Subramoney

So here is Children’s Day – a good day for parents and children to take stock financially speaking!

Most parents like to think they are helping their children by helping them financially. Especially if you are doing well – but in many cases even if you are not doing so well. Take the case of Amitabh Bachan – a bungalow in Juhu was anyway within the reach of Abhishek and Aishwarya also!

However even assuming that it was not there was a good chance that the “successful father” would have gifted it! Most parents love their children and want the best for them. And they want their children to have an easier run through life than they may have had. Consequently they tend to spoil their kids a bit: certainly the kids almost always get more material benefits than their parents had at the same age.

And they keep talking about how difficult life was for them! If your parents grew up in India during the 1960s and 1970s you will hear horror stories of queues for ration, milk, kerosene, etc. However, they will continue to spoil their kids. Helping children financially is not a good idea.

One 23 year old girl told me “I just want a small wedding, but if my parents want a “tamasha” of a wedding, let them pay for it. Completely correct. If you pay for your daughter’s wedding, it is not because the kids want it, you wish to show off to your friends, relatives, colleagues etc. Children who receive significant financial assistance from parents tend to under-perform in the income and the asset accumulation stakes in their own personal lives!

May be the knowledge and expectation of regular financial assistance takes away the imperative of working hard for oneself. The children may not be hungry for success, and may not feel the need to work hard and generally plan for their own financial successes. I know of many successful lawyers and doctors whose progeny is no patch on their parents. I know of a 40 year old who still keeps talking of his father as a great success – he now has a major complex!

Of course one exception is education: financial assistance to allow children to maximize their education almost always makes sense. Education is NORMALLY an excellent investment. And the return on investment is almost infinite. I earn more per month than what my father spent on my education THROUGH OUT MY CAREER. Other exceptions can be found – medical help, a short term loan to bail out of a difficult situation, a start up with a small capital requirement, etc. However it is better to structure all these as loans (or gifts) properly documented and transparent to all the other kids.

Nevertheless, as a general proposition financial assistance to children is not a good idea. The child buying his or her own home incites strong emotions for parents. Parents can be anxious that the child buys well and gets a good home in a good location. If ever there will be financial assistance, it will be now (even if the parents are not doing that well themselves). I am still against this. Funnily in India sons being helped by their parents is accepted but a father-in-law helping a son-in-law is emasculating!

I know of a doctor who wanted to insure his daughter – I convinced him to insure his son-in-law! After all, his daughter needed protection. It was a difficult sale, I can assure you!

Another doctor’s wife was delighted to tell me about her daughter’s recent wedding to another upcoming dentist. The daughter was looking after the parent’s practice and the son-in-law was a dentist practicing in the same area. The parents were looking for a suitable house for the young couple – and the budget was far, far beyond the young couple’s budget for sure!

The elder couple wanted to pay about 70 per cent of the cost! Will tell you what happened in a later post!!

I meet a lot of doctors in my professional and social life. Luckily I met a great homeopath doctor about 30 years back - and he has kept me away from medicines SINCE then! So I do not meet doctors for seeking medicines / treatment. However, here are my observations about a doc’s business skills. If you are a doctor I know, Or I do not know, please give a feedback on what I have said here!

Some amazing facts that come to light are the following:

1. Many doctors business skills, but do not know that they lack business skills.
2. The income that is reflected in the Profit and Loss account is a function of what their accountant thinks should be shown as an income – the reality is nowhere near the shown figure.
3. As they have a large amount of cash accumulated, the only “investment” that they can think of is property.
4. Throwing data about equity performance vs. real estate performance is of no use to them – they have far too much of cash to be invested – which can only be invested in real estate.
5. All the skill up-gradation that Doctors do is with regard to their own field and very little on practice management.
6. Doctors are a little scared of technology, finance, income tax, search, seizure, raids and of course accountants – unless they are married to one!
7. Most of the “finance” and “investment” knowledge that they have is got from their Accountants, real estate agents, or fellow doctors – and could be very lop sided.
8. A very, very few doctors plan their practice – which means taking on a partner, creating a franchise, selling while retiring, taking a vacation, are all very difficult.
9. Doctors ability to “market” their services is restricted to “hoping” that their existing clients will give them references. They do not even seek to members of networking organizations to learn the nuances of networking.
10. Doctors idea of financial planning is largely restricted to tax planning – which means they buy assets (and claim interest and depreciation as “expenses”), or use some tricks given by their accountants.
11. Insurance planning, wealth creation, making a will, financial goal setting, MIS, are alien to most doctors.
12. In all their education they have never thought it necessary to learn money or practice management skills. Nobody thinks it is worth teaching the docs!

Doctors normally start their practice and the money starts coming in – first in trickles and then as a flood. Over enthusiastic accountants and ignorant doctors are a dangerous combination – they keep the doctor’s income low so that lesser tax can be paid.

Suddenly if the doctor wants to set up a bigger practice, buy some property, or employ some juniors, the doctors suddenly start wishing that they had showed more income. One thing doctors can do is to invest in commercial property – for his / her own practice and for renting out.

Doctors should invest in commercial property because it is an asset class generates good inflation adjusted returns with relatively low risk. This risk can be diversified down by investing in a mix of commercial properties, whether by owning multiple properties.

Over the last 20 years commercial property returns have averaged more than 12% per annum, and in the last ten years it has been the second highest performing asset class, second only to the index of equities. The returns from commercial property is surely superior to residential property especially from a cash-flow point of view. Read on, it is not difficult to understand, even if you are a doctor! If commercial property comes ahead of residential property, then why own any residential property? Why not only own commercial property?

Residential property buying is far more emotional than commercial. It is a social and emotional need, and it surely generates some capital gain for doctors over a long period of time.

One reason is that commercial property usually generates higher income yields than residential property. Rental yields of 7% or more are not unusual, and rental yields of 10% are encountered as well, whereas residential property yields are normally closer to 3% (with occasional exceptions in less popular areas).

And with commercial property the tenant pays the outgoings (rates, repairs, society charges etc), not the owner, so there are lower cash outgoings as well. Higher yields and lower outgoings mean cash flow being positive even with high levels of borrowing. That is more cash comes in than goes out, even before the tax advantages are considered. Many leveraged commercial properties cover the interest on the loan and also leave a surplus. This is better than a residential property, where the cash flow effect is usually negative.

So for a new doctor it makes more sense to buy a commercial property and put it on rent, while for an older doctor it makes sense to buy residential property! Soon after the doctor buys a residential investment property, cash flow is down compared to what it was before; whereas in case of a commercial property, cash flow is up comparatively!

Each purchase of a residential property reduces the doc’s ability to service the loan on the next residential property investment; whereas each purchase of an industrial property increases his ability to service the loan on the next commercial property.

This of course ignores capital gains: historically residential property has achieved significantly higher capital gains than commercial property. Obviously investors buy residential property with medium and long term capital gains in mind: why else would you borrow at 13% to buy an asset earning 3% rent? The answer has to be an expected capital gain in five, ten and twenty year’s time.

But expected capital gains are far away if the doctor cannot meet the loan repayments in the meanwhile. And for doctors whose cash flows are not guaranteed always, this is a risk to worry about.

Another reason why doctors should consider owning commercial property is diversification. Studies show that diversifying across asset classes reduces risk. It boils down to not putting all your eggs in one basket: if you have all your wealth in say equity only – through a mutual fund or an unit linked plan, your fortunes are 100% determined by that asset class’s performance.

However, diversification is a two edged sword: it reduces up-side risk as well as reducing down-sized risk. It all depends on the individual doctor’s risk profile, and most prefer some diversification.

Commercial property usually has much longer leases than the residential property. Lease terms of five years, with options for a further five or ten years at the end are not at all unusual. This creates more security than residential property, where terms are

usually for no more than a year. Most residential property tenants see themselves as renting short term, whereas a business in a well located retail shop, or an ATM of a bank, will want to secure their own goodwill by obtaining security of tenure.

This means they want the certainty attached to a long term lease.

Diversification from residential property to commercial property makes particular sense when the cash flow of commercial property is considered: this creates a cash flow buffer that takes away some of the stress of residential property prices falling.

My suggestion to a doctor is to build a portfolio of 2-3 residential properties, plus their own home, and then diversify into commercial property. Another residential property may have created too much strain on the practice’s cash flow, whereas a commercial property instead adds to cash flow and reduces some of the strain caused by the existing residential properties.