Sometime back, whilst corresponding with a batchmate of mine, I asked him if he had invested in real estate. He is one of those lucky ones who own ancestral property and did not need to buy a house to live in. His answer surprised me ‘I never had a need to invest in Real Estate’, he said.
So here is a basic primer of investing in Real Estate:
One should not invest in Real Estate till the following have been taken care of:
- Medical insurance is bought.
- An emergency fund of 6 months’ expenses in is place (including EMIs if any).
- Life insurance – only Term policy, is bought.
- The home bought for own residence is paid up for completely or at least a substantial part is paid.
Once all the above are taken care of – which means, whatever happens, accident, loss of job, sickness or death, one won’t be on the street, it is time to look into real estate investing. Remember, the house where one lives in is not an investment.
Why invest in a residential house?
- Wealth building.
One can put up 20% down, take a loan for the rest and buy a house. Over a period of 10 – 15 years or so, repaying the loan and interest in small portions, one owns a house worth several lacs or even a crore – something that would be very difficult if one had to pay up at one go.
- Benefits of resale and reinvestment
Once the property is held for 3 years, sold off and the profits invested in another property, there is no tax liability. This can be done as many times as possible in one’s lifetime. It is a great strategy to build immense wealth without paying any taxes.
The two reasons mentioned above should suffice to convince anyone to make real estate their no.1 investment component, but there are many more. Read on.
- Indexation benefits
When one sells a property, the purchase price of the property is ‘indexed’ to arrive at the tax liability, in case one decides not to invest the profit in another property. This indexation, generally, is in line with the inflation. This means that the government is, in a way, guaranteeing inflation linked returns.
- Tax benefits
The amount paid in interest for the home loan is tax exempt upto Rs.1,50,000 per year and if the property is rented out then there is no upper limit for the tax exemption.
- Different strokes for different folks
There are various types of real estate investing:
- Book in a ‘pre launch’ project and sell in a couple of years. This option, in my opinion, gives the highest returns and has a higher risk.
- Book once the project work has commenced and sell off just after three years to take advantage of the long term capital gains exemption. This has minimal risk.
- Buy a house after the project is completed and keep it for a long time for rental income and as an asset for the next generation.
So, there is a wide range of options to invest in residential real estate, depending on your goals and risk tolerance.
Leverage is a fancy word bandied about by financial experts. Generally, it is used in the context of investing in shares. Quite a lot of brokers allow you to buy on ‘margin’. Let me explain.
Say one has Rs.10,000 and wants to buy shares of Reliance Industries, which costs, say Rs.1,000. So, technically, one can buy only 10 shares with the money. However, given a choice of ‘buying on margin’, one needs to put down only 20% (may vary), or only Rs.200 per share, so one could buy 50 shares!
However, say, the market tanks and the price of Reliance comes down to Rs.900. In that case, Rs.100 per share has been lost and 50% of the amount put up as margin per share is lost and the margin has been reduced to Rs.100 / share. However, there is a 20% margin (or Rs.180) requirement. So, there is a call from the broker’s office for what is called a ‘margin call’ to put the additional Rs.80 per share. If one can’t, then the broker has to sell shares to make up the difference, which, considering the market is falling will further add to the losses!
In the case of real estate, say one buys a 1000 sq.ft house at a rate of Rs.4000 per sq.ft. – total cost Rs.40 lacs. Puts down 20%, ie., 8 lacs and takes a loan of 32 lacs with a monthly EMI payout of Rs.32000 (approx.).
Let’s say the price in that area suddenly tanks and comes down to Rs.3500 per sq.ft. What happens? Nothing. As far as one keeps paying up the monthly EMI of 32,000 there is absolutely no change for the buyer.
Now let’s say the price goes up to say 4,500 per sq.ft and one has paid, say, 40% of the amount – Rs.16 lacs (plus some interest component). The profits are calculated on the entire amount – (4500 – 4000) x 1000 = 5 lacs! So, there would be a Rs.5 lacs returns on an investment of Rs.17 lacs or so which was gradually made over a period of a year or 18 months. Even assuming a 33% tax, the returns would work out to over 20% annualised!
So, residential real estate investment has an inbuilt ‘leverage’ option without the risks associated with the share market. If the price goes down, nobody can force you to sell at the lower price.
All investments should be considered as a business. So, if one considers investing in residential real estate as a business, then this is one business (probably the only one) for which the govt. gives subsidized loans (current rate is around 9.5% and is bound to fall). Though the RBI mandates a 20% down payment, the various lenders fall over each other to give a higher loan by taking advantage of various loopholes! What could be better?
- Profit through government spending
When investing in residential real estate, one should study the development plans for the area and book a flat at a strategic location, where some public facility is supposed to come up – be it a good garden or a bridge, etc. This adds value to the investment without any additional investment on one’s part. Just consider those who invested in the Chembur – Wadala belt. Once the Eastern Freeway came up, the house prices there nearly doubled! Similarly, flats at Navi Mumbai have been sold for more than 20 years on the hope that the airport will come up. Now, that it is slowly becoming a reality, the prices there are expected to shoot up.
- Tangible asset
Unlike most investments, one in real estate is tangible. Especially the youngsters feel a great sense of pride when they actually see the place taking shape and they can visit it. I recently accompanied my friend and his daughter who had invested in a house and the pride that child felt when she saw the place (though half finished) is indescribable.
- Illiquid investment
Real estate is an illiquid investment and yes, it is a positive quality. Nobody thinks of selling a house for an upgrade of the car. Hence, the investment remains for a longer time.
There are many more reasons –
- Social status
- Most of the rich people and companies have invested heavily in real estate.
- If nothing works out, you can use it for staying there yourself.
Risks in Real Estate Investing
- Crooked brokers.
Most of us rely on brokers for advice and as there are no regulations on who can become a broker, there are many unscrupulous ones out there. Talk to more than one broker. Ask for references and if possible, deal with one who is an investor himself so that he knows the pitfalls.
- Crooked builders.
Though there are a lot of good builders, almost all of them would try and make a quick buck. In my experience, I feel a small builder who talks to you directly is much more reliable than the big ones where one only talks through the ‘sales’ guys who promise you the moon! Take everything in writing. Expect delivery of the property at least a year later than promised.
- Illogical laws and officers.
There have been quite a few occasions where the government has changed laws midway. In the case of a huge project at Navi Mumbai, all permissions were given and the buildings were constructed. Banks have also given loans to the buyers. But after everything was done, someone in the govt. department belatedly came to the conclusion that it is CRZ (Coastal Restricted Zone) land and they are not issuing a completion certificate.
- Illiquid investment and Greed
There is one rule, which we have always noticed. Whenever one is desperate to sell a flat, it just does not sell. So, money invested in Real Estate should not be ‘dated’. Though one should have a general time frame to get out of the investment, it cannot be accurate. Generally, it should be “I will sell whenever the rate comes up to xxx value” That could be in 2 years or 5 years, no problem.
On the other hand, whenever there is a customer, we’ve noticed the investor becomes greedy and asks for a much higher price, thus eliminating any chance of a deal!
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