It is common and considered highly profitable by investors to invest in property and real estate as a form of reliable investment. With inflation and fewer cash inflows, it seems intelligible to buy a second home to provide a regular source of income and security for your family. But is it really the smartest choice that you can make? Imagine that you suddenly win a lottery meriting you 5 crores. What will you do with that money? The first thing that will pop into your mind is to invest it in real estate.
With bonds, the credit rating is the key factor. With property, location matters the most. Not all properties earn a steady rental income. A holiday home in the mountains might enjoy occupancy rates compared to hotels in the area if it is well maintained and efficiently marketed. Investors, who have bought adjacent flats to live in one and rent the other, are only taking care of the maintenance costs and control. The income stream still depends on the location of the property and the demand.
What should you as an investor consider and be cautious about, when it comes to investing in property?
Why do People Go for A Second Home: Asset Fanatics?
Having your own house is a big deal in the India Culture. Once people start earning well, or for even those who are fresher’s in their job, start dreaming about having a place of their own. And there is nothing wrong about it one should seriously think about having their dream house, but should they stop at it? Or continue to dream about one more. While we can’t say which is right or wrong, let us try and understand why owning a second home might be or not be beneficial for you.
When it comes to owning a second home our rationality takes the back seat while our emotions take control of the steering wheels on the busy roads of life. People see a second home: an additional property as a status symbol more often than not. “Home interest rates at 15% low” is all it takes to push them to make the decision of parking a huge sum for the long term. In doing so they tend to ignore the emerging asset classes investing in which could bear sweeter fruits for their finances over time.
We take on this emotional aspect of buying a second home from two major sources, firstly from our forefathers and secondly from society. Indians have had a close affinity to have their own home which is passed on to them by our forefathers, adding to it the mental satisfaction that something physical, in real form exists that can call our own. And adding to this is competition, we see other people whom we know going in for that another house, we think about doing so ourselves.
There is in fact nothing wrong about dreaming to purchase as second house, it is just that this decision should be considered objectively and financially. Roti, Kapda aur Makaan is still important, but figuring out whether you need that second Makaan should require further analysis. To analyse what good things might come out of Owning A Second Home, let us consider some advantages of making this realty investment.
Questions to ask before going in for that purchase
- Do you have any existing debt obligations: If you have existing debt obligations hat you need to fulfil then taking on a housing loan will not be a smart choice. You will add unnecessary pressure on your finances making it harder for you to make ends meet. Take on a housing loan only if you’re free of such overhead debts obligations.
- What is the value appreciation of the property: The property should appreciate at a greater rate than the interest rate only then one should think about investing in such a project. For example if you take a loan of Rs. 45 Lakh at 7% p.a. and you appear in the top tax bracket of 30%, you will be eligible for a tax benefit of 2.1% (7%*30%), thus making your tax rate 5.9% (8%-2.1%). Only if the property appreciates by 5.9% it should be considered as a fruitful investment.
- What will be the rental yield on the second home: Rental Yield is (Monthly rental income12)/Original price of the property] 100. For example a property fetches a rent between INR 20,000-25000, hence the annual rent will be around INR 2.4Lakh-3Lakh the rental yield will thus become [(2.4 to 3 lakh)/1 crore]*100 = 2.5% to 3%. Furthermore deducting taxes @30%, maintenance and other miscellaneous charges will reduce this yield to 1.5%-1.8%. It is advisable that one should consider buying a second home only if the post-tax rental yield for that property is to the tune of 3%-5%. Once the effective rental yield goes up ~5%-6%, the property is considered more lucrative and it marks the beginning of another bull run in real estate.
- Will you be able to fulfil your EMI obligations: As you will most probably take on a loan for the property your finances should be in a condition to sustain your current lifestyle as well the EMI obligations. Many people will compare SIP with EMI’s but what they fail to understand is that while SIP is a disciplined way of investing, EMI is a commitment, where SIP can be stopped the EMI’s can’t be stopped at any cost.
- Do You Have enough Emergency Funds: You should have an adequate amount set aside for unforeseen circumstances and emergencies that may arise in the future. If there is no such provision made, buying a second residential property will not be a helpful step for your future.
Finding Out Alternatives Investments
If you analyze and find out that purchasing a second house might burn a greater hole in your pocket, then there are other investment avenues available that might still help you have a pretty sweet bump in your incomes. The prime example of such an investment is a mutual fund. Rather than parking your funds for a second home, park that same amount in diversified mutual fund schemes. An investor might end up making more if not less by doing so.
In comparison to Real Estate mutual funds will show many benefits such as:
- Lower initial amount required for investing
- Easier liquidity during times of emergencies
- A well regulated market system with proper checks and balances to ensure the safety of your money.
- Providing inflation adjusted returns to the investors
- Provision of SIP, SWP and STP for accumulation or withdrawal of money at regular intervals.
- Options to choose a scheme depending on your risk appetite. One can choose between large cap, small cap, mid or multi cap funds and there are also options available for investment in debt instruments as well.
All the above advantages remain absent a real estate scheme. Let us consider an example to better understand the returns one might earn by investing in a mutual fund scheme than a second house property.
Let us understand the variable returns one can get if a) one chooses to invest in a real estate property or b) invests the same amount in an equity linked mutual fund scheme.
a) Firstly let’s take a look at real estate investment: Let us assume Mr. A is eyeing a property the cost of which is Rs. 80 Lakh.
Mr. A takes a loan of Rs. 50 Lakh for the same, at a fixed interest rate of 7%. The EMI comes to around Rs. 38,765.
Loan amount 50,00,000
Interest payable @ 7% 43,03,587
Loan Tenure 20 years
Total Loan Amount Payable 93,03,587
This property is let out by Mr. A at Rs. 20,000. He also assumes that the rent will grow at an average of 5% pa.
Total Loan Amount Payable (A) 93,03,587
Total Rent Receivable (B) 79,35,828
Tax paid on rental income @ 30% (C) 23,80,748
Maintenance Charges @ 20% (D) 15,87,165
Net Outflow (A-(B-(C+D)) 53,35,672
Mr. A will also incur certain additional expenditures namely maintenance and tax on rental income
Maintenance Charges @ 20% (D) 15,87,165
Net Outflow (A-(B-(C+D)) 53,35,672
Down payment for the property 30,00,000
Actual Cost of Owning the Asset 83,35,672
Mr. A also anticipates appreciation in property value. He assumes that it will appreciate annually between 7-8%. Looking at the reality in realty, there has been huge unsold inventory of houses available in metros but due to the low demand the growth has been very nominal of about 4%. But taking on an optimistic view he still assumes the rate to be 5%
Current Value of The Second Home 80 Lakhs
Value appreciation expected @ 5% 2.56 Crore
Actual Cost of Owning the Asset 83,35,672
Returns From Property 1.72 Crores
Hence the returns come to about 1.72 Crores by effectively investing 83.35 Lakhs. For an investment period of 20 years this doesn’t seem a lot.
b) Now, let us take a glance at the mutual fund investment:
Let us assume Mr. A is to invest the amount of 30 lakhs and the additional EMI amount of 38000, for the same period at a rate of return of 12%. The down payment amount is invested as lump sum, whereas the EMI’s are invested as SIP’s. The investment is made in an Equity Mutual Fund which can positively provide inflation adjusted returns that will contribute to adequate wealth creation
Maturity amount of 30 Lakhs as a lump sum investment 2.89 Crore
Maturity amount of 38,000 invested as SIP 3.79 Crore
Returns From Investment 6.68 Crore
DISADVANTAGES OF INVESTING IN ANOTHER PROPERTY
1. Not All Properties enjoy a steady source of income:
When it comes to having a property, location always matters. In case of residential properties, not all properties enjoy earning a steady rental income. It will depend majorly on the social infrastructure such as schools, hospitals and retail centres and also on the demand for such rented properties.
In times of emergency, liquidating a residential property becomes a difficult task. Real estate tends to be the most illiquid investment. A ready market is absent for real estate as it involves a huge sum of money and one can’t sell out a single room the whole house has to be sold in entirety. Whereas having another commodity in your portfolio such as a mutual fund might prove to be more beneficial in testing times. After liquidating a mutual fund scheme, the money typically reaches the investor within 2-3 days.
3. Lack of Prudence might land you in trouble:
Investment in a second home is a pretty big decision, it requires a lot of groundwork in selection of the property. An added danger that looms over such an investment is unknowingly partaking into any illegal matters can make matter worse and can burn a greater hole in your pockets. It will further stretch on to the legal turf thus resulting more time and resources.
4. Other hassles:
An additional property requires regular maintenance as well as modernisations to keep it up and running in the market. The house will require additional maintenance after changing of tenants. If the tenants turnover is high then brokers’ commissions and the period where the property sees no renters would result in increased expenditure as well as loss of rentals for the owner.
5. Regulatory Body:
Real estate sector lacks a strong regulator to curb unethical practices that might result in loss of the capital invested by general public. The REARA stands as a recent development in the sector but in comparison to say SEBI’s regulations for the Mutual funds and Equities sector, it looks a little bleak.
Since it is normal to get emotionally attached to your investment in properties because of its physical presence. Booking profit from real estate sometimes is emotionally hurting when it is done wrong. You should always weigh your pros and cons when it comes to buying a second home for investment.
Buying a second house will be a big decision considering your finances. In the end if you wish to go through with it your decision shouldn’t be based on whether a property has become “cheap” or “expensive” over time. Inflation in prices plays a huge difference in these price changes that happen over the years.
Consider your total income and find out whether the property is accessible within your income bracket. A property worth 1 Core will be affordable if you earn 50-55 lakhs in a year. Also carefully evaluate how this decision will affect your investment portfolios and long term financial plans. Look out for ready-to-move-in properties that can get you rental incomes faster.
If you feel that maybe this isn’t the right time for you to have another home then you can source out other avenues of investment which will help in active wealth creation for your funds. As mentioned above mutual funds can be a relatively lucrative option , also one can think about investing in equity, debt, gold or even in global companies for a diversified portfolio that will help your funds grow and take a softer blow when there are losses in a sector.
Weigh in the pros and cons of your decisions, what may work for some people might not work for you. Investing your money might not be a “one size fits all” only you can charter a path to gain a greater financial freedom to achieve your dreams.
(Saarthi for your financial dream)