Middle class families: Read this before you invest in real estate!

I routinely see middle class families put most of their wealth in real estate, there are full page advertisements in whichever newspaper you pick up containing ads of real estate properties, there are property fairs all over, and it seems that investors’ appetite of this asset class does not have an end. I even once got an enquiry from a prospect where he had read a book “Guide of Investing” where Kawasaki says put all money in real estate, so he liquidated all his assets (including his PF money) and put everything in property and asked me to study that book and draw up a financial plan in line with what that book recommended:)

On the face of it, this gives an impression that the reason why Indian people are so fond of real estate is that somewhere they expect it to be the best asset class. Over the period of my experience in financial planning (and I am learning every day!), today, let me show you the other face of it.

In my view, the primary motive of investing in real estate is not the confidence but FEAR. And that fear is of 2 types:

  • First fear is that money should not get spent or wasted as somewhere they know they left to itself, it will get all spent & hence the urge to “BLOCK” it somewhere
  • Second fear is that they DO NOT UNDERSTAND FINANCIAL ASSETS like mutual funds. Also, there is a baggage of past painful experiences of losing money in shares/IPOs/ Mutual funds. So, the subconscious mind says better off not to make a fool of oneself & better invest in what dad said once: property, gold, insurance policies (in this post, I will be discussing only real estate)

So, when someone invests in an asset out of fear, natural thing to assume is that the asset is a SAFE ASSET. But is that really true?

Although there will be many who will disagree with me, I strongly believe that REAL ASSET IS A HIGHLY RISKY ASSET & IF YOU ARE A MIDDLE CLASS FAMILY, YOU SHOULD STAY AWAY FROM IT.

Now, why do I say this? There are multiple reasons given below:

A highly illiquid asset:

So, when you invest in real estate, you don’t foresee that some calamity can strike or you might require funds urgently. Let us imagine 2 scenarios:

  • Scenario 1: You’ve invested Rs. 50 lacs in a 2 BHK flat (of course took a loan) in a flat in Mumbai. Intention is that you’ll sell it for your son’s higher education. Couple of years down the line, your wife is diagnosed with blood cancer and you urgently need Rs. 15 lacs for her chemo. Now tell me, will you be able to sell 1 room out of that 2BHK flat to get Rs. 15 lacs? What if you don’t have enough cash/ bank balances? What will you do?
  • Scenario II: You have earmarked this flat for your retirement. Now, you also earmarked some money for his higher education and that falls short by Rs. 15 lacs. What you’ll do? Ask money from people or sell your flat, thereby disturbing your entire financial planning.

Of course you’ll say oh, these days loans are so easily available. So, if your idea is to take a personal loan for any emergency (since they are so easily available now a days), I won’t argue further with you. You win, I lose:)

Ask yourself my friend: what’s the use of an investment if it does not come to your rescue when you need it the most?

Timing the market (oops, be sure that you don’t fall flat on your face):

When you invest in so and so area, you trust the word from your broker, friends, media etc. that so and so area will develop and you’ll get fantastic returns from your investment.

First thing you need to keep in mind that most of it is PAID NEWS: if you’re not discerning enough to dissect paid news from free media, you’re doomed. Secondly, brokers etc. may be more concerned with pocketing their brokerage with the deal (their families run on that) & may not keep your best interests in mind. Thirdly, friends & relatives, no matter how intellectual and in the know of they seem, might be as uninformed on this issue as you are. Also, investing in real estate is like timing the market in one go, which can prove so wrong when there is a prolonged low phase & it’s not even easy to find buyers if you want to sell your property.  

Upkeep and maintenance:

You are in Mumbai, property is in Gurgaon. It’s been lying vacant.

One day, you visit the property, you see some goons sitting inside (this is not a made up story, I’ve heard of exactly such instances where goons of political parties encroached flats of people who went out of India). Also there is that fantastic & touching movie (that was again based on real life story of the director of the movie): Khosla ka Ghosla. So are you like Anupam Kher putting all his PPF and everything in a plot only to find that there is an illegal encroachment on it. And if you are like him, then be prepared to take revenge from Khurana like he did in that movie:)

Under construction property issues:

So, why middle class families prefer under construction properties? Because they are available at some discount and you have the option of paying in instalments (construction-linked) instead of one shot payment in case of resale. But there are so many issues that these families face that one reads in newspapers almost on daily basis like:

  1. Delayed possession: My friend pays a big EMI along with the rent and possession is not in sight. No wonder he cannot sleep at night!
  2. One sided agreement by builders (and the attitude of take it or leave it): There are clear-cut penalty clauses for delayed payment but no such clauses/ ambiguous clauses on delay in possession. And several other issues.
  3. Lack of approvals: Everyone says approvals are in place but as a consumer, are you humanely able to check all of it? So, there is trust. And trust leads to Campa Cola!

Taxation issues:

Real estate investment, assuming long term capital gain (where asset is held for more than 36 months) is taxed at 20% with indexation benefit. Compared to this, long term capital gains on equity MFs after 1 year of holding is zero. So, real estate is definitely less tax efficient than MF. Yes, you can claim exemption u/s 54 which creates a trap (i.e. to get tax benefit, you’ll have to again invest in property) or u/s 54EC where you’ll have to invest in specified bonds which give ~ 6% returns and money gets locked for 3 years. But the fundamental question is: why not enjoy tax free returns instead of subjecting it to investment in other assets.

High transaction costs:

When people calculate the returns from real estate, they conveniently forget the associated paperwork & transaction costs (lawyer’s fees, brokerage, stamp duty, registration etc.). Also, there is a opportunity cost of time that is spent on seeing the flats, dealing with the broker, negotiating with builder/ owner of flat, due diligence like 24 ghante paani aata hai ya nahi:)

Now, I give you a challenge, count all these costs and then calculate the Internal Rate of Return (IRR) on your real estate investment, and it will be much different from the IRR you’ve always had in mind!!

If the construction is delayed by more than 3 years, the benefit of interest u/s 24 is restricted to Rs. 30,000 only. Also, if we go about the wording of Section 54F of the Income Tax Act, exemption cannot be claimed if construction is not completed within 3 years. However, there has been a court judgement in Jyoti Arun case where court has given relief to assessee & has taken a lenient interpretation of this section & allowed the exemption – you can download PWC analysis of that judgement here

The way out

First & foremost, the most important thing is to become self-aware of your thoughts, feelings and deep seated beliefs on money. Ask yourself: Did it happen that your father suffered losses in the ’92 stock market crash and you heard him telling everyone that equity is bad and real estate is the only “safe” option to invest? Why because research has proved that one is most likely to carry such childhood thought processes forward, and that children are greatly influenced by their father especially on money matters.

So, if not real estate, where should one invest?

And my suggestion will be: Explore mutual funds.

Remember, I said “explore” and not “invest”. As against real estate where you invest in an illiquid asset and don’t have to apply any mind there and rely on “luck” to get a good return, in mutual fund it’s the other way round. You need to do some study on how mutual funds work & then start putting small amounts in good funds and track those investments.

The beauty of mutual funds is its superb flexibility & I believe that mutual funds are a boon for middle class investors. There are features like you can invest as much as you want, move your investments between funds, features like Systematic Withdrawal Plan (SWP), Systematic Transfer Plan (STP), a highly sound regulator like SEBI which oversees working of this sector, you can see your investments value at a click of a button, and there are a host of free learning resources on the Internet (here I will recommend a website www.freefincal.com)

Some handpicked articles on this topic:

The other side of real estate investments: Livemint

The reality of real estate: Moneylife

Why real estate is a bad long term investment: Economic Times

Lessons from the Campa Cola crisis: Business Standard

A personal word:

I am not an agent of a mutual fund & I have nothing against builders and real estate as an asset class. Also I do not advocate investing in mutual funds or for that matter any asset BLINDLY. But I’ve seen people suffering by investing in real estate primarily due to the “fear” and “ignorance” of better ways to invest. Through this post, I have tried in a small way to discharge my social responsibility in this area and wake up investors to stop being mercy of real assets like property and gold. I feel that if just one investor wakes up by this post, my job is done and I have complete faith in that. And if YOU are that investor, don’t keep this to yourself; share this post with at least one person/ friend. Thanks.