As the dust settles on demo, most sectors are coming out of sluggishness and official figures report a steady growth. Many experts have doubted the figures and suspect a downward revision. In my view, stable GDP was obvious to anyone with an understanding of estimation methodology. As the official figures consider only recorded transactions and formal economy, I had predicted a double digit growth within 1-2 quarters here (penultimate paragraph). Albeit, this is just due to a flaw in the methodology; and our country may be struggling in the informal sector if the formal growth has come at the expense of the informal sector. There is no scientific way to find out if the informal sector shrunk significantly.
The only sector that is still reeling under duress is the cash-heavy construction and real estate sector. The pages advertising sale of properties had nearly disappeared from leading newspapers. The number of transactions registered with Telangana government has dropped to about half of pre-demo levels, clearly indicating a slump. In Maharashtra, the value or volume of transactions registered this year is not likely to catch up with those seen about 5 years ago. Formal sector (listed companies / organized developers) are probably out of the woods, as the BSE Realty Index is back to pre-demonetization levels. Bulk of the construction business is still struggling to find buyers. Sensing an opportunity, many of my middle class friends are jumping to buy property :-)
A problem faced by a young friend got me thinking whether owning a house has any more advantages than renting one. I did the math, subject to certain assumptions, and found that buying a flat as investment isn't any advantageous compared to renting.
Assumptions: Property valued at INR 25 lakhs, requiring modifications / furniture worth about 5 lakhs. Home loan is available for 30 lakhs at 10% interest (give or take). Similar property can be availed at 4% annual rent (1 lakh per annum) - global and Indian benchmarks rarely cross this figure. Rental value increases at inflation rate (6%), which should also be the rate of growth of property value. Buyer (or renter) is in highest tax slab (30%) and tax laws do not change over the term of the loan (15 years). Rented property requires about 3 months deposit (national average) and furniture worth 1.5 lakhs. Buyer stays in the property for the entire term of loan.
Under the stated assumption, the buyer ends up paying about 400k EMI, 200k registration / connections / maintenance in the first year and gets a tax shield of about 90k. The tax benefit gradually drops to 0k over 15 years. For renter, the first year spend is 100k rent plus 200k furniture and deposit; on rent there is a tax benefit of 30k, which increases to 65k in 15th year. Its a no brainer that renter ends up spending lot less, but the buyer ends up owning the property. Are these two comparable? This gets answered by asking the following question. Could the renting person buy a similar property at that time with the saved money?
Let us start by checking the two options - rent vs buy, and check the future worth 15 years down the line of the two.
1) Money spent by buyer on the property: The total investment in to the property (EMI, furniture, etc. excluding maintenance) would be to the tune of 52 lakhs in nominal rupees, and 111 lakhs considering time value of money. Maintenance cost is ignored.
2) Money spent on rents: The renter would end up spending 18.3 lakhs in nominal rupees, and 38.8 lakhs considering time value of money.
To illustrate, two persons with same income choose different paths - rent / buy decide to park any surplus money (after rent / EMI) in to a fixed deposit giving 10% interest. After 15 years, the renter would be richer by 111 - 39 = 72.7 lakhs. If the renter decides to park money in more risky assets, then the benefits would be higher. With 72.7 lakhs, will one be able to buy a house then ?
It turns out, the property worth 30 lakhs would become worth about 76.2 lakhs (if it grows at the rate of inflation). If the buyer chooses to encash the 32 lakhs investment, he may get only about 45 lakhs after deductions on account of age, taxes, stamp duty, etc. As per data compiled by The Economist, in the long run (15+ years) property prices grow at nearly the rate of inflation, and very rarely a percent above the inflation rate. In the rare case, the replacement price of the property could hit 90 lakhs, giving back about 52 lakhs in cash to investor.
Thus, a person renting property does not lose much (if any) in delaying the decision to purchase. If there is hope in the governance of the country, one can expect more level playing transactions in the real estate, lesser black money and fairly priced properties. In which case, one should delay any purchase decisions and benefit from more fair market.
All the above numbers have been checked for the sensitivity to estimation errors within reasonable limits, and the conclusion remains the same. One point of contention from ardent believers of real estate is that property appreciation is faster than inflation rate (which has happened in recent past, but there are no fundamental reasons to cause this. It can be explained by the expectation of the market that rental will grow eventually, which it never did).
In case you have reasons to believe that inflation will be more than 6%, or real estate will appreciate better than 6%; then there is a case for investing early. But many people invest because real estate is a good investment. There is no such law of physics !! It is good only if you manage to time the markets or to identify opportunities before developers. Otherwise rental and buying are not very different, add to that the added flexibility of a rental space. Still for the sake of argument, let us see if investing in real estate helps your portfolio.
According to portfolio theory, if we don't understand an asset class, we can still blindly invest in it, provided 1) there is a liquid market for it and 2) it helps in achieving diversification. If these conditions are met, investing in real estate is desirable. According to crude calculations, the proportion of investment in real estate should not be more than 25% of one's net worth (all wealth minus all loans). People do stretch this to about 60% for short periods, but that's not advisable as real estate investments cannot be disposed off in short time, in event of a distress.
Bottom line for upwardly mobile friends - use rented property to enjoy the real estate today. Buy property only if it diversifies your other investments. If REIT market picks up, one won't need to buy property to invest in real estate!
