Is Real estate the best investment option? Often we hear things like

• “He bought a flat of Rs 40 lakh and is selling it at Rs 80 lakh. He had made a down payment of only Rs 8 lakh at the time of buying the flat. Value of the house doubled in around 5 years! Boss 40 lakh profit in 5 years”
• “My grandfather bought the property for a paltry sum of Rs 99,000 in 1959. I sold it at a stupendous price of Rs 2.50 crore in 2013. In fact, had it not been for some legal issues about tenancy and family issues, the sale price would have been much higher!” 
• So widespread is the belief that real estate gives spectacular returns that people I meet tell virtue of investing in a plot of land on the outskirts of large cities or smaller towns. It is available in lakhs today and because it is illiquid you won’t be able to sell it and you will reap a sale price in crores in 20-25 years.  Even famous writer  Mark Twain said “Buy land They’ve stopped making it“

People have long seen real estate as a safe investment. The notion is intuitive , the supply of land is limited, and the population is always growing ,and until 2007, national home prices had not fallen significantly since the Great Depression. But let’s look at the Other side of investing in Real Estate, the returns, what does one need to be careful of investing in Real Estate?

Other side of the coin:  Do you know the return you have made in Real Estate?

Let’s take the case of  “My grandfather bought the property for a paltry sum of Rs 99,000 in 1959. I sold it at a stupendous price of Rs 2.50 crore in 2013. In fact, had it not been for some legal issues about tenancy and family issues, the sale price would have been much higher!”  If we plug in the  values in our Returns calculator  we get an absolute return of 25152.53%. But a CAGR return of 10.79%.  CAGR is the year-over-year growth rate of an investment over a specified period of time. It’s an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. Our article Understanding Returns explains about the different kind of returns such as Absolute, CAGR.

If in the above example grandfather had actually put the money in an asset class that could deliver 15% pa, the sale price would have been Rs 19 crore. BSE Sensex has delivered 17% pa(CAGR( for a period of 34 years since its inception in 1979. And the return from the Sensex are  tax-free.The point I am making is not that equity is a better investment but that one should not be swayed by the large investments that real estate entails.  Our grandson in the example above is not alone in vastly overestimating the actual returns from real estate, after all, an investment that multiplied 250 times can’t be anything but spectacular. What he  forget is that over long periods of time it is not the high return but the power of compounding that is producing the huge sale price.

For reference we show returns of various asset classes over different period of time. Our article Returns of Stock Market, Gold, Real Estate,Fixed Deposit shows Returns of various Asset Classes in India over a period of time. Please remember Torture numbers, and they’ll confess to anything. 1 and 1 can be made 2,0,11 based on calculation applied. Click on image to enlarge.

Returns of various asset classes

About the costs and taxes associated with real estate investments that people usually don’t take into consideration , mostly because of their inability to add these up. A case study by Urmin Vohra , which appeared in Times of India 6 May,shows that in general, after taking into account all the costs and taxes, returns from real estate can at best be close to returns from bank fixed deposits and recurring deposits . Calculation is shown in image below (Click on image to enlarge)

Real Estate returns

Other side of investing in Real Estate

What are myths related to Investing in Real Estate or Property? What should one take into account while investing in Property. Let’s see.

It only appreciates in value : Many people are of the view that land can only appreciate in value. Unlike other asset classes such as equity or gold, which witness cycles of price appreciation and depreciation concurrent with various domestic and global economic, political and socio economic events, real estate prices tends to be sticky, after attaining a certain level,they tend to remain there or increase ultimately. There are, however, pockets across the country that do seen slight correction at different times. Just like  Sensex and Nifty tracks the stock prices, index for tracking price movements in residential properties India is NHB RESIDEX or simply RESIDEX. Our article Index for Real Estate : NHB Residex explains it in detail. Image below shows NHB residex for few cities from 2007 till Oct-Dec 2013.

Real estate trends in different cities based on Residex NHB

There are factors that can go beyond one’s control in determining the true value of a property.  One cannot ignore the basics of economics, just like demand and supply dictate market economics, so is the case with real estate. The shortage in many markets,wide gap between demand and supply in residential real estate, and the sticky nature of realty prices in India have contributed to keeping prices firm over the long run. And Different places  such as ,Hyderabad, Jaipur, Kochi and Bengaluru, have different demand drivers. For example, Bengaluru is driven by the information technology industry, and prices there largely follow the industry’s fortunes. The Residex data show that prices fell around the 2009 period and then slowly recovered from 2010. Jaipur and Kochi, on the other hand, have not developed at the same pace as other urban centres. The demand for homes in Kochi tends to be driven a lot by population working outside the country and so prices there have been subdued because of the global recession. In Hyderabad, political uncertainty and its impact on business growth have had a role to play in property prices.

Costs Even if a property has appreciated significantly in value, we tend to ignore frictional costs such as maintenance charges, registration costs, stamp duty, property tax, capital gains tax, lawyer fees, broker fees and other associated costs with real estate sales and purchases.

Risks in buying Land : When you invest in a plot of land on the outskirts of large cities or small towns , you need to consider the real risks of encroachments, zoning changes, compulsory acquisitions at low prices, etc and the time and effort required to manage an investment in a remotely located plot. Modifying the famous ad of the cosmetic company says “Is it worth it”

Illiquid asset :Unlike other investments, real estate is also a very illiquid asset. In most circumstances a property owner cannot sell his property very quickly if the need arises. Depending upon market conditions, it could take anything over a month to close a real estate deal. At times, such deals could take over a year to close.If the property is sold in a hurry, the buyer takes advantage of the distress sale and bargains for a lower price. And the fair value of a property is not realized.

Rental Income : Another common misconception is that rental incomes can fund expenses after retirement. Apart from the hassles of finding a good tenant and maintaining the apartment on a regular basis, rental yields in India are on average between 3% and 5% pre tax. With inflation hovering between 6%-8%, rental incomes will seldom beat inflation. Our article Income from House Property and Income Tax Return deals with rules and pictures

 What if the value of house drops? Value of real estate going down..Nah..that does not happen. It did happen in US.  Many US citizens who bought Real estate in the middle of the Bubble just because credit was cheap and thinking that they could make a lot of money by taking a Home loan and almost nil Down payment. When Real Estate broke in US , people who has put $10,000 from their pockets for a $4 million house were in losses of $1 millions , because they had to pay $4 million a loan money for something which is now costing $3 million .That’s a unrealised loss of $1 million in a short time. Ok so what it happened in US.  It will not happen in India. Why should I  consider the case that  house value drops by  say 15 lacs and they have just invested 5 lacs from their pocket, and are in loss of -300% (absolute). Till last year people thoughy that  investing in debt is safe? So one cannot be sure of how things can change.

On Selling a property : Unless you buy another property or you invest the money in capital gains bonds, which come with a three-year lock-in, the investor will be charged capital gains tax on the gains from property investments. The rates of capital gains tax from the sale of a real estate property depend on the duration for which the property was held. Compared to equities, where the long-term capital gains is waived off after just one year of holding in case of real estate the long term capital gains of 20% after indexation is applicable when the holding period is more than three years. In case of short term capital gains, the rate is according to the income tax slab rate applicable to the investor. And even if one invests in capital gains bonds, the net gains come to about 4.5% per annum. Our articles On Selling a house , Capital Loss on Sale of House

I am not trying to argue that real estate is a bad investment. Just that it is like any other investment with risks that require the reasonable return that it provides. It should be a part of any portfolio that is big enough to accommodate the lumpy nature of its investment. Often buying a house for your own stay is not considered an investment. For most people, the psychological stability of having your own house adds tremendous value and makes this a must-do investment.

Related Articles:

• Understanding Returns
• Tax : Income From House Property 
• Index for Real Estate : NHB Residex
• Stock Market Index: The Basics

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What should one consider in buying a property? What should be the reason for buying property? What should one consider before buying a house?