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Getting “Real” About ROIs

 I read a very nice blog on bear market recovery here. While you can check out the blog in detail as every word written is good piece of wisdom, here is the gist:

-          If you just refer to nominal returns, you will be looking at a distorted picture. To get an idea of real (pun intended) situation, look at inflation adjusted returns

-          For example, if one sees in nominal ROI terms, total length of worst bear market, the dotcom bust was 5 years***. This period includes markets downward leg, to the recovery time to breakeven status

-          However, once you bring inflation into picture, the same period stretches to 13 years***. That’s more than double the time for breakeven in nominal ROI terms

That said, it is very rare for people to start thinking in real terms. It simply is “out to sight”.

For me, the true realization of looking at financial matters on real basis came post selling my residential property. While sell decision was easy given I was not going to stay in that property for at least a decade, I did have my “post sale blues” thinking how to invest the proceeds and then some to ensure I don’t get priced out of the real estate market when I want to buy a house to stay, say in 15 years time.

While my situation is different, other reasons why one may not want to buy a home, even if having the capacity to purchase it outright may be:

-          You are in a job which has the potential to move you around quite often and you are not sure you will stay put in the house you buy for say more than 3 years at a stretch,

-          You consider renting out and managing tenants not your cup of tea. Simply put, you don’t want to waste your precious time in taking on another “job”, even part time

-          Your retirement is more than a decade way. You are not sure which city you would like to call your home once your regular 9 to 5 grind is not there. Maybe you will move over to your home town – who knows!!!

But, as it happened with me, you and your family are concerned that house price appreciation may make the property out of reach in future. Valid concern. Or is it? I ran some numbers and checked out:

-          Let’s say I am eyeing an apartment currently valued at INR 1,00,00,000/-

-          Land Component: 60%. This is the part of property which will appreciate. Say inflation is running @ 5%. We will assume land will appreciate @ 10% -  double the ongoing inflation rate.

-          Structure component: 40%. This is the part which requires upkeep expenses, hence depreciates. Say 2% every year

-          The nominal value of property after 15 years: Approximately INR 2.79 Crores. See the detailed working here. The number does look formidable if looked at in isolation as it is pushing close to 3X the current value of property

-          Switching over to real property appreciation rate. Once we adjust for inflation @ 5%, property appreciation is real terms comes to 1.97%. Fact check - this is nearly double the appreciation I got from my property which I sold in mid 2021, which coincidently was “owned” for slightly more than 15 years!!!

-          Terminal property value in real terms: Approximately INR 1.34 Crores. The good thing about this number – as this is on real basis, you get an idea that you need to muster up nearly INR 34 Lacs extra in today’s value in 15 years to keep the property currently valued at INR 1 Crore withing your reach. Put another way, I or anybody else in similar predicament needs to ensure that INR 1 Crore corpus designated for buying a home gets at least 1.97% ROI in real terms.

-          Where to stash the cash: With current 10 year government bond yields hovering around 7% nominal, and if history rhymes, we can expecting a 3% risk premium on equity (index) investments. A 25% equity (index funds) exposure and the rest in 10 year constant maturity gilt funds to avoid paying taxes in fixed income investments, can help the house purchase corpus grow @ 2.62% per year in real terms. As for me, I would go by 50 – 50 allocation. This allocation may end up giving me a real yield of nearly 3.33%, thus ensuring my home purchase corpus is very well protected against home price appreciation

-          Playing it extra safe: But let’s play out a worst case scenario. Rather than home purchase corpus matching up or exceeding real property appreciation rate, assume one makes poor investment choices and is able to get just 1% real ROI on the home purchase corpus. This is nearly half of home price appreciation. Even in this situation, if one allocates just INR 10,000/- per month additional contribution to home purchase corpus, it will still easily match up to home price in real terms after 15 years. Do the maths!!!

Doing the numbers on real basis did rest my concerns (at least for the time being) on being priced out of real estate market. But the actual benefit accrued in realizing that ensuing real return on investments will be important to ensure my home purchase corpus keeps up with price appreciation.

 

***Nominal data is for UK markets, while real is for US markets. My guess is given the markets are mostly connected during bearish situations, we can assume data to be will mostly mirror the situation for both the markets.

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