FACTORS AFFECTING REAL ESTATE INVESTMENTS

Student Projects ( posted on 26/10/2006)

Real estate sector in India is on upturn. Research estimates that Indian Real Estate market is expected to grow from the current USD 14 billion to a USD 102 billion in the next 10 years. The main growth thrust is coming due to favourable demographics, increasing purchasing power, existence of customer friendly banks & housing finance companies, professionalism in real estate and favorable reforms initiated by the government to attract global investors.

Why real estate investment stands out?

• Quantum of investment required is high

• Investment horizon is long

• Dual returns are available in form of rental income and capital appreciation

The promising avenues of real estate investment:

• Offices

• Shopping malls

• Retail outlets

• Industrial warehouses

The following table gives a list of the factors to be considered in case of investing in either commercial or residential real estate:

Determining Real Estate Returns:

Real estate returns, like stocks, are determined by a combination of two factors:

• Income (lease rentals, like dividends in the case of stocks)

• Capital appreciation.

The only difference in the two is that in real estate, the lease rentals are fixed, largely predictable over a period of time and a very significant component of overall returns. Investors wanting to earn rentals from residential property can get an average yield of around 6-7 %, and this has been constant for a long time. Most lease deals have an escalation clause that provides for close to 15% upward revision in rentals after three years. This would further improve the returns beyond the existing tenure. For commercial property, the lease rental yields are even better at 10-13 % and form the basis for investment.

To arrive at a correct and more realistic estimate of returns, an investor should consider the following five factors:

• Acquisition cost: The buying costs are higher than other asset stocks. For instance, the transfer of property requires registration and payment of a stamp duty. Some of the addiction costs involved are:

• Stamp duty

• Broker commission

• Miscellaneous costs of drawing up legal documents

• Maintenance expenses: While the purchase is a one-time expense, maintenance is an important recurring cost for preserving the value of your investment, maintenance expenses are normally Rs 5-20 per sq.ft per month for commercial property depending on the quality of the property, and this needs to be factored into yield calculations. Further, each lease contract is structured differently and a contract may incorporate clauses that create some financial obligations for the lessor. To arrive at true it is thus important to look at yields after deducting such expenses.

• Taxes: Property tax and taxes on capital gains are the two aspects one needs to familiarise oneself with and consider when evaluating returns and comparing them with those on other asset classes. From the tax point of view, the points to consider while buying are:

• Cost of acquisition : Apart from the cost of purchase (agreement value), the cost of acquisition includes stamp duty, registration charges, legal fees, brokerage transfer charges payable to a housing society, and payments made for parking space.

• Date of acquisition : For taxation purposes, the date of acquisition is taken as the date of execution of the purchase deed or the date of possession, whichever is earlier.

When renting it out

As the owner, one will be taxed on the annual value under the head income from house property, provided one does not use it for business or a vocation. The annual value will be the actual rent received/receivable. When the actual rent is less than the expected rent, the income from the property is taxed on the national rent (expected rent).

• Interest on borrowed capital : The interest payable is deductible up to Rs 1.50 lakh where a loan is taken on or after 1 April 1999 and acquisition/construction is completed within three years from the end of the financial year in which the loan is taken. Otherwise, the interest deduction is restricted to Rs 30,000. With effect from 1 August 1998, interest paid for self-occupied property is eligible for a set-off against salary income for the purposes of tax deduction at source by the employer.

• Section 88 : Principal repayments are eligible for a rebate at 15 or 20 % (depending on the income bracket) of a sum of up to Rs 70,000. This is applicable for housing loans from specified sources like banks, housing loan companies and most categories of employers.

When selling

• Taxation of capital gains: Gains from property held for less than three years are taxed as short-term capital gains (STCG) and taxed at the normal tax rates applicable to the tax payer. For property held for a period exceeding three years, the gains will be taxed as long-term capital gains (LTCG) at a concessional rate of 20%. Further, in case of LTCG, the taxpayer can claim the benefit of indexation – increase the cost of acquisition against the inflation index. For property acquired before 1 April 1981 will be taken as the cost of acquisition.

• Section 50C : In computing capital gains, this section seeks to tax a notional amount in the hands of the seller. And so, where the consideration for the transfer of the property is less than the value adopted or assessed by any State Valuation Authority (SVA) for determining the stamp duty liability, the consideration actually received will be substituted by the valuation adopted for stamp duty for the purpose of computing taxable capital gains.

• Exemptions : LTCG is not taxable when it id reinvested in another residential house property a year before or two years after the date of transfer, or constructed within three years of the date of transfer. The exemption is also available if the LTCG is reinvested in specified bonds of NABARD, NHAI, REC or Sidbi within six months of the date of transfer. The quantum of LTCG that is exempt is the cost of the new asset or the LTCG, whichever is lower.

• Loans: An important cost is the loan taken – including the processing charges and interest. Since real estate entails a sizeable investment, many investors opt to leverage the asset value to part finance the investment.

Funding sources supporting investment in real estate:

• Banks

• Financial institutions

• High net worth individuals

• Real estate mutual funds

• Security: When property is rented out, the investor also gets an interest free security deposit and advance rent. The returns from this also should be considered. The key to investing in real estate lies in identifying growth areas and factoring in demand and supply for property.

BIBLIOGRAPHY:

Knight Frank India Research ‘India Property Investment Review Quarter 4 2005’

Sonal Sachdev and Clifford Alvares, “Is real estate a good investment?, outlook money, (15 May 2003).

Sonal Sachdev and Clifford Alvares, When investing in real estate, look for outlook money, (15 May2003).

Yatin Desai and Nitin Shingala, House breaks, outlook money, (15 May 2003).

Lisa Vander, Three key factors real estate investors must look at when the market changes, www.msmoney.com, (27 March 2006)

www.indiaproperties.com

www.icicibank.com

www.mymoney.tips4me.com