At the outset, let me hasten to clarify that this article is not about renting vs buying a property. This article is purely an analysis on investing in real estate, its plus and minus points. i.e., treating direct investment in real estate as one of the avenues for deploying your surpluses for good returns and the risks associated with such an investment choice. The term real estate is used to describe residential property (independent houses, villas, row houses and apartments), plots of land for residential / commercial development, purely commercial buildings, malls, resorts, farmland, hotels and holiday homes etc.
Whenever you make an investment decision, you should know the advantages and disadvantages of the type of asset selected and go for it if it matches with your financial goal. The real estate market requires higher deployment of capital than any other class of investment like equity, debt, gold, mutual funds, ETF etc. Therefore the investment will have your own capital plus borrowed capital like a bank loan etc. Real estate market entails leveraged investment on account of the large investment required. Tax incentives alone should not be a consideration when investing. Hence, you cannot afford to go wrong in a real estate investment. Having said that, let us find out what are the negatives in this market.
One-time and Recurring Costs. The investment requires recurring and one-off payments. The one-off payment can be listed as, one-off deposit for an agreement to sell with the vendor and/or deposit to be paid to the society, legal fees for ascertaining the legal title of the seller, the processing and other fees of the bank/financial institution, the stamp duty and registration charges, electricity and water deposits etc. The recurring payments are maintenance charges of the society or the caretakers fees as the case may be, repair and maintenance charges, loan EMI, insurance and taxes etc. Many of these are either lump sum, recurring or large outgoes. This impacts your return on investment.
Also, it is a balancing act to bridge the gap between the unexpected recurring costs, including rent-free periods on account of vacancy, and the expected recurring expenses. If there is a shortfall, it will have to be bridged from your other income. Hence, even if your net worth is great on paper, your standard of living may not be that great! A sorry situation indeed!
Lack of Liquidity. Liquidity is basically how quickly and with least expense you can turn your investment into cash. Property investment scores least in this test. Even though you may get a good price, you need to wait till a good buyer comes along with the offer matching your expectations. The buyer also should be able to quickly pay the agreed price and not make you wait long. In such deals, the parties enter into a sale agreement and determine an upfront deposit. The deal needs to be concluded within a mutually agreed time frame and if not concluded the deposit amount will be forfeited by the buyer. Since the intention is to sell, this does not give much comfort to seller. The seller might also lose any other good deal that he may come across as he is bound to wait till the time specified in the agreement to sell. The cost of sale can be time, legal fees and opportunity loss.
In the event of your inability to immediately sell, rent out or lease the property, you tend to lose. This is because the EMI does not stop and your outgoes towards utilities, maintenance, taxes, insurance also do not stop. These rent-free periods eat into your return on capital employed. A builder with unsold apartments will also feel the financial squeeze.
Taxes. Even if you hold the real estate investment for a long term you cannot escape the capital gains tax. At the most, you will be entitled to indexation benefit. In equity investments (including equity mutual funds), there’s no tax on capital gains if holding period exceeds one year.
Bad Tenants. If you are renting or leasing the property, you always run the risk of bad tenants or lessees as the case may be. Problematic and vindictive tenants can severely damage your property, refuse to make rent/lease payments and sometimes even refuse to leave the property. Some disputes can take months to resolve and become very stressful and frustrating. Since there is an emotional attachment to the property on account of money invested, it will affect you severely. You may also end up enriching your lawyers and doctors and also run the risk of rent control taking over the property.
Risk of Huge Loss or Dead Investment. In case of investments in equity/debt, you can set up risk management triggers like stop loss and quickly unwind your position. But in the case of real estate investments, it is very difficult to do so.
Black Money. One of the main irritant in this market is the dominant role of black money and underhand dealings at every stage.
On the other hand, real estate investment however scores over other asset class due to many positives.
Not Rocket Science. You need not be a market pundit and do research, and be familiar with derivatives, gain expertise in a large amount of risk management techniques etc. to successfully attempt direct investments in real estate market. Certain basic knowledge, market savvy, timing and patience is all it takes to invest in real estate market.
Possibility of High Returns. Property investment gives capital appreciation as well as lease/rental income. In the last two decades, investment in real estate and equities are said to have given returns averaging 20% per year! This is way ahead of all other asset class! In certain niche segments of real estate market, the return has been much more than 20%!
Leverage. As I stated earlier, real estate investments are classic examples of leveraging. Real estate is one of the few investment vehicles where using the bank’s money couldn’t be easier. The ability to make a down payment, leverage your capital, and thus increase your overall return on investment is incredible!
Ownership with Full Control. Unlike other asset class you have full control over your real estate investment. You can do anything with it within reason. You can develop a residential property or a commercial property, you can rent or lease it etc. When investing through mutual funds, for example, you have no control over the portfolio.
Government on Your Side. A boom in real estate market results in increase in manufacturing activity in sectors like cement, iron and steel, paints etc. This in turn results in higher GDP. Government has recognized this and recently allowed REITS and FDI in in real estate. This will bring down cost of borrowing by the developers.
Tax Benefits. Individuals can get enhanced tax benefits of Rs.1.5 lakhs u/s 80c, and Rs 2 lakhs u/s 24 of income tax. Even though this cannot be the sole reason to invest in property, the benefit is there to enjoy. This is also available for second housing loan!
Safe in the Long Run. This is one of the safest investment avenues and most forgiving. Even if you have invested in worst possible property, over the years you will be able to get your investment back at least with a small appreciation.
Risk Mitigation. Risk mitigation is possible through suitable insurance cover. You can insure your asset against most risks: fire/damage/a tenant leaving, damaging your property or breaking the lease.
Timing is Important
Like any other market, you need to time your entry. The property market moves in cycles. Property values may rise due to strong market growth, remain steady or even decline during certain phases of the cycle. Thus, as an investor it is important to know where the market is within the cycle to ensure you secure your property at the right price. A good indicator is liquidity in the system which pushes up the price of all asset class including real estate. A real estate investment therefore is an excellent investment if timed right and property is selected right. You cannot go wrong, and exit with 20% plus returns!