“Trust me Sir, real estate will always give you best returns. The prices cannot go down and you will be double your money in 3 years. I think you should book this flat.” said Kunjan Srivastav, a seasoned real estate broker to his potential client Vaibhav Deshpande, a 33 year old IT Professional.

Vaibhav seemed to be convinced with Kunjan’s logic and told him that he will get back to him. During tea break, he discussed it with his colleague Niraj Desai.

 

Vaibhav : Niraj, I think Kunjan is right. I am looking to invest for say 3 years. What’s wrong if I can double it in 3 years ?

Niraj : How much money you are willing to invest ?

Vaibhav : Say around Rs. 15 Lakhs.

Niraj : Where do you find a flat for Rs. 15 Lakhs ?

Vaibhav : No, actually the flat cost is Rs. 75 Lakhs. I will use Rs. 15 Lakhs for downpayment and balance Rs. 60 Lakhs will be taken as a loan.

Niraj : Loan ?? You are taking a loan to invest your money? That’s pretty strange!!

Vaibhav : But I will repay the loan from the profits earned.

Niraj : Profit !! Ok, let me share a real life story with you. Do you remember our ex-colleague Rakesh Sawant?

Vaibhav : Yes, I do. Whats the thing with him?

Niraj : Rakesh had done something similar. He had purchased a flat of Rs. 66 Lakhs in 2008. He recently sold it for Rs. 97 Lakhs.

Vaibhav : See, I told you. He made excellent returns.

Niraj: Please hold on before you listen to the entire case. He didn’t have entire 66 Lakhs with him. He just had Rs. 10 Lakhs, so he sought a loan of Rs. 56 Lakhs. With the interest rates at that time, he had to service an EMI of almost Rs. 61,660 p.m.

Now, lets do some calculations.

He paid Rs. 61,660 X 60 EMI = Rs. 36.99 Lakhs + 10 Lakhs Downpayment = Rs. 47 Lakhs (rounded off)

When he received Rs. 97 Lakhs from the buyer, his loan outstanding was almost Rs. 51.38 Lakhs. This is because in the initial years, his EMI had a higher component of interest and very small component of principle repayment. Thus, he was left with Rs. 45.62 Lakhs in his hand.

So he paid Rs. 47 Lakhs and received Rs. 45.62 Lakhs after 5 years.

Now, if you see, he has a net loss of Rs. 1.38 Lakh in this investment. Also, he had to pay a Capital Gain tax of Rs. 3.1 Lakhs. So the total loss was Rs. 4.48 Lakhs.

 

Vaibhav : What ?? Loss of Rs. 4.48 Lakhs in a property investment ?? That’s unbelievable.

 

Niraj : Yes, that’s because you understood the entire calculation. Otherwise people will flaunt the gain of Rs. 31 Lakhs in 5 years.

 

Vaibhav : What about the tax benefit he would have got for the interest payment and principle repayment ?

 

Niraj : Good question. Lets understand that as well. When he booked the flat, in the first year, his interest component was around Rs. 6,60,000, Whereas his Principle repayment was Rs. 68,400.

Out of Rs. 6.6 Lakhs interest, he got a tax break on only Rs. 1.5 Lakhs u/s 24(b).

For the principle repayment, his PF deduction anyways added upto Rs. 48,000 and he had a term plan with a premium of Rs. 10,000 p.a. So technically he got a deduction of only Rs. 42,000 from the principal repayment.

In the total 5 years, he has paid an interest of Rs. 32.37 Lakhs whereas he has got a tax deduction on only Rs. 7.5 Lakhs.

Coming to principal repayment, he has repaid Rs. 4.62 Lakhs. But he has been able to get a tax break on only Rs. 1.7 Lakhs.

Even if we assume a tax relief of 20%, he got a total tax deduction only of Rs. 1.84 Lakhs in 5 years. But that still does not compensate for his loss of Rs. 4.48 Lakhs.

 

Vaibhav: I am totally astonished by this case. I never looked at these factors which could affect my returns. One last question, why did he sell it off cheap then? He should have sold it at a higher rate.

 

Niraj : Again a very good question. He didn’t sell it cheap actually. The buyer had to pay almost Rs. 1.03 Crores for the property. And Rakesh had a real tough time to find a buyer. He wanted to sell it at around Rs. 1.12 Crores, but couldn’t find a buyer.

The buyer paid Rs. 97 Lakhs to Rakesh and balance Rs. 6 Lakhs in stamp duty, registration and other charges associated with the property. So even if the outgo was Rs. 1.03 Crores for the buyer, Rakesh got only Rs. 97 Lakhs, which entailed him a loss as explained above.

 

Vaibhav: And I thought one can never make a loss in property as prices never come down.

Niraj : That’s another myth. Since real estate is an opaque market, people stick to their prices. Doesn’t mean there is a buyer available at that price. It is like saying, some builders come with offers, that “Come and book the flat today. The prices will be increased by 15% from next month.”

Now, any sane person will understand, if the builder is increasing the price from next month, and he is confident of people buying at that rate too, then why is he showing desperation to sell it today?? It is just a gimmick to attract people to buy today. He is facing a big problem of illiquidity. His funding cost has increased to almost 30% p.a. Thus, if he does not reduce the price and has to hold on to the property for one year, he has already lost 30%. Instead, it makes sense for him to reduce the prices by 20% today and make a gain of 10%.

But somehow, they want people to remain in the myth, that property prices can never come down so that the buying continues. If they start reducing price once, they think that people will wait even further for price reduction and sales would still not happen.

 

Vaibhav : Oh my God !! So do I read that one should never invest in real estate?

Niraj : I am not saying that. But I would disagree with the argument of Real Estate being the risk-free investment with highest returns. If that was the case, everyone would stop working and just keep trading in real estate to earn money.

I would suggest following points to be kept in mind while investing in real estate.

1. Real Estate investment, like any other investment, comes with its own set of risks.

2.  The biggest risk in real estate is of illiquidity. Suppose you have a real estate of Rs. 1 Crore and you want to sell it urgently, it will be very difficult for you to convert it into cash immediately.

3. Non-Divisibility is another substantial risk of Real estate. Suppose you have a 2 BHK flat of Rs. 75 Lakhs, and you are in need of Rs. 25 Lakhs, you cannot sell 1/3rd of it. Another option is mortgage it, but it will come at an interest cost. Moreover, if the property is already taken on loan, then you can’t even mortgage further.

4. If you have surplus funds to invest in real estate, you may do so. But if you are borrowing to invest in real estate, you need to do your calculations right. A visible profit of Rs. 31 lakhs could actually be a loss of Rs. 4.48 lakhs as seen in the above case.

5. Diversification will always remain the mantra of investment. You should diversify across asset classes with real estate being only one of them, not the only investment.

We look forward to your feedback and comments on the above article. Please feel free to contact us on saurabh@nidhiinvestments.com if you have any questions.

(The views mentioned in the article are personal opinion of the author)

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26 Comments

  1. Gud one saurabh.

    Reading your blogs are always helpful. Your blogs are like the constitution of India for us :), that too in brief.

  2. I completely agree with the gist of the article.. People blindly run behind real estate due to the lack of awareness..

    Still calculations will differ if we consider flat was rented for the 5 year period (as he was buying it for investment & not for staying).
    In that case he would be able to claim higher interest exemption (Total Interest Paid – Total Rent Earned – Maintenance deduction).

    Total interest paid (5 years) = 32.37 Lacs
    Assume rent earned (5 years) = 12 Lacs (Rs 20K per month * 60)
    Assume maintenance deduction (5 years) = 3.6 Lacs (approx 30% of rent)
    So Total Interest Exemption (5 years) = 32.37 – 12 – 3.6 = 16.77 Lacs
    And Total Principal Exemption (5 years) = 1.7 Lacs
    With 20% tax bracket, total tax deduction = 3.69 Lacs (higher than 1.84 Lacs above)

    Plus he would have earned interest income (5 years) = 12 Lacs

    So total profit = 12 + 3.69 – 4.48 (estimated loss) = 11.21 Lacs
    Also, profit will be more if we consider the fact that person getting 56 Lacs loan will certainly fall into 30% tax bracket & hence total tax deduction will be more.

    This is just to show the net impact if one rents out the apartment.
    Overall I completely agree that real estate investment is not that exciting as summed by your 4 points (mainly low liquidity, higher interest costs in initial years & prices may not always go up).
    But it’s the same case with other asset classes in India mainly Gold & endowment policies which offer very low returns (or NO returns I would say due to our very high inflation rate).

    Thanks for pointing out fallacies of such assets. Keep awakening people with such informative articles.

    Regards,
    Pankaj

    1. Dear Mr. Pankaj,

      Thanks for your valuable comments and statistical analysis. I would like to mention below points here:

      1. I am myself not in favor of Endowment policies (You may read my articles “Time-Time ki baat hai” and “Why is insurance Mis-sold in India”.

      2. Gold is another asset class which people buy blindly but I dont second that. (Please visit “Investing in Gold !! Which way to Go?”

      3. Your calculations are elaborate but I found a few flaws.

      (a) Suppose you set-off interest against rent, then you have ZERO tax deduction on interest paid. This is because, suppose Rakesh had an annual salary of 10 Lakhs, and he claims deduction u/s24(b) and 80C, his taxable income will reduce to Rs. 7.5 Lakhs. However, if he sets it off against rent then first Rs. 2.4 Lakh will be added to his income (going by your 20k rent assumed) and then Rs. 2.4 Lakhs be reduced for interest paid. So his net taxable again becomes Rs. 10 Lakhs from which he can claim only 80C.

      (b) Also, getting rental income is not always as smooth as one expects. I have myself come across several cases, wherein people buy flats to rent out, but there isn’t enough demand and they have a higher rental expectation. So first couple of years, their flats remain unoccupied. Later, they settle down with whatever rent comes their way. Meanwhile, they have to spend from their pockets the society maintenance costs, municipal taxes etc and also minor repairs which need to be carried whether the flat is being used or not. So in the article we have assumed that it can cancel out each other to a great extent.

      Anyways, full credits to you for your analysis. Assumptions may differ from person to person.

      But largely we agree that we should not be BLINDLY investing, be it Real Estate, Gold, Endowment policies or anything else.

      We look forward to more visits and feedback in future.

  3. I always tried to convince my friends to carefully evaluate taking loan for investment, interest may just eat up profit. But none of them took it seriously.
    This article nails this with facts and figures. Now I can point them to this. Hopefully some of them will now understand it after reading this article.

    Good article sirjee.

    1. Thanks Sirji.

      I agree that there is a huge chunk of population who turn a blind eye towards the interest cost which ultimately eats up their profits and rather lands them in loss.

      Thanks again for your visit and feedback. Looking forward to more in future !!

  4. Well framed, to the point, wonderful article. Thanks for the enlightenment.

    I am curios to know the other side of the story, i.e In which case would it be good to invest in real estate ?.

    I also beleive its very difficult for a person to accquire a property without taking loan. In such a case, what would be maximum percent of investment that can be secured from loans in order to avoid net losses. Probably taking 20% (or some X%) may have net loss of Zero. How to arrive at that X?.

    Thanks,
    rc

    1. Thanks for your words of appreciation.

      I would like to answer your query as below:

      1. If you have entire amount with you to invest, you may go ahead with it. But a word of caution, understand that this is going to be an illiquid investments, so even after investment, you should have enough liquid money for your other goals or requirements. Or else you might have to do a distress sale of the asset.

      2. Since the above sounds too difficult for a middle-income or upper-middle-income person, he may look at other options of investments requiring smaller ticket size.

      3. For calculating the X%, there cannot be a universal formula. It will differ from person to person depending on disposable income, tax slab, liabilities, market conditions, interest rate scenario and so many other things.

      In a nutshell, my main aim was to make people aware that please dont be under the myth that you will “ALWAYS” make money by investing in real estate. You have to get your calculations right so that you dont stand to lose.

      Thanks again for your visit and feedback. Looking forward to more in future !!

      1. I understand there is no one single value of X which works well for all.
        I request you to show some light on how to arrive at that X?. what factors to be considered?. how to calculate X?.

        It will be much helpful if you can illustrate the calculation of X with a real life example something like person earning 6 lacs, has 20L to invest, and other assumptions if required.

  5. This article is good and informative, I have bought a flat , will discuss with saurabh on have to get profit still we have got many components which adds up to loss

  6. Good Article… Nicely elaborated. Can’t agree more… One thing to note is. if you do your basics right its not a bad investment strategy as well. But as author suggested, dont put all eggs in one basket.. Have diversified portfolio.

    1. Thanks for your feedback.

      I have not done a comparison between, investing the money in real estate Vs any other investment avenue. If that was to be done, there could be several avenues which could yield a better return. But that is an opportunity loss we are talking about.

      Here, I have referred to a real loss, which people perceive as a profit.

      But yes, your point is valid. Going by your example, even a 9% FD would earn you between 45-50% return on investment in 5 years. i.e. Your 66 Lakhs could become 95-99 Lakhs, whereas your flat became 97 lakhs. But people will think property as a great investment as it has grown 50% but for other investments they would be stuck to annual returns.

  7. thanx once again prof..
    for ur detailed analysis and illustration….the article is comforting for salaried people like me,,who cant make huge down payments!!!
    i have full faith in ur advice regarding financial matters and can rest assured that at the end of my investment term , i ll not have to worry bout so many things ;n that i ll be able to just hang up my boots and realx!!! thanx

    1. Thanks bro. Yes, indeed its the IT guys who are viewed as soft targets by all these Realty and Insurance companies to dump their products.

      You are more than welcome to share it among your networks to create awareness.

      Thanks again for your visit and feedback. Looking forward to more in future.

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