“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.
The Author Prof. Saurabh Bajaj (BE, MBA, FRM) is Chief Investment Planner with Nidhi Investments, Mumbai. He may be contacted 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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