Property is a very important and widely held asset class. It occupies our planning horizons and capital in a significant manner. House is the critical component of the triad of essential needs viz. Roti, Kapda and Makaan. For most of us, it is either the objective, or means to some objective. Investment in Real Estate needs huge amount of capital, and once acquired we generally hold it for long durations. Hence it is important to evaluate the various issues surrounding such a major decision. It is highly possible that in an attempt to create an asset, we might end up carrying a liability.
Peculiarities of Real Estate
We can categorize Real Estate under different, and sometimes overlapping categories like Rural/Urban, Industrial/Commercial/Residential, vacant/building etc. Whatever be the category, all real estate has some common peculiarities from financial point of view. These have been discussed in the previous article on Understand Your “Why?” of Investment, Before Deciding on the “Where?” Over time it is an efficient growth instrument but it also lacks in calibrated liquidity. The capital outflow is in bulk, but can be easily funded through debt with added tax benefits. The resale proceeds are generally large and cause tax and re-investment concerns. During the period of holding, the property needs continuous supervision and monitoring to ensure control. There is also some effort and patience needed in realizing fair value of the property at the time of disposal. Possession of real property also gives us a good sense of overall net worth.
Need for Owning House
All our actions are driven by a purpose and so is the case with purchase of real property. The basic reason being to fulfil the essential need of housing. This need can be fulfilled by either buying property, or by renting a house till such time one is capable of buying one. In the case of government , PSUs and some big corporates, free housing till retirement is provided. This category of people can conveniently defer their plans to purchase house till the need actually arises. The need is generally closer to retirement. There are also many of us whose parents have built property which might be sufficient to accommodate all family members. In such cases also, housing should not be a critical need.
Real Estate as an Investment Option
Over the last decade, some locations witnessed steep appreciation in real property rates. This was primarily driven by cash floating in the parallel economy. This phenomenon clubbed with the easy availability of housing debt and consequent tax benefits, propelled most of us to look at real estate as an attractive investment option. The appreciation over time at some places has been very rewarding, while at most other places it remained modest.
The housing index, based on data pertaining to 10 major cities, was 100 in 2010/11, and has moved to 280 in 2020. This indicates an average annual appreciation of 11% with a declining trend (source: RBI). It is also a fact that we desire to fulfil maximum agendas with one action. A majority of us buy house for later years, and to earn some rental income during the interim period. Further we want to do this while enjoying the tax benefits on repayment of debt. In some cases, we overdo it by buying one for own need, and another for returns.
Example
Let us try to understand the financial rationality with the help of an example. Mr X who is 30 yrs of age and working for last 5 yrs, wants to buy a house. He has identified a property which is costing ₹ 50 Lakh. With savings of about Rs 10 lakh he can get a loan of ₹ 40 lakhs at 9.5 % interest. Though he is getting house from his employer, he thinks he can rent out the property at about Rs 10 k per month. The rent should fund some portion of his EMI. He also plans a loan tenor of 20 yrs so that the liability is over in time before his retirement. The consequent tax benefit will reduce his tax burden to the extent of 60 k each year. His estimate is that the property will appreciate at 10% annually.
We can compare this option with the opportunity cost, ie the cost of alternative option. We take a simple investment in an Nifty Index Fund as the alternative option. The assumptions are based on historical data of home loan rates, appreciation in property rates and returns from Nifty Index. The table below shows the cash flows and final returns if we liquidate both options after 20 years.
@ Balance being funded from Debt
^ Rent increasing at 5% per year
# Sale of Property
$ Capital Gains tax at 20 % (the actual tax liability will be lesser after factoring appropriate indexation)
* Net in hand from Property after Tax (@20%)
& Net in hand from Equity investment after Tax (@10%)
Evaluation of Options
At the face of it, it looks a doable and attractive proposition. After factoring the tax rebate, rental income and the capital appreciation as desired, the overall annualized rate of return based on cashflows (including EMI, rent, effective tax benefits) works out to about 12 %. The tax liability on rental income becomes positive in later years due to increase in rent, and decrease in interest payment. It is also interesting to note that with the tax benefit limited to Rs 60 K per annum (on interest repayment up to 2 lakh), out of total of about ₹ 50.78 lakh of interest payment, only ₹11.3 lakhs is received back as tax benefits.
We can compare this with another simple option of investing the net cash outflow in a passive Nifty Index fund for 20 yrs. The annualized returns in this case would be around 12% (based on data of last 20 yrs). The only issue is that one has to be able to withstand the volatility wherein some years might show negative returns also.
If we see the net returns, both options seem to be comparable. However, qualitatively the equity option remains far better as the aspect of calibrated liquidity is a significant advantage. Also, the returns on investment in active funds over this time horizon have been much better than 12%. It is also pertinent to factor that in the case of debt funded real property, while cash outflows on loan repayment would be constant, the cash inflows on account of rent may not be as smooth and constant as assumed. Realizing fair value of property at the desired time also remains a challenge.
When, and for How Much to buy Real Estate
Housing however has a deep psychological context along with overbearing pressures from family and society. Doing away with the requirement all together would need a lot of conviction and support from family members. I assume that sooner or later, most of us, for either of the discussed purposes, will indulge in real estate. In my opinion, there are two issues to evaluate. First the fair cost of property, and secondly the time to buy it. Looking at the timing part, I feel one should defer the decision till such time one needs it. And until one can buy it from own savings/investments. In case you need it before building the requisite financial capability, then you may consider funding it through debt. But the size of expense should fit the overall Financial Plan and not upset other objectives.
To arrive at the fair value, we should consider our expectation of returns. If I want to fetch greater returns than equity, say 15%, then assuming a capital appreciation of 10%, the annual rental income should be about 4-5 % of purchase cost. The fair cost than translates to be less than 25 times the annual rental value. This means a property giving monthly rent of Rs 15 k should cost around Rs 45 lakh. Finding such a property might not be easy.
Owning Real Estate in Digital Form
What has changed over last decade is a spectacular evolution of financial technology. This has made available extensively user-friendly online platforms. Further the increased supervision by the regulatory bodies, esp. SEBI, has enhanced the investor confidence in these platforms and instruments. Now most of the assets including Gold and Real Estate can be held in digital form. One convenient avenue to invest in Real Estate is through Real Estate Investment Trusts (REIT). These are regulated by SEBI. The gains are in the form of rentals as well as capital appreciation. The lot sizes, though large as compared to Mutual Funds and shares, are very small in comparison to real property. This facilitates investment in small proportions. At the moment there are only two listed REITs. But soon there would be more and one can consider some investment in REIT as part of the overall portfolio.
Recommendations
(a) If one needs house for personal use at any point in time, then he/she should explore funding it through debt so as to benefit from tax relief. The size of purchase, quantum of debt, and tenor of repayment, should be such that the overall monthly repayment does not exceed 30% of monthly income. You should do this as early as possible so that the debt can be repaid well before retirement.
(b) If you do not need a house immediately, then you should start building the requisite financial capability through appropriate savings/investments. You can do the actual purchase after accumulating adequate corpus. And a little before the time when you might actually need the house.
(c) The uncertainties of later years shall unfold only with time. Those with conviction, can consider living in rented accommodation with all the associated freedom of change and relocation. The earnings from accumulated corpus would be able to fund the entire rent plus the living expenses.
(d) If you do not need house for personal use, then preferably purchase real estate using accumulated savings/investments only. You may rather consider investment in Real Estate based financial instruments like REITs.
(e) While deciding on the loan amount, one should consider how much of the interest repayment would qualify for rebate factoring the annual limit and the carrying forward provision which is presently 8 years. In the above example we can see that the buyer can claim rebate only on 38 lakhs of interest paid. The balance about 12.8 lakhs could not qualify for any rebate due to carrying forward duration and annual ceiling constraints. This amounts to availing tax benefit of about 22% against expected 30% (assuming that one is in the highest tax bracket). In the discussed case, if the loan amount was Rs 23.5 lakh or less, then entire interest paid over 20 years would have qualified for rebate. The interplay of loan amount, interest rate, ceiling on tax benefits, carrying forward duration, and loan tenor, has been discussed in “Taking Home Loan- How Much & till When“.
Conclusion
Some real-estate as part of a diversified portfolio is certainly desirable. The size of capital requirement being huge, one needs to evaluate what portion of his net worth should be locked in real property. The downward trend in interest rates might work better for those looking for housing for personal use. But in light of multiple instances wherein hard-earned lifetime savings of some has been stuck in incomplete projects, they need to be cautious in choosing the right source and location. Those with investment motive should be guided by the future trends in real estate capital appreciation. In our societal context, for most of us the capital gains on property are likely to remain notional for life. And very commonly property becomes a management issue for estate planning and inheritance purposes.
There are people with high property holding, but still living a restricted quality of life due to poor cash inflows. While psychological security related to ownership of a house remains a concern, one needs to exercise financial prudence. One should limit the urge to indulge in real estate beyond the needs and avoid management issues in later years.