Too many loans for buying real estate can be risky

Last Updated: Sun, Mar 03, 2013 04:35 hrs

There is a worrisome trend today. People take loans to acquire properties - not just for home for self use, but for investment in home and land. The current thinking among most investors is that property is the only asset that will give good returns. One may wonder - what is so worrisome about this? The point is that investors are going in for multiple properties, in many cases liquidating most of what they have and taking a loan for the rest.

We need to understand that most people have other loans and not just property loans. Many people also have vehicle loans. Some have personal loans, credit card repayments, consumer durable loans, and so on. Property loans go on for long periods. Hence, one has to consider all aspects thoroughly before going in for one. Also, in case of floating rate loans, the EMIs can go up. So, we find many people with multiple loans - their overall loan servicing burden goes as high as 80 per cent of their income, in some cases. When most of the income is going into servicing EMIs, even a small increase can be very difficult to service.

The second important point that we need to realise is that no asset class, including property, will perform forever. There is a school of thought that property prices can never come down. Some argue that even if it comes down, it can come down by 20-30 per cent, but not like equities. It is true that property prices may not come down by a huge percentage; but properties can remain stagnant for long periods, thereby, depressing returns. Like it happened between 1995-2003. So, there are price cycles in properties just like in every other asset class.

Gold is another favourite. About two years back the gold fever was at it's peak. Again, there are those who believe gold cannot come down at all. Gold has performed well in the past 10 years; but if you look at the past 30 years, the annualised returns would be in high single digits. That, too, is not due to gold returns; it is due to rupee depreciation.

The other aspect to consider is the return on investment in properties, in the holding period. For land, there is no return. For residential properties, the gross returns as a percentage of the property value would be 3-4 per cent. For commercial properties it can be double that. If one calculates the various outgoes like society charges, property taxes, income tax on the rent received, brokerage and so on, the net in hand would only be between 50-60 per cent of the rental income. So, every year one is earning only about 2 per cent on residential property and may be twice that for commercial properties. One is potentially losing 5-6 per cent in terms of returns, every year. The capital returns on the property has to make it up.

Other costs such as registration, stamp duty, brokerage and other incidentals add to the cost, but do not reflect in the value of property. Also, during the period when one is holding the property, the property has to be maintained, which is over and above the costs discussed earlier. At the time of liquidating the property, one also has to pay capital gains tax. Or else, one needs to invest in Capital gain bonds (yielding 6 per cent taxable return) or buy another residence to save tax.

However, many investors talk of creating an asset on borrowed capital and tax savings. While it is true that one is creating an asset using borrowed capital, one is also paying interest. Only for residential property the interest rate is benign at about 10.5 per cent and the real cost of borrowing can be low, if it is a second home. In case of commercial property, the cost of capital will be at least 3 per cent more than the residential home rate.

The loans taken to create such assets are long term loans, which means the borrower is assuming significant risk. One is making a commitment for a long period like 20 years to acquire a property, which is a huge risk.

What works for property investors is that, to begin with, people hold property for the long term. They don't look at the property prices every second day. Secondly, they also make consistent investments into it for years.

But, this kind of commitment would have worked well for other asset classes as well.

People are afraid of volatility. They do not realise that, ultimately, they should be concerned about returns over their holding period. Volatility is one of the accepted parameters of measuring risk. But given a long time horizon, volatility is less and less significant. That is, risk goes down as time increases, as one will be able to capture both up and down cycles that way. It will be even better, if one is investing regularly over time, as this will further ensure that the investor participates at all levels of the markets. Long term investment horizon reduces risk. This is an important fact to bear in mind while investing in assets prone to volatility and cycles. Most investors dread volatility and end up cashing in or out at the wrong time.

A portfolio is created to offer diversification, deliver returns after taking into account risk, liquidity, maturity profile and other considerations. No asset class will perform at all times. Only Fixed Deposits or fixed income products can always provide a stable and positive return. But the post-tax return, will be minuscule.

A good asset allocation should have equity, debt, property and other assets in the required proportion, based on the investor's needs. Moving from one to the other, just because one asset is performing well, will skew the portfolio.

Also, timing error will come in as we may not always be able to time correctly in terms of moving back and forth. Besides, there will be costs involved and there could be other issues like liquidity, taxation, tenure and so on. In essence, it is better to stay true to the desired asset allocation, save for any tactical calls of a minor nature.

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