Why (not) to buy a house

Last month I got a phone call. Finally I had found a buyer for my house. In a few weeks time - the sale was finally done. I was thinking what my reaction would be once the house was (really) sold with money in my bank- would I be sad that I would be selling a 'fixed asset'? Should I be thinking of buying 'another fixed asset'? Well, actually I just felt free, a big relief. Finally - I was able to free up some under-performing capital that was not generating sustainable, inflation beating economic returns.

I decided to pen down my thoughts on why it is such a bad idea to look at real estate as an investment class - especially first time buyers (like I was) looking at cheap (that's a relative term) investment which will magically grow once you purchase that house/apartment. Especially in the current situation. Also, especially if you are looking at buying something for 'investment' and not to 'live' in it.

I want to use my use-case for ease of explaining.

I bought a house in 2007 and sold just a few months shy of holding 7 years in 2014. Also, since I took a loan to buy the house - I did end up paying more through all these years for the interest component. Some rough calculations later - I have a number of Rs 49L for the overall ownership cost (based on loan closure). For the sake of maintaining simplicity I have not considered time value of individual loan payments which will make my overall returns worse still (not better). Considering a discount rate of 7% (inflation), here's what I see (all values in Rs.)-

Annualized return of 5% is not what you would have hoped when buying a house - would you? That quickly turns negative if you take inflation into account which hovered in range of 7 - 8% through the period. Investing in a index fund would have returned 10% annually (Jan 1: Sensex at 14,090).

Well - you may ask, what am I getting at? I'm jotting down a few mistakes I did as a real estate investor which one can easily avoid (lest I forget and make another mistake in future). Here are my top 5. I hope you can benefit from my mistake!

- I have only talked about the purchase price and sale price and not about the most important aspect - where and what did I invest in. As they say - the three most important things in real estate investment are location, location and location. Its better to invest in a property in a very good location (when you find something within means so to say).

- Avoid buying when something looks costly and indicators suggest that you are not able to afford prices being asked. Is the EMI equal to the rent you are paying currently? Are you just buying the house as an 'investment'. Buying a house which costs >3 times your annual income with a costly loan (as a thumb rule anything over 2% points over 'Fixed Deposit' rate would look high to me).

- I learnt it the hard way. The first investment should be a property to live in, not to look on. As Francis Bacon told in 1500's - "Houses are built to live-in and not to look on". Especially since any real estate investment needs 'taking care off' - it does no usually generate effort-free rental returns i.e., its better to think in terms of return on unit effort put-in; rental yields you calculate and actually end up with after expenses are quite different - its usually a modest 2 - 3%. And if you think you can increase rents 10% y-o-y think again :-)

- Investing to get tax benefits  as your primary reason (especially on the first property) is not such a good idea! Its good to pay your taxes.. someone needs to pay for the roads, lighting, government running (I know.. who likes it?), etc.. But if you find a nice property to live-in and save on rent plus create a nice environment where your children grow - that is an added benefit.

- Think before you jump. Its much easier to invest in a cheap index fund or an actively managed fund or better still invest in stocks yourself which would be highly enjoyable especially if you like do some thinking behind your investments (I ended up making 21% yearly returns from 2007 until 2013; taking away 2014 which would skew the returns further since this year returned close to 78% ytd). Its a good question to ask if you are ready to make an illiquid, not-so-easy-to-dispose real estate investment!

A normal question to ask oneself: Are there metrics worldwide which rationalize price paid for housing. Well, I read an interesting forbes article a few years back. 'Income to Home price ratio' is an interesting historical indicator.. read on, here's something I picked up -

The price-to-income ratio looks at the total cost/price of a home relative to median annual incomes. Historically, the typical, median home in the US cost 2.6 times as much as the median annual income (so if the median income in an area was $100,000, the median price of a home would typically be about $260,000: $100,000 * 2.6).

A similar scenario exists in UK. A January 2014 article on www.economicshelp.org points out that "First time buyers in London are seeing house prices at a record 7.5 times average earnings. For the UK as a whole, the ratio of 4.3 is still above long term trends." Most people in Germany prefer not to own homes. Here's why: article.

In comparison, if it takes 20 - 30 years of annual income to buy a home in any tier 1 city of India, what it clearly means is that the real estate companies have priced themselves out of the market. Looking at the huge inventories built up by companies like DLF, Unitech, Purva, Shobha, Prestige, others (on top - the enormous amount of debt these companies carry).. its prudent to think again.. is it not better to wait than rush in to buy?

Finally - Is the juice really worth the squeeze?

Ciao till next time...Harsha

Ownership..ownership..ownership.

I read this statement of an American-Indian chief and found it greatly amusing.. something in this made me re-think about 'ownership'-

How can you buy or sell the sky, the warmth of the land?
The idea is strange to us. If we do not own the freshness
of the air and the sparkle of the water, how can you buy them?

- Chief Seattle, Nineteenth Century American Indian (Tribe: Suquamish)

This is the great paradox of our times. That is the essence of investing. You see - stocks are but pieces of business ownership material. I am interested in holding and increasing  pieces of business that I like and admire. What I like and is available at a bargain price - I intend to buy and what is selling at a higher price than what it really is worth - I am willing to part with (maybe lets say I am  learning this aspect of selling still; for you see I would like to hold onto something for as long.. I mean forever.. unless it screams in the eye that its a sell..)

No animal but man can lay claim to own things, places, and stuff like that.. Animals are known to defend themselves, their mates, children, pack, food and area where they inhabit. Animal territory is defended by scent and once the animals are gone.. come new ones (not exactly offspring's) to take their place..

Human beings are different. We purport to believe that individuals can 'own' the most astonishing things.. we can own land, whole islands, mines, mountains, forests and anything else we can name and lay our hands on.

We do believe we own ways to execute a mere 'idea' - the basis for patents and intellectual ownership. Even more astonishingly we pretend that names can own such things, what else to do we call a partnership, company of even a country but a name?

I get this concept, its mind blowing... Something inside struck a deep chord.. Thank God we have this 'ownership thingy', however cynical it really is.

Ciao till next time...Harsha

What an inspiration!

Learning of the day!

Ciao till next time...Harsha

Getting on the right train..

I was reading the Q&A's that Buffett took when he visited the Tuck's school of business. Here's a interesting answer. What a gem!

Q:I worked in the paper and packaging business this past summer and really enjoyed my experience. None of my classmates are interested in the paper business and the company I worked for has not had MBA interns in years. Clearly the paper business has its challenges, but do you see this as an opportunity or a roadblock?


A: Well, you've got it right that the paper business is challenged. High capital intensity, low margins, cyclical. It is a brutal business; no one cares who made the box their Dell computer came shipped in. In general, commodity businesses, even you're the low-cost producer, are difficult. There are generally two recommendations I offer to college and business school graduates. The most important thing about where you work is that you admire/love it. So it sounds like you liked your experience, and that's great. But we come to my second recommendation, which is to get on the right train; that is, moving in the right direction. There's no course in business school called "Getting on the Right Train", but it's really important. You can be an average passenger but if you get on the right train it will carry you a long way. You want to learn from experience, but you want to learn from other people's experience when you can. Managing your career is like investing - the degree of difficulty does not count. So you can save yourself money and pain by getting on the right train.

Ciao till next time...Harsha

Buffett on Retained Earnings

Found this old article of Buffett interesting. Low P/E and high earnings.. not always mouth watering. What the company does with the earnings retained - reinvest to maintain the current position (constant capex need as, i.e., cyclicals), give out dividends (FMCGs, Oil and Gas companies), issue ESOPs to exec's and drain money buying back shares or reinvest for growth (organic or inorganic) is quite important.

BUFFETT: FOLLOW RETAINED EARNINGS
In the 1934 edition of Security Analysis, Ben Graham introduces his readers to Edgar Lawrence Smith, who in 1924 wrote a book on investing entitled Common Stocks As Long-Term Investments (Macmillan, 1924). Smith put forth the idea that common stocks should in theory grow in value as long as they earn more than they pay out in dividends, with the retained earnings adding to the company's net worth. In a representative case, a business would earn a 12% return on equity, pay out 8% in dividends, and retain 4% to surplus. If it did this every year, the stock value should increase with its book value, at a rate of 4% compounded annually.
With this in mind, Smith explains the growth of asset values through the reinvestment of a corporation's surplus earnings in the expansion of its operations. Graham, however, warns us that not all companies can reinvest their surplus earnings in expansion of their business enterprise. Most, in fact, must spend their retained earnings on simply maintaining the status quo through the replenishment of expiring plants and equipment. Predicting future earnings of any enterprise can be very difficult and given to great variance. This means that making a future prediction of earnings can be fraught with potential disaster.
Warren Buffett concluded that Graham's assessment of Smith's analysis was correct for a great majority of businesses. However, he found that under close analysis some companies were an exception to the rule. Buffett found that these exceptions over a long period of time were able to profitably employ retained earnings at rates of return considerably above the average. In short, Buffett found a few businesses that didn't need to spend their retained earnings upgrading plant and equipment or on new-product development, but could spend their earnings on acquiring new businesses or expanding the operations of their already profitable core enterprises.
We want to invest in businesses that can retain their earnings and haven't committed themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding, which is the secret to getting really rich.
Capital Spending for Maintenance vs Growth
One of our key stock screens for our WS8 Portfolio, as our Intelli-Vest members are well aware, is to think carefully about how management allocates capital. How much is paid as cash dividends? How much is required to be invested in maintaining or replacing plants and equipment just to maintain current levels of sales and profits? How much is spent on expanding production to create new business, new sales and new profits? To understand the investment merit of any business, we must be able to answer these capital allocation questions.
Making money is one thing, retaining it is another, and not having to spend it on maintaining current operations is still another. Buffett found that in order for Smith's theory to work he had to invest in companies that (1) made money, (2) could retain it, and (3) didn't have to spend those retained earnings on maintaining current operations.
Buffett discovered that the capital requirements of a business may be so demanding that the company ends up having little or no money left to increase the fortunes of its shareholders.
Let me give you an example. If a business makes $1 million a year, and retains every cent, but every other year it has to spend $2 million replacing plant and equipment that were expended in production, the company really isn't making any money at all; the business is only breaking even. The perfect business to Buffett would be one that earns $2 million and spends zero on replacing plant and equipment.
Buffett used to teach this lesson when he conducted a night class on investing at the University of Nebraska at Omaha Business School (image enrollment demand if he still taught such a class today!). He would lecture on the capital requirements of a company and the effect that it had on shareholder fortunes. He would do this by showing his students the past operating records of AT&T and of Thomson Publishing.
Buffett would demonstrate that AT&T, before it was broken up, was a poor investment for shareholders, because though it made lots of money, it had to plow even more money than it made into capital requirements -- research and development and infrastructure. The way that AT&T financed the expansion was to issue more shares and to sell lots of debt.
But a company like Thomson Publishing, which owned a bunch of newspapers in one-newspaper towns, made lots of money for its shareholders. This was because once a newspaper had built its printinig infrastructure it had little in the way of capital needs to such away the shareholders' money. This meant that there was lots of cash to spend on buying more newspapers to make its shareholders richer.
The lesson is that one business grew in value without requiring more infusions of capital and the other business grew only because of the additional capital that was invested in it.
Warren Buffett decided he wanted to search for a few businesses businesses that seldom required replacement of plant and equipment and didn't require ongoing expensive research and development. He wanted a few companies that produced a product that never became obsolete and was simple to produce and had little competition: the only newspaper in town, a candy bar manufacturer, a chewing gum company, a razor blade producer, a soda pop business, a brewery -- basic businesses with products that people never want to see essentially change. Predictable product, predictable profit. And he found a few, and he became the richest man on the planet!

Ciao till next time...Harsha

Some thoughts..learning's as I leave Europe and move to US

Decided to move out of Europe. Had a ball of a time in 3.5 yrs at Cypress in Europe. I will cherish the field experience; should give me enough perspective moving back into a BU role in US. Many top class sales guys in difficult environment...gave a good accelerated learning experience.

Summarizing some of my thoughts' from the time spent here; tried to make them as generic as possible.. here goes-

- The most popular software for writing fiction is not Word. It's Excel. Amen.
- Constant fight as it is.... Beware of lollipop of mediocrity... Lick it once and you suck forever....
- Not everything that counts can be counted, and not everything that can be counted, counts (this one is taken from something written on a purchasers' desk :-)
- It’s better to be approximately right than to be precisely wrong.. False precision is totally crazy... It only happens to people with high IQs.. (mostly)..
- If something looks irrational.. and has been so for a long time... odds are you have a wrong definition of rationality.
- Limitation of our Appraisal, CSFs System - People do extraordinary things at work only when they want to, not when they are forced to.

There are more, but these were some generic sounding themes I had noted in my diary.

Ciao till next time...Harsha

The Professional

I have been a ardent fan of Jesse Livermore ever since I read his wonderful book "Reminiscences of a Stock Operator" during my school days..

Came across a quote from the guy on one of the sites when researching a stock. Couldn't agree more..
Here goes:

Ciao till next time...Harsha

Modi wave - tsunami it was..

Hmmm.. Portfolio return: Sep 19, 2013 to May 22, 2014 - 74.7%.

That says it all. Somehow, I don't like this growth beyond estimation.

Ciao till next time...Harsha

First Locate, then Insulate :-)

Very interesting news.. Rahul Gandhi post elections

Ciao till next time...Harsha

Float and moat mixed with the election goat

State of affairs in India - 2013

Being locked out of your trading account can be good sometimes (lets hope so). Especially when it comes to the election time. Sitting on neat 30% profits on portfolio for past 6 months - I am having dual mind of either pulling out some money or buying more hoping that 'Ab ki baar Modi sarkaar' can give more impetus to the market. However - the decision for me to sit tight is made as I'm locked out of my trading account for the time being..

Last year was good for picking stocks as two factors came in handy for me - the currency devaluation (exchange rate EUR to INR dropped from 70 to 85ish i.e., 21%) and Sensex below 20K levels (add on top loads of stocks hovering at discounts to book value with 5%+ yields..).

As Charlie Munger would say - "Being rats in other person's granary" - investing is a crude way of wresting money from another in a capitalistic sense. Nepotism, monopoly and add some government backing (sprinkle some corruption) - you could be talking about India now. I think the trio can be good for investment though (corruption definitely not). I am not really proud of taking advantage of things as they stand - but; I'm not the PM right.. I'm just an average guy trying to earn a hard way to retirement..

Though - I do wish for the goodness of nation - there is a stable government; I really don't mind having any government in India at the moment. Being a net investor in the market for next 5 years, I would love that I can build my positions in few stocks favorably. Weak governments mixed with unstable policy matters don't seem to be a deterrent for me to invest (the long term consumption story remains intact - so I frankly dont really mind buying good businesses at cheap valuations). Actually who doesn't like to pick stocks with mouth watering margin of safety trading below BV and yielding 5%+ yields.. (on hindsight - being locked out, I definitely missed the golden chance to pick Corporation Bank and Syndicate Bank at 230ish and 70ish levels respectively which in turn would have yielded upwards of 9% yields..).

Shit happens.. but, I think we definitely live in interesting times.. ever checked the kind of returns Buffett made through the 1950's? I think its the kind of market India is in now. Amen.

Ciao till next time...Harsha