Thursday, November 20, 2014

Physical Assets: Can You Depend on them?

The acquisition of various assets during the life of an individual depends on the income level, financial goals and aspirations of the individual. One acquires assets either for current consumption or future welfare. Current consumption includes perishable items and physical assets as well. Physical assets are bought either towards some enumerated financial goal, Social esteem or based on some long held belief about the asset. For example one would put the money in fixed deposit towards the achievement of some future financial goal, but will buy an expensive item like an artifact as a Hussein painting for the purpose of glory.
In the Indian Scenario as per a survey conducted by National Council for Applied Economic Research (NCAER) and Max New York Life in 2008, 23% savings of Indian households are parked in physical assets.  In this note we would like to evaluate their dependability as stores of Wealth

Before arriving at a conclusion whether the asset in question is dependable or risky, one needs to evaluate the purpose for which the asset is acquired. Following points, if kept in mind could help in such an analysis.

a)   Notions about the Physical Assets

People tend to acquire the assets without proper notion about the nature and characteristic of the asset. If one is investing in an asset for the purpose of glory, then the same asset would not add value to the net worth of the individual from the point of view of achieving some financial goals and individual even after allocating the funds would still be in want of allocation towards the achievement of the financial goals.

b)    Stakes in the Assets ( opportunity cost)

 The next question that an individual needs to ask while making a decision to acquire an asset is the stakes in question, if an individual is acquiring a depreciating asset at the cost of a future financial goal like retirement then it must be strictly avoided. An example could be the purchase of car on loan reducing the amount available to be invested periodically for retirement.

c)   Debt against these Assets/( Liquidity Potential)

 With the availability of credit it has become easier for people to acquire a physical asset, but caution must be exercised whether debt must be taken for acquiring this asset. Debt must not be taken against a depreciating asset unless there is a possibility of investment arbitrage and an individual has the corpus available to pay off the debt in short term if required. For e.g. if one buys a car on loan, then it is preferable that one has the amount equal to the loan he/she has taken for car available with him which can be deployed in  another investment option which could generate a return which is higher than the rate of interest one has to pay on the loan
However in case of appreciating asset like house property , taking debt could be a good option as  the rise in value of the house property will increase the net worth of the individual and at the same time one would be able to take the advantage of tax benefits under section 22, 23 and 24 of the Income Tax Act, 1961 under which interest on the housing loan is deductible from taxable income up till a limit of Rs 200,000 in case of a self occupied property, while there is no limit if the property is let out. Additionally one can claim the deduction with regards to principal repayment up to a limit of Rs. 150000 under section 80C.

d)   Appreciation/ Depreciation in the value of the assets

Another question that may be asked is whether the asset being acquired is depreciating or appreciating in nature. While an asset of appreciating nature will aid in increase of the net worth, the depreciating asset will reduce the net worth which should be taken care by some alternative strategy to set off the reduction.

e)    Regulatory Infrastructure

In case of physical assets, there is lack of regulatory infrastructure as available for financial instruments and the possibility of market imperfections cannot be ruled out.

Based on the above factors, it may be inferred that a particular physical asset is dependable or risky for a particular individual. Notwithstanding the above, goal based financial planning approach should be employed at all times and it must be ensured that no long term financial goal is compromised at the same time maintaining a reasonable corpus in short term for emergency requirement.

Only purchasing power  or debt repayment capacity should not be the reason to motivate one towards the acquisition of these assets , ( e.g. :An individual who is capable of paying off 20000 Rs per month should not get into buying a bigger car taking loan without proper need and benefit analysis). The Decision to acquire an asset using debt is sensitive and should be done after proper analysis of appreciating/depreciation potential of the Asset preferable in consultation with a financial adviser. Following table gives an indicative list of physical assets and whether the same should be procured using debt.

Following Table gives an indicative list of Physical Assets and suggestion w.r.t. procurement through loan.

S. No
Loan to be sought
House Property
Provided (1)25% margin is utilized
(2) tax Benefit in case of Self Occupied Property
(3) Income generating in case of second Property
Provided there is appreciation potential
Vehicle for personal use
Not Encouraged except in case benefit claimed out of investment arbitrage (for individuals) and depreciation arbitrage (for professionals)
Lifestyle Assets(Mobile/Watches)
Vehicle for Commercial Use
Provided the income generated covers the cost of credit.

Thus it could be said that loan should be sought against only those physical asset which are expected to appreciate in value. In case of real estate there is an additional advantage in terms of tax benefit as mentioned above.

In conclusion one could infer that while acquiring a physical asset could be undertaken if one’s financial position allows, whether it is for glory or one fancies it, the same should not be done at the cost of financial  goals and needs.

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