A question our Squirrels invariably ask us is, “Should we invest in property? I know of [so-and-so] who bought [such-and-such] and earned [so many] pots of money!” or words to that effect.

And our answer, just as invariably is, “Buy property if you plan to use it for your own benefit – if you are going to derive joy out of it. Because property comes with its own perils (just like all investments do), but the perils of investing in property are particularly misunderstood.” Or in the inimitable words of George Bush, “misunderestimated”.

I’ve been meaning to write this particular blog entry for a while, but it has been provoked today by this article in the Economic Times: Why investment in property is both lucrative and safe. Well, I don’t think it’s necessarily either lucrative or safe. What that article should have done is prefaced itself with a comment I see frequently on tech reviews: YMMV – Your Mileage May Vary. Which is to say, that while it may be lucrative and safe for some, it ain’t necessarily so for all.

Which is true of all investing, but it bears repeating.

I guess in the interest of brevity, the author of that article has necessarily had to generalize (I’m being charitable here) but a lot of what is written is at best balderdash and  at worst egregiously misleading.

Safe? Hardly!

For instance, “as operating costs increase, the rental income increases too” is complete nonsense. Utter rot. Rents are dependent on a host of factors such as the locality the property is in, the state of the building, the availability of other rent-able properties around, completely subjective factors such as whether South Mumbai is a more desirable locality than Dindoshi, the state of the economy and so on.

Example: rents in Nariman Point that was once the acme of business address desirability have crumbled as companies have moved to the northern margins of the city. I visited Maker VI (one of the best-maintained buildings in Nariman Point) and was astounded to be allowed to park within the premises. The reason: as many as 50 offices are lying vacant in the building.

Example: Rents in Lower Parel are as low as Rs.100 per square foot thanks to acres of newly available office space.

Example: A friend who rents out her apartment in Lalbaug in one of the swanky (relatively) new buildings here has seen her rental income dwindle from Rs.1,50,000 per month three years ago to Rs.1,00,000 per month today (that’s a 33% decline in 3 years, if you’re paying attention). The building is as nice as ever, but there are newer ones now available around and supply has ballooned, driving down rents.

Another bit of irresponsible writing is the author’s assertion that you can get a loan to buy a house. True, you can, but that’s hardly a reason for buying one. It’s not even a valid reason for investing. “Hey, let’s invest because we can get a loan to invest,” is exactly the kind of sentiment that drove the property bubble in the US and elsewhere that so recently burst so painfully. Simple rule to a happy investing life – invest from your earnings, not from your borrowings.

If you need to buy a house and you need to borrow to do so, that’s fine, but that’s not investing, that’s ensuring you have a roof over your head, which is a different imperative altogether.

And as for being safe, property is anything but safe, particularly in this country. Property laws have been notoriously skewed for the longest time, developers get away with murder (sometimes literally), projects get postponed, title is often uncertain, tenants are difficult to eject, deals can take forever (so forget about liquidity), buildings need to be maintained else they become literally unsafe… the list goes on. Stand in any metropolis at any corner at any waking hour of the day and throw a brick. You’re sure to hit someone who has a problem with property.

Which is where, for a change, I agree with the author of that article – do your homework before buying. Do lots of it and do it thoroughly. If the country’s second-largest property developer (Unitech) can go broke, deliver its CEO behind bars and postpone projects all over the country, something’s wrong with this sector.

And yet, we get seduced by all those crores and lakhs that get thrown around in any property conversation. Those large numbers obscure the reality of property returns, which are good, but no greater than elsewhere. Which brings us to “lucrative”.

Lucrative? Not so much!

Sometime back there was an email going around from the chief investment officer of a mutual fund who did an IRR calculation on what had been reported as one of the largest property deals in Mumbai and discovered that the actual return on that deal was no great shakes. Unfortunately, I can’t find that email any more, so I’ve decided to crunch my own numbers.

There are two recent property transactions that I am personally aware of, so let’s use these as anecdotal evidence of the return on property. I think they are fairly representative since between them they cover the very-long-term and the long-term, both of which are useful timeframes to evaluate return.

Both are properties in South Mumbai, which is among the most highly priced regions in the country, and is one where supply is not expanding rapidly, which means prices remain high or go higher, so arguably returns should be better than in most other areas.

The first one is a property bought in 1978 at the then princely sum of Rs.1.40 lakhs. The owner put it on the market in 2010 and 18 months later, seems to have found a buyer, although the deal is yet to be consummated as it winds its way through the various bureaucracies of the co-operative society, Collector of Mumbai, buyer’s bank and so on. The sale price is a mere Rs.6.80 crores. Since the seller does not intend to purchase a new property with the proceeds, capital gains tax (after brokerage etc.) will be paid in full, which means about Rs.1.30 crores goes to the exchequer. No matter, it’s still a princely return, no?

Rs.6.80 crores selling price against a purchase price of Rs.1.40 lakhs is a profit of Rs.6.79 crores, which is a return of 48,741%. Whew! Fabulous, right? Sure, but take a look at the dates involved: 1978 to 2012 is all of 34 years, which technically, is a generation and then some. The uninitiated might say that 48,741 divided by 34 is still an annual return of 1,425%, which is arithmetically correct, but mathematically wrong. The correct calculation is the Internal Rate of Return (which admittedly makes some assumptions that may not be true, but is still the more accurate way of calculating returns over time, as any financial professional will tell you). Calculating the IRR for this 34-year span, results in a more prosaic return of 19.05% (if you ignore the tax, the IRR is 19.95%). Good returns, sure, but quite comparable to the stock market or other long-term investment options (with none of the particular headaches of owning property).

[Co-incidentally, the BSE Sensex base year is 1978-79, i.e., the Sensex is treated as being at 100 in that year. Yesterday (4 Feb 2012), it was at 17604. That’s an IRR of 16.43% over the same years. Of course, you could have chosen better or worse stocks and out-performed or under-performed the market, but you could have chosen better or worse buildings too. Or different time periods. The point is real estate returns aren’t that spectacularly better or worse than others.]

And how many of us can wait 34 years for returns? So, let’s look at the second transaction I’m aware of.

A flat, again in South Mumbai, was bought in 2001 for Rs.1.60 crores. A similar flat in the same building was recently sold for Rs.7.50 crores. Assuming no real differences between the two flats (a reasonable assumption) and ignoring capital gains tax and anything else that might dilute this, this implies an appreciation in value of Rs.5.90 crores (“almost 6 crores!!!”) in 11 years! Wow! Superb! Pop out the champagne!

Not so fast. Let’s do ye olde IRR calculation. Er, a more prosaic return of 15.08%. Doesn’t sound quite as sexy as 6 crores does it? After all, the recent tax-free bonds issues (NHAI, IRFC) are yielding pre-tax returns of close to 12% on a similar timeline. 3% additional return from owning property than owning sovereign debt with none of the safety of the latter and all of the headaches of the former may be attractive to many, but does not qualify as lucrative.