BackThe real cost of your real estate investment
Does a house bought at `60 lakh and sold at `1.2 crore mean a profit of `60 lakh? No, it doesn't
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A house is probably the most expensive purchase that one makes—be it for self-use or as an investment. The confidence that any real estate investment would give spectacular returns is so prevalent that people are ready to invest even their last paisa and do not hesitate to borrow heavily.
However, the fact remains that “past returns do not guarantee future returns". Moreover, typically, return on an investment is calculated on the basis of its initial investment and maturity amount. But a return so calculated may be far from correct, especially in case of real estate. Aditya Verma, chief executive officer, Makaan.com, a real estate portal, said: “Numerous costs are associated with a real estate investment. While calculating return on investment, one must think of all the costs incurred during the ownership of a property." If we take into consideration costs such as brokerage, stamp duty and registration fee, interest paid on borrowed capital, maintenance and repair cost, municipal taxes, and so on, the amount of profit from a sale will come down significantly. And most of these expenses will not get added to the cost of acquisition while calculating capital gains.
So, before you look at investing in real estate, put together all the heads that will help you arrive at the true cost of a real estate investment and then evaluate your investment decision. Remember, once you buy a property, these expenses will certainly occur, but there is no certainity on the returns.
Real returns
Let’s take an example. Now the calculation looks difficult. That’s beacuse it is. But don’t shy away from it because understanding the details makes all the difference. Say, five years ago, you bought an apartment for 60 lakh and are now selling it at 1.2 crore. You had made a downpayment of 12 lakh at the time of buying the apartment. The value of the property has doubled in about five years, which means returns of 60 lakh in five years, or a compounded annual growth rate of about 15%. Right? Wrong, because expenses incurred on the house have not been included, which would have given the actual returns (see graphic).
You had funded the purchase through a home loan of 48 lakh, and a downpayment of 12 lakh from your own sources. Beside this, other initial expenses came to about 8.3 lakh (stamp duty and registration fee, interiors, brokerage, and other miscellaneous expenses). During the period of holding, you paid about 25 lakh as interest on the home loan, 4.4 lakh as principal replayment and another 3 lakh as monthly maintenance and so on. The total investment you made was of 53.03 lakh, and have an outstanding home loan of about 43.59 lakh. Besides this, when you sold the house, let’s say, you paid 1.2 lakh as brokerage. All these outflows put together come to about 97.81 lakh.
However, unless you buy another residential property or reinvest the money (23.38 lakh) in capital gains bonds, you will have to pay capital gains tax. In this case, it would be around 4.7 lakh, bringing the return further down to only 17.49 lakh. This means an internal rate of return (IRR, which takes into account all cash flows) of only 8.27%.
Returns from sale of a property held for more than three years are considered as long-term capital gains and taxed at the rate of 20% with indexation. In case the property is held for less than three years, it would be considered as short-term capital gains, and the rate of taxation is according to the income tax slab rate applicable to the investor. But before investing in bonds one should know that such investment has a lock-in period of 3 years to claim capital gain deduction, beside that interest on such bonds hovers around 6% per annum and are taxable in hand of assesse.
What this example shows is that your profit, which was looking so good initially at 60 lakh, actually came down to just 17.49 lakh.
Of course, you can add rental income if you want. Say, we consider rental income to be 1.2 lakh (2% of the property’s value) in the first year, increasing by 5% every year. If you are in the highest tax bracket and able to claim tax exemption on the entire home loan repayment, your net profit would increase by approximately 14 lakh.
The above example is based on an ideal situation where property prices went up by 15%. But in reality, not every property would be able to fetch such returns.
Below expectations
Many people are of the view that real estate investment can’t go wrong and property prices will move only upwards. But like any other asset class, 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 also tend to undergo such changes.
Rajiv Bairathi, executive director, capital transaction group and north, Knight Frank, said: “On an average, long-term returns from residential real estate stays in the 12-15% range. But returns can vary depending on what stage of real estate cycle one has invested in."
From 2002 to 2007, residential property prices in India rose rapidly. The euphoria still continues and investors expect the similar returns even now when the market has been slack for many quarters. If we look at the data since then, it shows a different picture. National Housing Board (NHB) residential index (Residex), which tracks property price movement in different cities throughout the country, shows that returns vary throughout the country. Some cities have seen negative returns since 2007; Hyderabad and Kochi being two. Since 2007, property prices in cities such as Delhi NCR, Mumbai, Kolkata and Chennai have increased by 10.33%, 12.57%, 10.88% and 19.55%, respectively, according to Residex. As per Makaan.com’s property Index, which has been tracking residential property prices since 2008, this period yielded an annual appreciation of around 8.48% per annum.
What should you do?
First, you have to distinguish between these two factors—are you buying the house for self-use or for investment? If it’s for yourself, then go for it, buy the property which fulfills your criteria and fits into your budget.
However, if you have enough investment in other assets and are looking for diversification of your portfolio, you may go for real estate depending upon your budget and risk appetite. The returns may not be what you roughly calculated. Make sure that when investing in real estate, your other life goals are not hampered.
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