- By Vivek Kaul
The flat was now worth close Rs 1 crore and my friend was really happy with the decision he had made. I had tried to dissuade him from buying the flat in 2005. Those were the days when I did not like any kind of loan.
Given that he was living in the flat, it turned out to be an excellent decision because real estate prices rose in the years to come. Nevertheless, from the point of view of returns how well has my friend done?
Like most other people my friend looked at the absolute return. An investment of Rs 28 lakh was now worth Rs 1 crore, is the way he saw it. But things aren't as simple as that. An investment of Rs 28 lakh, amounting to Rs 1 crore over a period of ten years essentially amounts to a return of around 14% per year.
Nevertheless, this calculation would be a very simplistic way of looking at the entire scenario. My friend had taken on a loan of Rs 20 lakh and invested Rs 8 lakh from his own savings. When he took the home loan in 2005, the rate of interest was at 7.25% and the loan was to be repaid over a period of 20 years.
His EMI worked out to Rs 15,808. Over the years, the interest rate kept shooting up. By mid 2012, the bank was charging a rate of interest of 14.25%. The EMI had shot up to Rs 22,183. Even that was not enough. The loan tenure had shot up to 405 months from the original 240 months or 20 years.
This was primarily because even at 14.25% only a limited amount of the EMI of around Rs 120 was going towards repayment of principal. Almost all of the EMI was going towards payment of interest on the home loan. A home loan amount of Rs 18.57 lakh was still to be paid. So, over a period of more than seven years only Rs 1.43 lakh of home loan had been repaid. The rest of the EMIs paid had gone towards payment of interest on the home loan.
This is when my friend decided to rebook the home loan by paying a one time fee to the bank. The bank added this fee to the home loan outstanding, and booked a new home loan of Rs 19.29 lakh. This home loan was to be repaid by mid 2025. The rate of interest to be charged on this loan was 10.75%. The EMI worked out to Rs 23,000 per month.
As of today, my friend still owes the bank around Rs 17.1 lakh. If he were to sell the house for Rs 1 crore, this outstanding home loan amount would have to be returned to the bank. This means that effectively my friend would get around Rs 83 lakh (Rs 1 crore minus Rs 17.1 lakh) on selling the house. Once this factor is taken into account, the rate of return falls to 11.4% per year. This is much better than the returns that bank fixed deposits pay. But its not very high by any stretch of imagination. An SIP on a good equity mutual fund over the same period of time would have given higher returns.
We are not done with this as yet. We also need to take into account the interest that my friend has paid on his home loan till date. From the financial year 2014-2015, interest paid on a home loan on a self occupied flat gets a tax deduction of Rs 2 lakh. Earlier the amount used to be Rs 1.5 lakh. Even after taking this deduction into account, there has been a considerable amount of interest outflow on the home loan over the past 10 years. Once this outflow is taken into account, the return that my friend will make on selling the house falls further.
A house also needs regular upkeep especially if you are living in it. This regular upkeep also costs money, which needs to be taken into account while calculating the returns on investing in real estate.
Also, long term capital gains on real estate are taxed at the rate of 20% with indexation, which allows you to take inflation into account. Of course, given this a lot of real estate transactions happen in black.
Long story short-once these factors are taken into account, the returns from owning real estate don't seem impressive enough in the long term. Given this, why are people so convinced about the investment potential of real estate?
There are multiple answers to this question. For most Indians (and even people living in other countries) a real estate transaction is typically the biggest money transaction they carry out in their lives. Hence, there is a tendency to look at absolute numbers. A Rs 28 lakh home now valued at Rs 1 crore, sounds fantastic. But this doesn't take the time value of money and other important factors into account.
Further, making these calculations is not easy. Most people I know do not know how to calculate compounded returns, even though this is something that is taught at the middle school level. Hence, there is a tendency to look at absolute returns and feel happy about the entire thing. Also, real estate is an excellent medium of hoarding black money. And people who have black money keep tom-tomming about the investment potential of real estate all the time.
To conclude, I have only discussed one example here and many other people may have different experiences. Nevertheless, once they start taking all the factors involved in calculating returns on real estate, their real returns will come down dramatically from what they thought they would be originally. If you do own real estate as an investment, try doing this exercise. The result might just surprise you.
Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.