Inflation makes rental income underperform
May 08, 2014
Source : The Times of India


BANGALORE: I live in a centrally located area of Bangalore. A canal bifurcates the main road into the ‘rich’ and ‘poor’ areas. On the affluent side of the canal, hotels, restaurants and highrises dot the street. The real estate rates hover between Rs 12,000 and Rs 15,000 a square feet. On the other side – home to a garbage dump – the rates are about Rs 3,000 a square feet.

I clearly know which side of the street offers a better quality of living, but how does one decide which side of the street is a better investment for the future? Pay a bomb and buy an apartment in one of the highrises, and expect high rental income, or invest low and hope that the eventual development of the locality and capital appreciation on the property will work in one’s favour?

Unlike a stock market index, which captures the market conditions based on a basket of stocks, it is difficult to benchmark the performance of real estate, where the variations in real estate prices are alarming even within the same neighbourhood.

Many people are of the view that land can only appreciate in value. This is far from true. Just like demand and supply dictate market economics, so is the case with real estate. There are factors that can go beyond one’s control in determining the true value of a property.

Even if a property has appreciated significantly in value, we tend to ignore frictional costs such as maintenance charges, registration costs, stamp duty, property tax, capital gains tax, lawyer fees, broker fees and other associated costs with real estate sales and purchases.

Another common misconception is that rental incomes can fund expenses after retirement. Apart from the hassles of finding a good tenant and maintaining the apartment on a regular basis, rental yields in India are on average between 3 per cent and 5 per cent pre tax. With inflation hovering between 6 per cent -8 per cent, rental incomes will seldom beat inflation.

Unlike financial instruments, real estate is also a very illiquid asset. In an emergency, it is difficult to sell a property in a pinch. If the property is sold in a hurry, the buyer takes advantage of the distress sale and bargains for a lower price. And the fair value of a property is not realised.

Equities, over the long run, tend to deliver average returns of about 16-17 per cent annually, while some of the best real estate appreciations in cities have been in the range of 10-15 per cent, excluding taxes and other costs. What’s more, gains on equity are tax free after a year. They do not have the high frictional costs of real estate associated with them.

Stocks or mutual funds can be bought and sold within a day at their actual prices on that day. Redemption proceeds can be in your bank within a week. In an emergency, financial assets like equities are much easier to access than real estate. With a high level of transparency in assets that they have invested in, no entry loads and low cost structure, mutual funds offer an efficient way to invest in equity. Over time, equities will outperform all asset classes by a significant margin. Get real about this, your estate value will grow faster.

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