Raman, a 40 year old software professional wants to build a retirement corpus and build funds for his only daughter’s education and marriage. For this purpose, he has invested in some fixed deposits and post office schemes and also wants to buy a second property worth Rs 60 lakhs as an investment. He wants to use his accumulated savings for the down payment of the second house. Based on his income and expenditure patterns, he could easily get a loan of Rs 48 lakhs from any financial institution.
Raman will retire in 20 years and opts for a 15-year loan on the new property. But once he pays off the down payment Rs 12 lakhs and starts paying the EMI he is left with no investable surplus.
He decides the last five years prior to retirement will be sufficient time enough for him to generate retirement savings. He also assumes the property will grow in value by the time he retires and, the rental income would be sufficient to take care of household expenses post-retirement.
Disadvantages of Raman’s existing financial plan
- His asset allocation is heavily dependent on real estate and because of that his asset allocation is less diverse.
- The potential appreciation of the property’s value as per his estimation is based on his past experience and not dependant on facts or figures of the real estate market .
- Real estate assets can be illiquid and unless one is able to sell-off assets, it will not fetch much returns, when needed .
- Unless the property was bought much below the current market value, rent yields hardly match the interest earned on the savings bank account.
- He has ignored the maintenance and depreciation factors of the property.
- While rent may support his existing budget, he did not factor in the impact of inflation on his subsequent monthly budgets.
- Investment in real estate is not risk-free.
Actions to be taken to correct the situation
- He should focus on a personalised asset allocation plan as per his risk appetite and diversify his portfolio across various asset classes such as fixed income, equity, gold etc. His primary home, where he lives must not be considered for this purpose.
- He should reconsider buying a second house availing a home loan.
- He lacks a corresponding exposure to equities and has not invested in growth assets to meet long-term goals.
- Though his financial goals are focussed enough he should plan for both short-term and long-term goals.
- He is also advised to review it and rebalance his portfolio periodically, preferably every year.
Pitfalls of linking financial goals with real estate assets
In recent years there have been many instances of investors having increasing allocations to real estate as an asset class. It is important to understand how this over exposure might have pitfalls for them. The drawbacks are stated below:
Illiquid Nature – Considering liquidity as an important parameter in investment decisions, the fact that real estate investments are high value and big ticket in fact leads to illiquid assets. This actually means not being able to use funds even though the investor may have a high net worth, mainly due to illiquid nature of this asset class. Thus, it would be difficult to sell property immediately when there is a need for cash for a financial goal. Moreover, regulatory and transparency issues in the sector also pose risks to liquidity and jeopardise the investment .
Too much affinity towards physical assets – Indian Investors have a bigger emotional connect with physical assets such as real estate and gold as compared to financial assets. However there are two kinds of corrections that assets can undergo – price correction and time correction. The real estate markets are at present experiencing a time correction, where values have remained same over a long period of time, giving investors an impression that the valuations of their holdings are intact. This comes in the way of investors making rationale decisions to exit investments in real estate.
High absolute values – Many a time we hear stories as to how property bought a couple or more years back has grown and multiplied to worth crores of rupees. If one calculates the growth rate for this investment made in terms of today, the rate of return would be in the range of 10-12% per year. Assuming a long term horizon say 30 years in the Indian stock markets, one could have got much better results.
Easy availability of leverage – With the lowering of interest rates and attractive financing schemes, Indian investors are finding it easier to fund real estate purchases. As buyers usually have to put down only 20% of the cost, the balance 80% being funded by lenders, property purchase has become easier for investors.
However, investors need to be aware that since this is an unregulated market currently, they should not fall for any false promises and /or funding schemes which they do not understand. This may lead investors to get into a negative cash flow situation especially if the EMIs that they have committed to are high. As under construction projects may not be completed in time, there may not be any rental inflows and hence the burden of EMIs may not be comfortable for investors.
Too much real estate investments just because of taxation impact – The tax rules currently make it mandatory that the capital gains made from sale of property to be reinvested in real estate and/or capital gain bonds. To avoid taxation, gains from sale of property thus flow back into buying more of this illiquid asset class , thereby creating an overexposure of investor portfolios into this asset class. The other option of capital gains bonds offers a 6% rate of return which is less attractive to investors, thus making them go back to real estate, yet again.
Real estate purchase does not allow portfolio re balancing – Real estate purchase does not allow portfolio re balancing to happen from one asset class to another. For investors that are planning re balancing from real estate to debt or equity may find that they may be in a fix after exiting from real estate as they either need to go back to real estate or to debt in the form of capital gain bonds.
Debalina Roy Chowdhury