Concentration risk in buying residential property

Real estate price in India have been moving up over the last few decades. The decision to purchase a residential property in India is an expensive one, especially in the metro cities. The median property price for a 2 bhk in metro cities at the end of 2017 was INR 40-50 lakh in an middle class neighborhood. Mumbai and Delhi rank among the most expensive cities in the world to buy residential property, based on multiples of average household income.

Conventional wisdom says we should spread our eggs to reduce our risk, but when buying property it makes this very difficult. For most of us, we do not have the entire capital to make an outright purchase of a house. This is especially true for young couples who are newly married. This means that we most often make a down payment of about 20% of home value in equity and resort to bank loans for financing the rest of the amount. What this means is that not only are we NOT spreading our eggs, but we are dependent even more heavily towards the potential success of this asset class.

Obviously it follows that to buy a residential property in India most of us are taking a significant punt on the success of this asset class and fortunately for most of us, the residential property market has delivered. The fact that Mumbai and Delhi etc are amongst the most expensive cities in the world, reflects this.

But even considering India’s residential property success, some properties have under-performed. The very definition of a median is the middle of the best and worst and for those who have already selected an under-performing asset, the impact of a concentrated approach is already being felt.

To illustrate this, consider the performance of the Hyderabad, which was down 10% over a three year period, to August 2015. This was mainly due to the formation of the separate Telangana state and the related agitation. Another example is Kolkata, where real estate prices have decreased in some pockets. This second example is an extreme one, as we all know about the fall out of the population migration and most of us would not have invested there in the first place, due to its somewhat speculative nature, but it does illustrate the point that not all property is created equally and there are several more examples to draw on.

It also highlights how vitally important it is to get the investment selection right as unlike other growth investments, like shares for example, where its likely your portfolio will be diversified to a range of companies, if you are only buying one property, your total portfolio success is riding on it.

Consider now how this could look if multiple investment properties are purchased. It’s not uncommon for property investors to try and compound their success, by consistently leveraging to further property purchases. Investing this way could deliver the best long term portfolio performance and again for many people in India over the past 30 years it has, however the point here is how it impacts concentration of risk.

Looking at the positives of multiple investment properties in a portfolio, it provides the opportunity to spread some of the ‘concentration risk’, by diversifying and purchasing in a different suburb or even more broadly a different state. It is, however, amazing how often I meet people who have invested a second, or even a third and fourth time, in the same area they hold their original investment. The logic being they have achieved some initial success and they feel they understand that particular market. On the point of concentration of risk, the implications are obvious.

Concentration of risk is something that all investors should be mindful of, regardless of how bullish they are on the specific asset class prospects. Simply put, high concentration of assets lends itself to periods of out-performance and periods of under-performance, compared to the alternatives, and with the impact of debt leverage overlaid into the equation, can result in being forced to realise negative outcomes by virtue of having fewer other options to draw on.

Property is a great part of a well-rounded portfolio of assets and several of our clients own investment property, however the point of concentration risk goes to the heart of good portfolio management. Regardless of how you choose to invest, the starting position should be to consider the five asset classes of Cash, Fixed Interest, Property, Indian equities and International Shares against your personal objectives and risk tolerance. The better diversified you are, the lower the volatility generally speaking and being diversified provides more flexibility in trading in and out of investments, for personal or investment reasons, throughout the asset cycle.

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