Strategy for Real Estate Investments

(Author is an alumni of NITK,Surathkal and is presently pursuing Management studies at IIM, Bangalore. He was previously employed with Microsoft and Intel, and he also owns a ALOHA-Abacus franchise at Kulshekar, Mangalore. All views expressed here are his personal. He can be reached at )

Understanding Personal Finance: Part-3

The city of Bangalore has seen the highest price rises in its real estate over the past three to four years. Many have multiplied their wealth into many folds by just investing in real estate investments. It has been a gala time for builders, contractors and real estate agents. Best part of it is that even some of the salaried class people have booked their profits by investing at the right time, thanks to the real estate boom!!

While on one side people are busy buying and selling their properties, there are people on the other side who have missed the bus and are watching the show as they cannot afford the current prices. Is there anything you could do if you belong to the latter group?

One strategy that could be of great help is, leveraging debt. Nowadays banks are ready to loan up to 80% of the property cost. Well, if you are eligible for it, then you can definitely leverage bank?s money for your investments.

Let?s look at it step by step. Say, for example, you have Rs 1 lakh savings and the property which you are interested costs Rs 5 lakhs. Considering the growing demand, people believe that it has potential to go up to Rs10lakhs within 5 years. Would you grab this property or would you just be happy buying a smaller property costing Rs 1 lakh, having similar potential of price doubling in 5 years?

The options here are just two, with loan or without loan. If you buy a smaller property of Rs 1 lakh with full cash, your profit after 5 years would be Rs 1 lakh. It is a 100% Return On Investment (ROI), that is, for every Rs100 you invest, you would be earning additional Rs100 as profit.

On the other hand, let us consider the case of buying a bigger property, the one costing Rs5lakhs by using your Rs1lakh savings and going for loan for the rest Rs4lakhs (80%). For calculation purposes, let us consider loan with an interest rate of 10% and the term as 10 years.

For the first 5 years, your interest outflow and pre-closure charges together comes to Rs1.78 lakhs. Adding this to the original cost of Rs5lakhs, the total cost of the property would then become Rs6.78lakhs.  If the price doubles as expected in 5 years, your Net Profit would be, 10 Lakhs- Rs 6.78 Lakhs= Rs 3.22 Lakhs. What is the ROI in this case? It is 322%. Isn?t this amazing strategy?

While paying full cash payment is definitely good thing from the external liability point of view, paying partly cash and partly through loan may be a better option if one is interested in increasing ROI. In case of real estate investments, if the total expected price rise is more than the interest you pay to the bank, you can definitely increase your returns by taking a loan from bank. In other words, you can earn good returns not just from your money, but also from bank?s money. This concept is better known as leveraging debt in the corporate world which is used for increasing Return on Equity.

In the above example, considering the other way around, one can invest in a smaller Rs1lakh property by just paying Rs 20,000 as cash and the rest as loan. I have created table and a chart below to demonstrate how ROI in this case grows from 100% to 322% by increasing the loan amount step by step. The first row is with no loan and full cash while the last row has the maximum loan (80%) and just Rs 20,000 cash.

Though the loan is taken for 10years, but closed in just 5 years, it would incur additional 2% pre-closure charges. Considering all such charges and the bank interest for 5 years, total cost goes to Rs1,35,440 for 80,000 loan amount taken at 10% interest for 10 years term. Hence, selling the same property for Rs2lakhs at the end of 5th year would earn you a net profit of Rs 64,560 from your original investment of just Rs 20,000 !!! 

If you think the property boom going to last for many more years, you can repeat this strategy for next property, say, costing Rs4lakh, with 80% loan of Rs3.2lakhs and selling it at a later point in time, earning high returns. If it doubles in 5 years, again 322% returns would give you net profit of closer to Rs 2.5lakhs. In overall terms, a small sum of Rs 20,000 could grow up to Rs2.5lakhs in 10 years. If you thought only rich could multiply their money, this could prove you wrong.

Fixed deposit in a bank for 10 years at 10% interest for the same Rs20,000 amount would have grown to a sum of Rs 52,000 only (although you cannot directly compare the two because of their risk being different).

Are there any glitches here in this strategy? Not really, but two things one should keep in mind while taking loan for buying a property. Firstly, the EMI (Equated Monthly Installment), as you increase the loan amount, your EMI also grows and if one does not have capacity for this outflow of money every month, it is not recommended to go for a loan. In fact this is true for any loan not just while buying property.

The other point is about the expectations of price increase in real estate prices over time. Not many are good in their predictions of the future.  The boom period may not last long in reality. In the above table, we have considered that the price of real estate would double in 5 years. In reality it may or my not. Instead of Rs2lakhs, if the price goes up by just 30% in 5 years and if you sell at the end of 5th year, you would be making a loss of Rs 5,440 if you go with 80% loan, whereas with full cash payment, you are still at profit though small.

India has great potential to outpace other countries in the coming years. Looking at the GDP growth numbers for the last 2-3 years and going by the prediction of our economists, I think we can be very optimistic about our future growth. Real estate companies are betting high on these future numbers. If everything goes well on the international front, jobs coming to India would definitely grow at much faster rate and per capita income would also grow!!! This indirectly can create a huge demand for real estate and can push the real estate prices further up. May be it?s still a good time to buy and apply this strategy!!! 

Author: Pramod DSouza- Bangalore