Having a place to call home or investment property is a dream for many. The appeal of real estate as an investment is universal. Real estate, like other physical assets, is easier to understand than stocks, funds, or other “paper” investments and is seen as a safe investment. Although those are common perceptions, real estate presents its own unique risks and rewards. And for NRIs specifically, there are additional factors to take into account before investing.
Leverage: A double-edged sword
Leverage allows investors to borrow capital to invest in an asset. In real estate, investors typically purchase an asset by putting down a fraction of the purchase price and borrowing the balance; this concept is called leverage.
Assume you are looking for a house to purchase and have saved $100,000 towards its payment. Depending on your risk tolerance, you can buy a home valued at $100,000 and own it outright. Alternatively, you can use the $100,000 as a down payment and buy a house valued at $400,000 by using leverage and borrowing the $300,000 balance. In the latter case, the terms of the loan agreement will specify the required principal and interest payments on the loan over several years.
In both cases, returns on your home investment are generated when the market value of the property increases. Though both cases show a positive return, the leveraged investor is able to amplify their returns by borrowing.
Using the example above, assume home prices are increasing by 5% annually. If you’d purchased the $100,000 home, your home would now be valued at $105,000, giving you a 5% return on your $100,000 investment. On the other hand, if you borrowed to purchase the $400,000 home, your home would now be valued at $420,000, of which the bank is still owed $300,000, leaving your share at $120,000, giving you a 20% return on your original $100,000 investment.
On the surface, leverage sounds like a great concept as it allows investors to invest in assets with a fixed amount of money while significantly boosting returns. But leverage also has considerable risk when you consider that markets can also move down.
Assume home prices have decreased by 5% due to rising interest rates, an oversupply of homes, or even a natural disaster. In the example above, if you’d purchased the $100,000 home, your home would now be valued at $95,000, resulting in a 5% loss on your $100,000 investment. On the other hand, if you borrowed to purchase the $400,000 home, your home would now be valued at $380,000, of which the bank is still owed $300,000, leaving your share at $80,000, giving you a 20% loss on your $100,000.
Taking the above downside scenario further, an extended market downturn, such as a recession, may result in layoffs. As an NRI or H1B visa holder, you may be affected. If you want to consider moving to a different region or even back to India, you may need to sell your home. That may not be so easy, given the unique characteristics of real estate.
Once invested, real estate can be difficult to exit, especially in a market
slump. When real estate prices are rising, investor returns are positive. When real estate prices go down, investors not only lose equity, they must continue to pay the required principal and mortgage as well as maintain the asset to avoid further devaluation.
Real Estate Market Liquidity
Despite a vast number of buyers and sellers, real estate can, at times, be an illiquid market. The process of buying and selling a home is not instantaneous or quick, as other more liquid investments, such as stocks, mutual or index funds. It may take weeks or months to sell a property.
Real estate values can be volatile. When the market is down, investors may not be keen on selling at a lower price and realizing a loss on their equity and prefer to wait for a better market environment. Pricing takes time to filter through the real estate market. Unlike stock markets, where share prices adjust rapidly to news, real estate prices can take a longer time to adjust. When markets are bad, that may be months or years spent waiting to realize positive returns. NRIs that need to exit quickly may not only lose money but if they choose to sell the asset for less than the value of the loans outstanding, they remain liable for the outstanding loan value.
Location, Location, Location
When property values are down, it may be specific to the region, whether due to a decline in the local industry, recurring natural disasters, or an oversupply of homes in the area. These are medium to long term issues, which may result in an extended period of decline before prices start to come back. This means where you buy is as important as what you buy.
Real estate markets vary by location. While prices in Washington DC and neighboring northern Virginia are strong, home prices in Chicago and Seattle are down and expected to decline further. This can even affect a small segment of the market. For instance, luxury real estate in New York City is currently down due to oversupply, while luxury homes in Washington DC are at record highs.
Depending on the investment time horizon, real estate may not be the right asset class for NRI or H1B investors. For those with an uncertain time horizon in the US or even in a specific city, renting may be more suitable than purchasing a home. This gives the investor flexibility to upsize or downsize, relocate quickly if necessary, and avoid trapping their liquidity in relatively harder to sell assets, compared to index funds or ETFs.
Real estate should be considered as one asset class in a portfolio of investments. Being overweight in real estate may result in excessive cash requirements and limited personal flexibility in an asset class that is not easily liquidated.
Owning your own home has always been part of the American dream. But that dream doesn’t come risk-free. Leverage can be a double-edged sword, leaving investors flush when times are good, yet exacerbating losses when market prices fall. The protracted market cycle for real estate values and long transaction cycles for purchases and sales can potentially leave investors in a cash crunch. Even in the perfect location, regional dynamics inherent in real estate investments may also leave NRI investors unable to sell a property when desired, whether to pursue new employment opportunities or to move back to India.
Given all these risks, real estate should be part of a broader, diversified investment portfolio for NRIs.