Buying real estate? Read this!

By BankBazaar.com | November 30, 2009

Real estate appreciates in capital – particularly the land. The building generally depreciates. Recently the National Housing Bank launched the Residex, an index which will track the capital appreciation of real estate house properties. The data is updated for 3 years now. Over a period of time, the index can be used as a good measure for the capital appreciation of housing properties.

Traditionally real estate in the form of the house that we live in has been the single largest investment for most of us. This is seen not only in India by across the world. Let us now apply the metrics that we attribute to investments in general to real estate and see the answers that come up.

Current Income

If the investment is on the house that we live in ourselves, there is no current income. This is one of the main negatives about the house that we live in. In a financial cash flow perspective given by Robert Kiyosaki, it is not an asset. Because the house is cash flow negative owing to the maintenance activities and tax that we have to pay for it.

Rent from a house or commercial property is a good source of current income. Although at current bank rates the rent from a house is generally only about ½ of the loan EMI, the catching up will happen after the loan is closed. A 1000 square feet house will cost conservatively about Rs.2500/- per square feet (B class cities like Coimbatore, Kolhapur, Guntur, etc) leading to the house value of Rs.25 lakhs. A loan for 80% of the value (Rs.20lakhs) at current interest rates (9%) and 15 years term will require an EMI of about Rs.20,300/-. The rent for the same house in the mentioned cities may not top even Rs.10,000/-.

If we had 5% yearly increment on the rent as part of the agreement with the tenant, the rent will be equal to the EMI in the 14th year.

Another aspect of the real estate property which requires attention is that the cost of maintenance also keeps growing. For example, Akash had to spend Rs.35,000 for a sump rework in a house build by his grandfather. The original cost for the construction of the house itself was only Rs.30,000/- including the compound wall, and a fountain in 1967.

So a fully paid up rental property is an asset with good current income otherwise financially it is a liability.

Capital Appreciation

Real estate appreciates in capital – particularly the land. The building generally depreciates. Recently the National Housing Bank launched the Residex, an index which will track the capital appreciation of real estate house properties. The data is updated for 3 years now. Over a period of time, the index can be used as a good measure for the capital appreciation of housing properties.

A key aspect of the capital appreciation is that, it can be realized only when it is sold. And generally the house that we live in is the last of the assets that we sell. This has to be factored in before we make the house the largest investment in our lives.

The capital appreciation of the house can favorably be used in the form of a mortgage loan for business purpose or in the form of a reverse mortgage post retirement. The land that cost the Akash’s grandpa Rs.100/- per cent, is today worth Rs.600,000/- per cent. This is a compounded annual growth rate of 23%. Other property locations (grandsons) may or may not be so fortunate.

Risk

The risk with real estate is that it can go down sharply too. The current worldwide economic turmoil is because of real estate prices dropping more than the expectation. The other risk is related to its liquidity itself.

Real estate prices in India do not have a formal/scientific basis for quoting. Brokers are the key pins holding the structure together. The same property may be quoted different prices by the same broker for selling and for buying. The difference in amount going to the broker – this, apart from their consulting fees. The pity is that often the difference is more than the profit for the owner of the property itself.

The other risk is that only a portion of the sale price may be registered, the rest being paid as “Grey / Black Money”. Accepting such deals are counter-productive when we go for the selling as we have to bear the brunt of extraordinary capital gains.

The situation is changing but very slowly for comfort.

Liquidity

Real estate is probably the most illiquid of all common investment avenues. If there is an urgency to sell a property the value could drop drastically. Selling at ‘Market Price’ is counted in number of months not days.
Tax Treatment

Real estate attracts capital gains tax. The advantage is that we can use indexation benefits to our advantage. The indexation index is announced every year by the Income tax department. This is a number which links the inflation to property values. By using indexation, we can estimate the true appreciation of the real estate after adjusting for inflation.

The tax on the sale of the only house or agricultural property can be brought down to zero by reinvesting the sale proceeds in a new house or agricultural property. The capital gains can also be invested in low interest yielding Capital Gains Bonds. The details of the tax treatment are beyond the scope of the present article. We will discuss this in a separate article.

Convenience

Real estate has a low level of convenience.  It requires a large corpus for investment leading most of us to take up loans. Here are a few smart marketing companies that sell land in installments. However the overall cost for such deals is very high compared to one time payments.

The decision after buying a property cannot be reversed quickly or economically. The cost for registration, brokerage charges and taxes prevent us from getting rid of a wrong purchase quickly.

Summary

Traditionally, real estate has been the major investment avenue across the world. The trend is not due for a change as the capital appreciation is good. However the points to be thought about are that:

  1. Capital appreciation can be enjoyed only when the property is sold or when the value is unlocked through a mortgage loan or reverse mortgage.
  2. The house that we live in is not a financial asset as it has negative cash flow.
  3. Rent proves to be a stable and reliable source of income. This however is only applicable to properties that are free from loans.
  4. Overall convenience is low for real estates.
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