Should you invest in real estate, or shouldn't you? Now or later?

I'll try and tackle these very important questions that exist in the minds of many people as they build and nurture their investment portfolios.

Typically, the largest components within most investor portfolios are equity, debt and physical real estate. To keep things simple, I'll focus only on these three for the purposes of this column.

LET'S QUICKLY COVER SOME BASICS THAT WILL HELP US IN CONSIDERING REAL ESTATE INVESTMENTS

Firstly, let's outline the three key parameters used for evaluating any investment option:

1. Returns or the growth prospects for your capital invested

2. Risks or the associated volatility in values including potential loss of capital

3. Liquidity or the ease and speed with which you can convert the investment into cash-in-the-bank.

It goes without saying that each asset class has its own positive and negative attributes. The ideal scenario for investors is to create a balanced asset allocation mix that optimizes risks, returns as well as liquidity.

Now let's see how the three major asset classes listed above behave on these attributes.

Equity or stocks (whether held directly or through mutual funds) has the highest potential returns, the highest risk & volatility, but is also highly liquid.

Debt or a fixed income (debt mutual funds, fixed deposits, bonds, PPF etc.) generates moderate returns with commensurate lower risk & volatility and can offer high liquidity especially when invested through mutual funds or bank deposits.

A short pause before we move to real estate investments. Do remember that the house you live in is not to be considered a part of your portfolio or asset allocation mix. Ideally, it should not even be counted in your net worth unless you plan to sell the house, invest the proceeds, and live on rent. This is because the house you live in is actually your 'home' and has been purchased for your 'consumption' and not as an 'investment'.

Coming back to real estate investments - simply put - these are complicated. Generally, short-term volatility in prices remains low - especially for fundamentally sound locations and properties. Investment values will invariably move up or down. But usually, these movements in property prices play out over years instead of weeks, thereby giving you an opportunity to react. Further, real estate investments tend to have lower recurring returns in the form of rental yields, especially for residential assets.

But is real estate a high-risk investment or a low-risk one? The reason I pose this question is because unlike other asset classes, real estate changes character during its lifecycle - from the time you book a property based on a brochure to when it becomes real and habitable.

HOW SHOULD YOU DEAL WITH THIS? HERE IS A SIMPLE APPROACH

Under-construction property and speculative plots of land in yet-to-be-developed areas should be considered high-risk given all the moving parts - from execution risk to price, interest rate and market movements. Accordingly, they need to deliver relatively higher returns (like equity) during the development phase.

However, once a property is completed and possession handed over, or the plotted project location becomes mainstream, it can be considered low risk. Returns are likely to be low from then (like debt), but volatility would also be lesser.

If you hold the property for a long term through these two stages, your overall target returns should be somewhere between what you earn from the equity & debt components in your portfolio. In a steady market, real estate should be able to offer you returns that act as a hedge against the eroding effects of inflation.

As an aside, since a lot of people use loans to invest in property, you need to factor in the interest cost when calculating your net returns from the investment (plus all other costs including stamp duty, brokerage, recurring charges, etc).

SO, SHOULD REAL ESTATE INVESTMENTS BE IN YOUR PORTFOLIO AT ALL?

Among the big positives is low overall volatility, which makes it a storehouse of value in a choppy, uncertain world. For some investors, the fact it can be touched and felt is a psychological reassurance that arguably has value.

In the same breath, one also needs to factor in the hassles of monitoring construction progress, dealing with delays, maintaining the property once it is delivered, finding tenants, and paying maintenance and property taxes.

The relatively lower overall returns are a dampener, but one could live with them in return for the lower volatility.
However, where real estate really suffers is that it is an illiquid lumpy asset in an opaque market, which takes time, money and effort to sell. Those who have tried to offload a property in a slow market would vouch for this.

Because property values are large, they could skew your investment portfolio towards lower overall returns, lower volatility and higher illiquidity. This means that you should think very carefully about adding real estate to your investment mix and do it only when the overall portfolio size is large enough to handle the illiquidity that comes with such investments.

These are all important points to consider when you are thinking of adding physical real estate to your investment portfolio. Of course, options do exist for you to take property investment exposure through funds and REITs, but that's a topic for another day.

Irrespective of your decision, do remember to maintain your portfolio asset allocation prudently - across returns, risks and not to forget, liquidity.

(Ritesh Vohra is Head - Real Estate at Investcorp India Asset Managers. Views are personal.)