Financial leverage in real estate

As a part of the financial planning process I was analysing some financial facts of my client. He, a salaried executive, worked hard and made it to senior corporate ranks in 17 years of his career. Like many others in National Capital Region, he too resorted to adding multiple properties to his investment portfolio. He loves funding his real estate investments the EMI-way i.e. buy a property with borrowed capital and keep paying back via monthly instalments for over a decade. He loves the fact that in real estate there is so little volatility to deal with, tax advantages and the convenience of paying back the borrower in a systematic way. He is uncomfortable with direct equity and is reluctant to take the mutual fund route either, given their lacklustre performance in last 5 years.

Fair enough. I respect his judgement based on his experience. At the end of the day he is availing himself of all the tax advantages that our system provides in relation to the housing sector. And some of them are as below:

  1. You, as a tax payer, get a deduction towards interest up to Rs. 1.50 Lacs on loan for a self-occupied property per FY.
  2. You get to deduct even the principal (upto Rs 1 Lac) under Section 80(C) for a self-occupied property.
  3. If you have a second house and if it is a let-out property, you can deduct the full interest (NO LIMIT!) from your rental-income.You also get to claim deduction towards municipal taxes paid during the relevant FY and a flat deduction of 30% of the annual value towards repairs.
  4. The loss, if any, from the house property after considering the aforesaid deductions can be offset against income in any other head of the current FY. In other business you can deduct interest against income made from that business and not against your salary or income from capital gains. In short-term trading of shares, any losses made can’t be used to offset your salary. But for the loss from house property, such is not the case.
  5. The loss, if any, which cannot be set off against the current FY’s income can be carried forward to subsequent FYs subject to a maximum of eight FY’s for set off against the income from house property of subsequent FYs.
  6. Capital gains that you make when selling the house can be exempted from tax by buying another house if they are long term capital gains.
  7. If you make capital gains by selling other capital assets like shares, government bonds,and/or gold, you can buy a residential property with the sale proceeds and need not pay the tax on your capital gains if they are long term capital gains.
  8. Any property which is given out on rent for a minimum period of 300 days in the previous year is not considered as an asset. Such a property i.e. let out for 300 or more days, is excluded from net wealth and not subject to wealth tax as per the prescribed provisions of the wealth tax law.

The list can go on but writing in detail about the tax advantages is out of scope for this article. Coming back to my client, as an investor, he has properties in Mumbai, Pune and Gurgaon. Given his diversification (to mitigate risk) and the weak story of Indian capital markets since the fall in 2008, he felt proud of having taken a skewed asset allocation (real estate to 85%), and made wealth impressively. While he has been doing well, he still felt the need to rope in a financial planner to review his investment strategy. And there I was to assess his financial life. I noted that while he had no loans on the properties that he had rented out, he did take a good amount of loan on the property that he lived in. While he was using the deduction u/s 24(b) for his self-occupied house but he was not aware of using it to his advantage for properties that he had rented out.

I took it as an opportunity to educate him on financial leverage, tax advantages of the housing sector, and income offset by any loss from the house property (given that he belonged to a high income bracket of professionals).

How real estate investments offset annual income and build wealth

Let’s say you buy a house for Rs 1 Crore, where 50 Lacs is funded by you and the balance 50 Lacs is a borrowed capital (20 year loan at 10.50% per annum reducing monthly, EMI Rs. 49919). Assume the house has been rented out earning you a monthly rent of Rs. 25000. Also assume the value of house is increasing at the rate of 10% per annum (which is far less than what the returns have been in last 5 years given Pune, Mumbai or Gurgaon residential real estate market). If you avail deductions u/s 24(a) and 24(b), the loss from house property shall be (Rs 3, 20,081). Refer table below for a detailed calculation.

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Table1-New

 

If I do the calculation for next 10 years, assuming no part payment of outstanding loan, the annual income/loss from the same house property will look something as below :

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Image-1

 

Loss from the house property offsets annual income

The loss, if any, from the house property after considering the aforesaid deductions can be offset against income in any other head of the current FY. The loss, if any, which cannot be set off against the current FY’s income can be carried forward to subsequent FYs subject to a maximum of eight FY’s for set off against the income from house property of subsequent FYs. For someone who is in the 30% tax bracket, the loss from house property every year until 2020 (as per the table above) is a huge advantage. See Table 1above for Income tax saved every year by the loss from house property that offsets his annual income.

Financial leverage

Wikipedia states that leverage in finance is “a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.” In the scenario above, an individual borrowing 50% of the required capital to acquire a house (that is increasing in its asset value) is financial leverage. Using the tax exemptions for interest paid on a rent out property is another form of leverage. If you look at the incremental value created every year by taking the leverage (i.e. borrowed capital of 50 Lacs on an appreciating asset and the tax exemptions on interest paid) you would notice the impact in the growth of the net asset value of the house (See Table 2). If instead of investing 50 Lacs in a house, they were invested stand-alone in equity mutual funds, assuming 10% rate of return, compounding annually, the wealth creation graph would be as in Figure 3.

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Table2-New

Table 2

 

Table-4

Figure 3

So, if my client has invested in property in last 10 years and earned steady yields besides capital appreciation, I have no reason to not appreciate him for his decisions taken. However, I have taken this as an opportunity to educate him on financial leverage to build wealth and the shortcomings of having a portfolio that is predominantly real estate. It’s not ideal to have the investible surplus allocated to real estate in a high proportion. To know why please read Manish Jain’s article Don’t place all your Eggs in the Property basket.