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Sunday, December 15, 2013

Reasons why real estate investment is riskier than equity

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Few days back one NRI asked me a very specific question through business bhaskar. He asked that since Real estate is a growing investment class and has generated huge returns in past, why in India Financial planners are reluctant to advise on this area. Well, my answer was very short due to restriction of space, but I am elaborating the answer in this blog post. I believe that this is the concern of many and even I have faced such questions being asked by many of my prospective clients, so I hope this post will answer all of your doubts. Financial Planner's job is to help clients achieve their long and short term goals comfortably. He prepares a plan which also carries investment advise for allocating the surplus funds in different assets keeping in mind the risk profile, so that right amount of money should be available at right time to investor. Real estate and Equity both are growing and volatile asset classes, but still Real estate especially in India is more risky to invest in and generally financial planners finds it difficult to map with Goals. Below are some of my thoughts and reasons to it.

1. Lack of Transparency: Real estate is one sector where you can't get all the information on a single website or in a single document. Moreover there are many hidden/unclear things in a project which makes the deal more risky. Few of them are material information on Promoters, past project delivery experience, status of land, Statutory approvals etc. Usage of different ambiguous terms like Carpet area, super area etc., restricts the informed decision making. Also in case of Resale transactions sometimes establishing ownership is very difficult due to lack or availability of clear land titles. Such things have made this sector very opaque and thus resulted in widespread disputes and litigation.

2. High Transaction Cost: Brokers charge 1-2% of transaction cost, Stamp duty ranges from 5% – 8% depending on the state where the property lies in. If you are constructing your property then you also will have to bear the inflation cost which will hit the construction material, architects fees, contractor charges and also fees towards taking various approvals like for electricity connection, water connection etc. All these increase your cost of purchase and if not planned properly will hit your cash flows and surely the goal achievement.

3. Taxability: Any gain in real estate is taxable. Though tax rates vary for short term and long term and investor will also get indexation benefit for long term transaction but still he has to pay 20% tax on Indexed gains which reduces the overall net returns out of real estate.

4. Menace of Black Income: High Transaction cost and Taxability both has led to increase in tax evasion with the parties involved understate the property sale and purchase prices. Even if buyer wants to pay the price in white (by cheque) seller wants to receive the money in Cash so he can avoid paying some capital gain taxes. Sometimes even buyer wants to pay in cash so registration cost should be at the minimum required by law. This creates a vicious circle as black income generates more black income which can go nowhere but in real estate only.

5. Low Liquidity: Real estate can't be sold on a click of mouse. Many times you don't find a buyer, even if you want to sell below the purchase price i.e in loss. If the property has been mapped with a goal then in this situation complete financial planning can go for a toss. Keeping this in mind financial planners avoid mapping real estate with a certain time framed goal.

6. No partial withdrawal provision: You cannot sell your real estate partially like a room of a flat or some portion of your built up property. You may find yourself in a big financial soup if you have not planned your cash flow properly and also are over invested in real estate.

7. High maintenance cost: You have to pay price for keeping the property in resale able state. Even if you don't live in it or don't give it on rent, you still have to pay cost for maintaining that property in the form of society charges, minimum electricity charges, Renovation charges, improvement charges etc. Now many states have started levying Property taxes also.

8. Low rental Yield: Placing property on Rental and earn regular income is one of the main reasons of buying property by many. Many people give it as excuse that they will not lose money on maintenance cost as they will keep property on rent and see the capital value growing. But mathematically people lose on this front too. Rental yield especially in Residential property in India is very low. Its hardly between 1%-3% and that too is taxable. I have already pointed out the taxability, Black income menace on capital gain value. If one calculates all the costs and taxes out of the property income then the Net returns are not worth making so many efforts.

9. No ready market: Unlike other asset classes like equity, gold and debt, real estate does not have any ready market available where people sell or purchase on real time basis. The process is long and that too starts only if buyer and seller are available and agreeing to the transaction. The price discovery mechanism is also very opaque in this sector.

10. No Regulator: Unlike Stock market where is SEBI, banking where is RBI, Insurance where is IRDA real estate sector does not have any regulator. Means there's no one to keep a watch on what builders, real estate companies and agents are doing and thus no one to protect the interest of consumers. Increasing the prices by quoting less, not delivering the project on time, Charging for services which was earlier termed as free etc. are very common things these days. The plight of residents of Campa cola complex in Mumbai is also the result of having no regulator over builders and nexus between builders and corrupt politicians. We hope that the Real estate (Regulation and development) bill which is still pending in parliament will bring the necessary transperancy in this sector.

I wonder how and why in India people treat Real estate as safe and equity as risky asset class which is devoid of all the above mentioned issues. Equities are much transparent, cost and tax effective, properly regulated, liquid asset class. When investors expect trust, transparency and wise advise from Financial Planner, how can he expect a planner to advise on putting there hard earned money in such opaque sector. Real estate can surely give you a high and a sense of pride in ownership of a tangible asset but as an investment it has lot of flaws in it.

With the coming up of regulator and also Real estate investment trusts (REITs), going forward investments in this sector may become advisable, but till then Beware of the risks and cost involved. As warren buffet said "Risk comes from not knowing what you are doing". If you think that even after understanding the risks you feel safe in real estate, then its purely your choice.

Happy Investing!!

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