Owning real estate could be a huge step towards financial independence for many Indians. But to consider it a better investment than putting money in the financial markets may be short-sighted. The income generating property narrative starts to make sense when many investors end up renting their house instead of selling it, i.e. purchasing an income property to imitate their parent’s past decisions, or buying a rental unit because they weren’t sure what else to do with their money.
The misconceptions in the real estate industry being deeply rooted in the minds of investors might prevent them from making a financially-sound decision as they tend to ignore the potential risks. This article covers the actual facts and fictions of the real estate industry to avoid being saddled up in the future with an illiquid investment.
Land prices will always continue to rise is just an assumption
The ever-increasing population of the world gives credence to the myth of continuous property price hike in the future due to the shortage of the land. But, after closely scrutinising the data, it reveals that this is not the case. Even though the land in the world is limited, there would still be an abundance of it for humans to survive and thrive. This is possible due to technological development making use of the available land more efficiently. Some of the studies also state that the population of the world will stabilise as well.
Additionally, developing economies witnessing an unprecedented boom in the real estate sector gives birth to the assumption that the land prices will continuously move upwards. Considering the economies of developed nations like Japan and the United States, the real estate market has crashed with the prices falling by 40% to 50% in the last decade.
This concludes that the value of land cannot be determined by its scarcity or the standard of living of the nation. It is nothing logical but a propagation of the myth itself.
Real estate is an over performing asset class
The real estate investment is no different from fixed deposit as it sprouts more or less the same returns over a period of 30 years. It offers an annual rent ranging between 2% to 5% of the total asset valuation which is comparatively lower than returns on Fixed Deposits and less than the EMI payments being made.
Let us now understand how real estate could turn out to be an underperforming asset. Suppose, I was renting an apartment at a rental of Rs 50,000 per month. But then I decide to buy a house that’s worth Rs 1.5 crore, here’s how things will pan out for me if I were to take a loan from a bank.
I decide to pay Rs 30 lakh or 20% of the house cost as down payment. The rest amount, i.e. Rs 1.2 crore will be loaned from the bank. Now I need to factor in the interest payable pegged at 8%. Hence, I will now be paying an EMI of Rs 1,03,000. This amount is a 100% increase from what I was paying as a rent.
The total amount that I will pay to the bank over a period of 20 years comes to Rs. 2,40,89,474. Notably, the cost of the loan becomes higher than the loan itself.
Following the above example, if you invest the same amount in the financial markets, the returns you receive will be greater than those on real estate. Also, you will be able to save on other costs as the example did not consider other expenses such as annual property tax, maintenance, insurance and the sales commission when you decide to sell it.
Over-leveraging puts entire financial profile at risk
Leveraging can allow an individual to continue investing in properties by boosting returns and helping them gain equity a lot faster. While it can multiply the reward, it can also just as easily multiply the risk. Over-leveraging occurs when investors owe comparatively too much in a specific property than its actual value and the income it generates.
Let’s say you’ve purchased a property for Rs 50 lakh with a downpayment of Rs 2.5 lakh. If the value of the property declines by 30%, it’s now worth just Rs 35 lakh, but you’re still stuck paying interest and principal on the full loan amounting to Rs 47.5 lakh. And if the amount that you collect in rent drops too, you could be at great risk of defaulting on the property.
It is hard to predict the future performance of the real estate
Supposedly, twenty years ago you had bought land in the village of Devanahalli, the site where Bangalore’s airport is located. Today, you would have made a pile of cash as high as a villa. You would have witnessed the same scenario if you had invested in land in Amravati ten years ago, which would soon become the capital city of Andhra Pradesh.
Such windfall gains will come to you only if you are either extremely lucky or have prior knowledge about the location experiencing a development boom in the near future. Apart from these two occasions, real estate remains an underperforming asset class with huge stagnation periods.
Among many determining parameters including quality of construction and size of the land, the expansion and contraction of the property’s value is only determined by its location. For instance, a flat bought 20 years ago in Noida is today a liability. Conversely, the flat bought 20 years ago in Gurgaon is today an asset.
To elaborate, the flat bought at Rs 35 lakhs at Panchsheel Greens, Noida Extension, in 2012 with a hope that the new metro lines would result in property price hikes, is now valued at Rs 28 lakh after a decade. Similarly, a buyer at Amrapali Zodiac bought a flat at Rs 71 lakh in 2012 but when he decided to sell it, the current market value of the flat decreased to Rs. 50 lakh. Investors might make a smart move whilst predicting the location that is set to undergo development but in the times of uncertainty, these plans often get cancelled and they end up investing a high amount in a property that does not benefit them in any way.
Investing in real estate is like putting all eggs in one basket
Portfolio diversification is crucial to meet financial goals with limited risk. Unlike financial investments, real estate does not offer various types of opportunities based on investment objectives and risk appetite of an investor. It is impossible to diversify with real estate and the main reason behind this flaw is the heavy capital requirement to begin with.
Supposedly, if you buy a property in each market, it will cost you upwards of Rs. 50 lakh to acquire a single property. But, it doesn’t make sense to spend thousands of rupees on a single property, in a single state or in a single country when you can diversify your portfolio with 100 stock companies with the same amount.
Furthermore, even if you invest in multiple properties at different locations to diversify your investment, it wouldn’t be easy to manage the properties in a way you manage other financial assets. For instance, you can track the daily performance of the 5 mutual funds you have invested in with a few clicks. But, if you own 5 properties, can you physically check upon them frequently?
Passion has no place in investment portfolio
Amongst all investment categories available, real estate is the one that investors tend to get most emotionally attached with. The problem arises when investors are unable to analyse the merits and demerits of a purchasing decision objectively. The following rationalised and emotionally-driven actions have put an idea of real estate investment on a high pedestal, thereby making it one of the most overrated investment options.
The cultural obsession with owning properties makes people more comfortable to invest in real estate than any other investment option. Middle-class and upper middle-class groups of India have strong home-ownership aspirations as it is usually deemed more successful in the society. They often tend to ignore the fact that real estate investment is riskier as it requires them to take a mortgage and fall into the debt trap.
The bottom line
Owning a piece of property has a feel-good factor as it may offer peace of mind to the owner or make her less anxious about the future. But, the same cannot always be advocated as a desirable or viable investment option. Real estate might seem attractive but the ironic truth is that it is a high-risk and low-return investment avenue for an average middle class Indian. It’s important to consider multiple factors when investing in real estate. These factors should include your net worth, risk appetite, diversification, etc. Furthermore, one should put only a part of their wealth in real estate rather than pitching in everything in one go.
While considering real estate as an investment option, one must use all available information and make a decision that is cold, calculated based on the digits and their risk appetite. It is important to not involve passion and obsession while dealing in real estate as it can impact one’s financial future adversely.
(By Neha Juneja, CEO and Co-founder, IndiaP2P)