future. Does that mean we need to own no other asset but gold? Alas, if only it were that easy. The cash regime under which we all serve is more powerful than we are, and though gold holds purchasing power over long periods of time, because it is pegged to the fiat currency, its apparent value at any given time is the inverse of how the currency is performing. So if confidence in the currency is high, gold will perform worse than the currency, and if the confidence is low, gold will soar.

Understand this more

But if you treat it purely as insurance,

Should you treat it as investiment or insurance?

Generally speaking, gold does well during times

of inflation and hyperinflation, because the rapid loss of purchasing power in currencies propel people to the safety of gold. Stock market crashes and recessions are also good upside drivers of gold price.

So a better strategy is to refrain from considering jewellery as an investment vehicle, which, strictly speaking, it’s not. For our financial investments in gold, it is best to look at twenty-four carat gold in the form of coins and bars. Most jewellers stock pure gold coins and bars, and so do banks and other gold outlets. The biggest advantage here is that the pricing is transparent: you can walk into any jeweller’s store and buy a gold coin or bar at the official per-gram price plus taxes. Buyers generally need to pay import duty and value added taxes on all the gold they need to buy. These values keep changing, so you will do well to shop around at a couple of outlets to see who is offering

you the better deal. One other thing that you must keep in mind when buying gold is the mark of purity that it bears. Banks in India today sell gold that carries a 99.99 per cent Assay Certification from Switzerland, which signifies the highest level of purity according to international standards. So if you were to take your gold coin bought at an Indian bank to any country in the world, you will be able to sell it with no trouble because the purity mark is internationally recognized. Smaller jewellers deal in coins that have been certified by the Bureau of Indian Standards.

The more widely recognized the mark of purity on your gold coin, the more liquid (easy to sell for cash) it is. Therefore, the more widely recognized the mark of pur...

While shopping to choose between these products, the main question you must ask yourself is this: what is the underlying asset? Because ETFs could be structured around anything, a ‘gold ETF’ may not necessarily invest in gold. It may invest in gold mining shares, for example, or gold jewellery companies. If you want an exposure to gold, you must make sure that the ETF you select gives you exactly that.

Ideally, over 99 per cent of their holdings should be in gold, with the remaining in current assets and cash. This will ensure that the price of your paper gold will track the price of real gold with the least error. The lower the percentage of gold holdings in the ETF, the more error you can expect in its tracking. This measure is also listed in the fund document so that you can compare and select the product with the least error.

The four main factors, then, that will determine which gold ETF you buy are: Size – the larger a fund, the more liquid it is, and the easier it is to sell and buy in the quantities that you desire. Asset holding – the underlying asset should be physical gold, and the percentage should be in excess of 99 per cent. Tracking error – the lower the better. Expense ratio – the lower the better.

Once again, doffing our hat to the need for diversification, it may be a good idea to break up your gold holdings into three parts: jewellery, physical bullion, and gold ETFs.

The government simply pays the owner of the bond a certain amount as interest at regular intervals, as defined in the terms of the bond. For this reason, it is called a ‘fixed income’ instrument because, in theory, the income in bonds comes only from the interest payment that the government makes to the owner. It is also called a ‘debt’ instrument because, after all, the government is in the bond owner’s debt. However, in practice, bond investors get an additional source of income besides the fixed interest. This happens because of the secondary market, where the price of the bond could sell for

more or less than its original amount. So there is a possibility of capital gain as well for the bond investor.

Capital Gains (and Losses) in Bonds Let’s take the Reserve Bank of India and Government of India as examples to illustrate this. We’re doing this only for familiarity; the concept stays the same for practically any country in the world today that is run by a central bank. The Reserve Bank of India has the power to raise and quell interest rates as it sees fit to balance the economy. This is basically the rate at which it will lend funds to all banks under it, so that will automatically alter every interest rate in the market. So let’s assume that at the beginning of Year 1, you bought a twenty-year bond of 1000 rupees from the government at an interest of

7 per cent. Today you’re quite happy with the choice, because you’ve looked around the market and have found out that no other investment vehicle gives you that high a return on that low a risk. However, later that year, say the RBI raises the interest rate by 1 per cent. Now, the interest rate on the government bond that is issued after the rate rise will be 8 per cent. Notice that your bond, which you bought earlier in the year, is only giving a 7 per cent return. When new bonds from the same borrower are available at 8 per cent, why would anyone buy your 7 per cent bond? So if you wish to sell your bonds and raise money for an emergency, what is your option? People will still buy your bond but only if the yield on it matches the yield on the new bond. So if the price of your bond drops adequately to cover for the 1 per cent gap, then you will be able to find

So you lower your selling price of the bond and offer it to buyers in the secondary market at a discount so that the new owner will generate a return of approximately 8 per cent from your bond also. In this case, the price would be about 875 rupees. So if you sell your bond after rates rise, you will make a capital loss. The reverse is true if the RBI drops interest rates, say by 1 per cent again. Now the interest rate on new bonds will be 6 per cent, and your 7 per cent bond will look very attractive to new investors. The price on your bond, therefore, will go up in value until the 1 per c...

Remember: bonds offer safety from capital erosion, not from volatility. If market prices going up and down from one day to the next make you nervous, you should either refrain from buying bonds or from watching the markets closely.

Gold, because of its portability and liquidity, is also another volatile asset, though it should rank below stocks and bonds. Gold is not given as much