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Rental income - Is it practical to rely on it for your old age?

Investing in real estate has the potential to provide regular rental income, while also giving a scope for price appreciation. However, it is not devoid of challenges.

One of my relatives retired a few years back and currently owns five residential properties in various places. Instead of investing in financial instruments in order to build a retirement nest, he preferred the hard assets. He ploughed all his savings to buy multiple residential houses with the hope that its rent will provide him with sufficient regular income once he retires. 

Investing in real estate has the potential to provide regular rental income, while also giving scope for price appreciation. However, it is not devoid of challenges.

Riskier bet

First of all, investing in real estate requires a big-ticket investment. This in turn means one will be able to invest in only a few properties, unlike mutual funds where its investors could debut with a sum as low as Rs 500. 

Diversifying investments across different asset classes has the potential to mitigate portfolio risk. For instance, in the past, prices of equity and debt have moved in the opposite direction, providing strong protection to hybrid portfolio investors. By investing it all in real estate, one takes high risk emanating from investing in a single asset class.

Poor investment yields are one of the biggest drawbacks of investing in real estate. Annual rental yields (annual rent as a percentage of the market value of the property) for residential properties are in the range of 2-4% (See table) in major metropolitan cities.

Liquidity

Residential properties are not easy to sell. In case of an emergency situation, the owner might not be able to quickly offload her property; the whole process takes anywhere from three to twelve months depending on the demand and supply situation.

In contrast, mutual fund investors always have the much-needed liquidity, as investors get their money in their bank account within three to four working days of putting the redemption request. 

Rent dynamics

Poor investment yields are one of the biggest drawbacks of investing in real estate. Annual rental yields (annual rent as a percentage of the market value of the property) for residential properties are in the range of 2-4% (See table) in major metropolitan cities. Factors like open spaces, amenities, proximity to schools, hospitals and mass-transit transport systems affect the rent of a residential property. Furthermore, higher the property value, lower has been its rental yield. 

In contrast, rental yields are higher for commercial properties (6%-8% annually) but also call for a relatively bigger investment. Factors such as closeness to markets, warehouses, transport hubs and tax-exempt areas impact commercial rent. 

Time and money

Once you own a property, you need to regularly pay for its maintenance, insurance and taxes. If the water heater goes out or the roof gets leaky, you need to bear its cost of repairing. Also, you have to occasionally spend time shortlisting tenants, framing contracts and doing the inspection. 

Similarly, finding and retaining tenants for commercial properties can be a lot more complicated while you need to familiarize yourself with various terms, lease structures and title diligence procedures. 

After retirement, you need to figure out if you have the time and energy to undertake these responsibilities. Outsourcing the above work to a real estate agent, in turn, will mean paying a hefty commission. 

Providing for bad months

Also, you need to provide for the bad phases. Take the case of the current pandemic which has led to many shifting away from cities to their home towns and working from home. This has put pressure on rentals and increased vacancy rates. 

In the case of commercial property, longer leases (9 or 15 years) are a relatively safer bet. However, the tenant also has the option to exit (and not you) the deal by giving a notice of three to six months. If the market rates are lower than the going leased rates, it can result in a mass exodus of tenants or renegotiation of rent.

Tax implications

Unlike equity funds that have zero taxes on (long term) capital gains made up to Rs 1 lakh in a financial year, income from house property is fully taxable. As per Income Tax rules, one can declare two residential houses as ‘self-occupied for tax purposes. And the rest will be deemed to be let out and taxed accordingly. Notional annual rent is calculated on such properties and added to the income of such owner. 

Takeaway

As you age, your ability to tend to household needs might wane. Against this backdrop, managing multiple properties could get cumbersome and realty is not a smart way to provide for your retirement years. Instead, invest in equity funds that have provided the best returns (12% annually) among all asset classes over the long-term.

 

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