Real Estate as a part of your Asset Allocation
Asset allocation is an investment strategy that aims to balance our risk and reward by apportioning portfolio’s assets according to individual’s goals, risk tolerance and investment horizon.
The main asset classes are equities, fixed-income, real estate, gold and cash and cash equivalents; these have different levels of risk and return, so each will behave differently over specified time horizon.
Allocation of capital to different asset classes is one of the most important decisions in determining the future risk taken and overall returns generated by the total portfolio. The returns are volatile in nature including positive and negative returns.
In an Indian Investor’s context, real estate has been the dominant asset in individual’s portfolio, especially for middle-income group and HNIs. Indians normally inherit real estate and have a desire to own their own home. They tend to ignore the valuations, direct cost of mortgage rates, indirect opportunity cost in other asset classes, and other factors to pursue the dream of their own home or sometimes second home.
Myths about real estate:
1. Real estate prices never fall.
2. Real estate has good rental as steady income.
3. Home loan is considered as a good tax saving tool.
Reality about realty
1. Real estate has cyclical trends like any other asset class and it definitely has period of down trends.
2. Rental yields are really low for example residential properties now days have a rental yield of approximately 2% or less. And investors are counting on capital appreciation mainly. Maintenance, taxes and others expenses lead to a periodic net outflow if not compensated by rental income.
3. Tax implications are tricky and come with conditions. You should not buy real estate for tax purposes alone, but if it fits your desired asset allocation. Anyways you can claim interest paid and repayment of principle is restricted to yearly limits and conditions. Like:
• Repayment of housing loan principal is allowed as deduction under Section 80C. However, if the house is sold within five years from the end of the financial year in which you took possession of the property, then the deductions claimed in the previous year will be added to the taxable income of the year in which you sell the house. Deduction claimed under Section 24 (b) on interest payable on such loan will not be withdrawn.
• If your property is rented, there is no limit under section 24(b) on interest paid.
• You can claim the interest and principle deductions only after possession of the property has been taken and not for under construction properties.
[These are some brief examples of complications regarding tax implications and professional advice should be taken from a tax consultant before considering them.]
The real estate sector, which opened its door to foreign investors in 2005, has witnessed huge inflows and led to some handsome returns in last 10 years. This has led it to become the dominant asset class in an investor’s portfolio. But the returns, land developers make, compared to the end-users or last investors in the chain have huge differences and there are some pitfalls, which the individual investors need to understand. Like:
• Illiquid, difficult to buy and sell. Also, it can have huge discounts, when you want to transact.
• Buying today and selling in short term leads to heavy transaction costs like such as registration, brokerage and other cost.
• Cost of maintenance has to be borne like annual maintenance, upkeep, and brokerage if rented.
• Non-transparency about titles and ownership. This is expected to improve with digitization of records, however may lead to downward effect on prices as information asymmetry reduces.
• Short term capital gain @ 30.9% if you sell with 36 months and long-term capital gains @ 20.60% (with indexation of course) if you sell after 36 months. [Equity is the most tax efficient asset class with STCG of 15.45% and LTCG as Nil, if STT deducted.]
• Succession planning and inheritance of real estate assets is cumbersome.
• Individual investors in real estate generally take huge leverage at the time of purchase, with typically financing 10% to 20% from equity and balance 90- 80% through debt. This is a huge risk as real estate is also subject to cyclical trends like any other asset class, and the investor could be subject to heavy financial burden during negative cycle.
Readers are advised to evaluate their decision of investment in real estate post consideration of factors like their financial goals, current financial health, their risk tolerance and investment horizon. Investors should think of real estate investment as a part of the investor’s total asset allocation and should help to achieve the same.