Usually real estate market has a 'laggard effect' to the equity markets. What it means is a few months/year after equity markets have rallied the real estate markets also start moving up.
Investors sell their stocks at a profit in equity markets and invest the money into real estate. This time also we have observed a similar pattern. However this time we have also seen a new breed of investors into real estate markets.
Many of them belong to the new middle class families who have greater disposable income.
These are individuals/couples who already have one home and have bought a second one for investment purpose. Few of them have borrowed money to purchase a second house. Some of them still have an outstanding home loan borrowed for their first home either on their name or on their spouse's name.
You should invest in real estate, if it is fitting well within your overall investment strategy to reach your financial goals. However it is recommended to consider certain aspects before jumping into it. Please note that what is discussed below is the areas which needs consideration and may not be necessarily applicable in all situations.
Taxation
Wealth Tax: If you own more than one residential home than it is liable to wealth tax. Wealth tax is charged if your net wealth crosses Rs 15 lakhs. Wealth includes car, jewellery, more than one residential home and many other assets.
However, if the second residential house has been given on rent for more than 300 days in a financial year, then you are not liable to pay the wealth tax.
Income Tax: Apart from wealth tax, you are liable to pay income tax on the rent they you receive from your second home.
Even if you haven't been able to lease out your second house, income tax will be calculated on the 'annual value' of your house.
To put it very simply and only for the purpose of understanding -- suppose Mr Shah owns two houses. One is for self occupation. Another one is lying vacant. Income tax department will assume that Mr Shah has rented out one house -- even though it is lying vacant. It will calculate the 'annual value' ie how much (notional) rent the house will fetch annually.
Annual value (notional rent) will be added to Mr Shah's income and he will have to pay income tax on it. Of course there are certain rules for calculating the 'annual value.' Also he will be entitled for certain standard deductions.
Main contention here is that even if you have not been able to let out second house, you will have to pay income tax on the notional rent on your second home.
If you have bought a second house or if you are considering buying second house, please consult your chartered accountant and consider the above taxation issues.
Following issues are applicable for your first as well as second house.
Leveraging: Leveraging means borrowing money to make investments. Leveraging is high risk (loss) low returns game.
Now let's assume that Mr Shah borrowed from money from a housing finance company at 9 per cent rate of interest to purchase a second residential house. If the value of this house goes up by 30 per cent, his returns will be 30 per cent minus 9 per cent = 21 per cent. This means even though the market value rose by 30 per cent, he could only get 21 per cent return (after deducting 9 per cent interest paid on his housing loan).
Now let's suppose a scenario where the real estate prices fall. Yes, real estate prices do fall. Ask your NRI cousins in the US what is happening to the real estate market in that country. If prices of property fall by 5 per cent, then leveraged investor's loss will be 5 per cent plus 9 per cent = 14 per cent. Mr Shah's loss will be more than the market loss because he will suffer on account of the market moving down as well as the housing loan interest cost.
In effect, Mr Shah will gain less in a rising market and lose more in a falling market.
Leveraging does not necessarily mean borrowing for a specific asset. Suppose you have an outstanding home loan and instead of paying off home loan you decide to invest in a 'hot' mutual fund then that too is leveraging.
Leveraging happens when you borrow money to buy a house, property, stocks or mutual funds. That is you are creating an asset by borrowing money from somebody else.
There is absolutely nothing wrong in borrowing for the first home. We should always borrow -- if need be -- to build our house. It is always better to pay EMI on a house that you will eventually own than paying rent. However once you have borrowed, try and pay-off the loan as soon as possible.
Many a times we do not prepay a loan as housing finance companies levy prepayment penalty. The word penalty has a psychological impact on our mind.
Suppose your outstanding principal is Rs 8.5 lakhs. Now either you pay 2 per cent prepayment penalty on Rs 8.5 lakhs or you pay 9 per cent interest on Rs 8.5 lakhs. You prefer paying 9 per cent interest on home loan to avoid paying 2 per cent pre-payment penalty.
Another word that has psychological impact on us is 'tax saving.' We opt for a housing loan because we get tax benefit on repayment of principal and interest.
Assume that your total taxable income after all your expenses and deductions is Rs 5,000. To save tax on this amount you decide to go for a home loan such that this Rs 5,000 goes towards paying interest on this loan. This takes your taxable income to nil and you pay nothing in tax.
Now suppose a case where you have not taken a housing loan. Then you will have to pay tax on Rs 5,000. If your tax bracket is 30 per cent then on Rs 5,000 you would pay Rs 1,500 as income tax. Out of Rs 5,000 income, Rs 1,500 would go towards tax and the balance in your hand would be Rs 3,500.
To save Rs 1,500 in tax, you are willing to let go of Rs 5,000 by way of interest.
In fact in many cases tax benefit for repayment of principal is not available as Section 80C gets exhausted by EPF, Life insurance premium, school fees of children, retirement plans etc. This means you only get tax benefit for payment of interest.
Recently in a seminar when I discussed the above point, a member from the audience got up and said that because he had taken a home loan his take home pay had actually gone up -- this was because he was entitled for extra tax benefit on his housing loan repayment.
The trick is not to consider your net take home pay but your net cash flows.
Net cash flow is the balance money left in your hands after paying for all the expenses including your home loan EMI. Eventually what stays with you is net cash flow and not net take home pay.
While opting for a home loan will enable you to save tax and hence increase your net take home pay, it will also increase your cash outflow as there will be the EMI to account for after all your routine expenses. If after taking loan (paying EMI) the net cash flow in your hand is more then you may consider a home loan else opt for minimum possible loan and pay it off as quickly as possible.
Lastly real estate is an illiquid asset (very difficult to sell and convert it into cash on an immediate basis) and also it has higher impact cost.
Impact cost is the cost of undertaking an investment transaction. For purchasing a house you have to pay brokerage to the real estate agent. You also have to incur registration and stamp duty expenses. All this affects your returns.
By all means invest in real estate if it is making you reach your financial goals but after paying heed to what is discussed above.
Gaurav Mashruwala is a certified financial planner and wealth advisor.
