Asset allocation is an important step in financial and investment planning. It helps balance risk and reward by apportioning investments among major asset classes such as equity or debt or others.
So what about real estate? Does buying a house qualify as an investment?
All that appreciates is not an investment
All-India residential real estate index prices were up by 10.4 per cent annually in the last ten years. Why do you think the price of houses went up?
It’s simply inflation.
The demand for houses was more than supply in some cities, while land, labour and material cost (along with builder’s profit) added to the price rise. Cities such as Delhi, Bengaluru and Chennai have grown at double-digits, while tier 2 cities like Jaipur and Lucknow have seen only 5% annual appreciation.
So, whether house prices will rise or not is dependent on the inflationary trend in the city and locality under consideration.
Where is the return?
At 9.4% annual returns, a property bought for Rs 50 lakh in Mumbai, ten years back, should be Rs 1.22 crore as of today? Not really.
First of all, out of Rs 50 lakh, about Rs 5 lakh goes towards paying stamp duties, registration, parking and brokerage charges. These are sunk costs and you don’t earn any return on them. Returns are only on the remaining Rs 45 lakh. Accordingly at the above appreciation rate, the house should fetch you Rs 1.10 crore or effectively 8.2% p.a.
Secondly, there is a big carry cost of owning a residential property. Initially, owners spend on modular kitchen, marble flooring, safety gadgets and interior decor. Then there is monthly maintenance, repair, painting and other recurring costs.
If we assume Rs 10,000 as monthly expenses for such purposes, it adds up to Rs 12 lakh over a decade. Moreover, if the house was bought by taking a 10-year loan, another Rs 18 lakh goes as interest payments.
If these costs were added to the original cost of Rs 50 lakh, the actual cost increases to Rs 80 lakh (12+18). Now, the effective CAGR of your investment falls to 3.2%.
However, if you manage to give your premises on rent, you could earn about Rs 15 lakh (at 2% of market value) over the decade.
Net-net, your property returns will then work out to 5.4% returns on a pre-tax basis over a 10-year period.
Not exactly lucrative, considering that the headline consumer inflation is more now.
Don’t ignore taxes
Profit made on the sale of the property is taxed at 20% if sold after three years of purchase, after adjusting for cost indexation. In the above example, the indexed cost of acquisition for the property works out to Rs 80 lakh. So, if it’s sold for Rs 1.1 crore, it is a capital gain of Rs 30 lakh. A 20% capital gains tax works out to Rs 6 lakh.
Effectively, post-tax return on the sale of property works out to 2.7% annually, after ignoring other charges like brokerage and legal. If rental income is considered, it improves slightly to 4.3% annually.
One can save capital gain taxes, by reinvesting the capital gains in another property or capital gains bond. However, the latter is not tax-free and you earn post-tax returns of 3-4% annually.
Liquidity not guaranteed
One of the basic factors that make something an investment is the ability to control the timing of ownership, in order to achieve one’s goals.
Consider this – you invested in a property with the intention of selling it when you retire. However, at the time of retirement, the economy witnesses a downturn – resulting in subdued realty prices and lack of demand. It could result in a distress sale or even that might not be possible.
Lack of diversification hurts
Diversification helps reduce risk. In equity, you diversify across stocks. In bonds, you diversify by owning papers of different companies.
Unless you choose REITs, property investments expose you to greater (concentration) risk.
A House is for providing shelter and not an investment. The actual returns you earn on it are far lesser than the headline returns and lower than inflation rates.