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By Rajkamal Rao
Go back to Housing
Once you know which city you want to live in, you really have three options: stay in an existing home, buy a new home or rent. For obvious reasons, we will ignore the first option and consider the next two.
You can have differing opinions about any topic in India but there appears to be one constant that everyone will agree on: if you invest in real estate, you will not lose (and you will most probably gain).
The real estate bubble started about two decades ago and began to rise with India’s economic growth. Real estate is always a function of supply and demand - since there’s only so much land available for development. With India’s increasing population, and the rise of migrant workers in the major metro areas, demand for housing has continued to rise. As incomes rose with the growing economy and banks eased credit, the real estate industry took off.
Government policies have inadvertently contributed to the bubble while losing out on valuable tax revenue. When an Indian invests in a second home, he has to declare, on his tax returns, nominal income from rent whether or not the home is actually rented!
However, deductions are extremely generous. First, 30% of the rental income can be taken as a standard deduction for repairs and maintenance. Second, all municipal taxes paid can be deducted. Third, all mortgage interest on the second home can be deducted - without limit - and if any amount is left may be adjusted against other income. If the mortgage amount is large, this has the potential of wiping out all tax obligations for the year. If an additional mortgage balance exists, it can be carried forward to future tax years as a loss on property.
Let’s illustrate this by an example. Assume that an Indian invests in a second home by taking a 1 Crore INR mortgage at an annual interest of INR 7.5 Lakhs. He rents it out for INR 3.6 Lakhs and pays municipal taxes of INR 50,000 a year. Assume that he earns 9 Lakhs a year in a salaried position at a company.
First, 30% of his rental income - 1.2 Lakhs - can be taken as a standard deduction and can be added to the INR 50,000 he pays in municipal taxes. Next, all of his INR 7.5 Lakhs in interest income can be deducted. His deductions now total INR 9.2 Lakhs on an income of 12.6 Lakhs (salary plus rental income), even before other deductions (for travel allowances, life insurance and personal exemptions) kick in. If he plans these deductions carefully, he could potentially be liable to pay no income taxes and actually carry forward this part of his property “loss” into future years!
A report in the Deccan Herald in Aug 2011 said that just 2.77 percent of India's 1.21 billion people pay personal income tax. “The number of effective tax payers as on March 31, 2011 was 3,35,79,831 (33.57 million),” Minister of State for Finance S.S. Palanimanickam said in a written reply to a question in the Rajya Sabha.
For most Indians therefore, real estate is a sound investment choice and a great vehicle to reduce their tax burden. Although India has significantly liberalized its economy, developed mature financial markets and continues to seek foreign direct investment, the average Indian has little faith in financial institutions to preserve the value of his savings. He is concerned that inflation is often high and government tax policies are unreliable (and can even be made retroactive to suit the issue of the day). In real estate, he sees an unmatched level of value preservation, capital growth and financial stability - not dissimilar to buying and holding gold. And so, he invests.
So, as a returnee, should you rent or buy? David Leonhardt, the Economics Editor of the New York Times, says in a May 28, 2008 article that “one of the big lies of the real estate business is the idea that renting a home is tantamount to throwing money away. It's a useful fiction for real estate agents, because they make vastly bigger commissions on house sales than rentals. But the comparison isn't nearly so straightforward for the rest of us”. Leonhardt goes on to say that “renting involves one obvious, recurring cost that can never be recouped: the monthly rent check. Buying, on the other hand, involves multiple expenses, some of which aren't so obvious. On top of closing costs, there are repairs, property taxes, mortgage principal and mortgage interest. And when you own, you also lose the ability to invest your down payment elsewhere, like the stock market”.
Although Leonhardt is talking about the US housing market, the basics apply to India as well. To answer whether you should rent or buy, let’s analyze the economics of the decision.
Leonhardt talks about a concept called “Rent Ratio”. “You find two similar houses, one for sale and the other for rent. Divide the sale price by the annual rent. You can call the result the rent ratio”. He goes on to say that this is the “real estate market's version of a price-earnings ratio — a measure of how expensive an asset is, relative to the underlying economic fundamentals. Like a P/E ratio, the rent ratio provides something of a reality check”.
Let’s say the rent ratio of a property is 20. This means that if you put aside all the rental money that this property generates for 20 years, you should be able to buy the property with that rental money. Leonhardt says that historically, and throughout the 1970s, '80s and '90s, the average rent ratio in the US hovered between 10 and 14. In the early 2000s, though, it broke through that historical range and hit almost 19 by the time the housing market peaked, in 2006. In Boston, New York, Los Angeles and south Florida, it topped 25. In Northern California, it approached 35, higher than it had been in any city, at any point on record.
And we all know what happened to US housing in 2008. The bubble burst.
Let’s look at India property and rental values. A 2,100 square foot villa in Bangalore’s posh Whitefield area sold in May 2001 for INR 2.1 crore. This family was paying INR 28,000 a month in rent (i.e. INR 3.36 lakhs) for a home which was an exact copy, in the same community, two houses down the same street. What was the rent ratio? Divide 2.1 crores by 3.36 lakhs and the result is a whopping 62.5!
In fact, the rent ratio is actually worse. Remember that for most of 2012, the 30-year fixed mortgage rate in the United States has hovered around 4%. In India, the 15-year fixed mortgage rate (the longest fixed term available) is nearly three times this rate - about 12%. So, expect mortgage payments in India for a property of similar value to be almost six times that in the US. Assuming real estate taxes and maintenance are the same in the two countries, the rent ratio should be adjusted upward by a factor of six - to 375!
This means that on the face of it, investing in India real estate to generate rental income is a terrible idea and renting beats buying every time. But government policies on income recognition from second homes fully distort the market and encourage massive investments in real estate. It is no wonder that newspaper advertisements hawk new developments and the real estate section of the weekend newspaper is often fatter than the main section! There is no question that the Indian real estate market is in a bubble and the only difference from the bubbles of other countries is that there appears to be no end in sight for the India bubble. .
Go back to Housing
Once you know which city you want to live in, you really have three options: stay in an existing home, buy a new home or rent. For obvious reasons, we will ignore the first option and consider the next two.
You can have differing opinions about any topic in India but there appears to be one constant that everyone will agree on: if you invest in real estate, you will not lose (and you will most probably gain).
The real estate bubble started about two decades ago and began to rise with India’s economic growth. Real estate is always a function of supply and demand - since there’s only so much land available for development. With India’s increasing population, and the rise of migrant workers in the major metro areas, demand for housing has continued to rise. As incomes rose with the growing economy and banks eased credit, the real estate industry took off.
Government policies have inadvertently contributed to the bubble while losing out on valuable tax revenue. When an Indian invests in a second home, he has to declare, on his tax returns, nominal income from rent whether or not the home is actually rented!
However, deductions are extremely generous. First, 30% of the rental income can be taken as a standard deduction for repairs and maintenance. Second, all municipal taxes paid can be deducted. Third, all mortgage interest on the second home can be deducted - without limit - and if any amount is left may be adjusted against other income. If the mortgage amount is large, this has the potential of wiping out all tax obligations for the year. If an additional mortgage balance exists, it can be carried forward to future tax years as a loss on property.
Let’s illustrate this by an example. Assume that an Indian invests in a second home by taking a 1 Crore INR mortgage at an annual interest of INR 7.5 Lakhs. He rents it out for INR 3.6 Lakhs and pays municipal taxes of INR 50,000 a year. Assume that he earns 9 Lakhs a year in a salaried position at a company.
First, 30% of his rental income - 1.2 Lakhs - can be taken as a standard deduction and can be added to the INR 50,000 he pays in municipal taxes. Next, all of his INR 7.5 Lakhs in interest income can be deducted. His deductions now total INR 9.2 Lakhs on an income of 12.6 Lakhs (salary plus rental income), even before other deductions (for travel allowances, life insurance and personal exemptions) kick in. If he plans these deductions carefully, he could potentially be liable to pay no income taxes and actually carry forward this part of his property “loss” into future years!
A report in the Deccan Herald in Aug 2011 said that just 2.77 percent of India's 1.21 billion people pay personal income tax. “The number of effective tax payers as on March 31, 2011 was 3,35,79,831 (33.57 million),” Minister of State for Finance S.S. Palanimanickam said in a written reply to a question in the Rajya Sabha.
For most Indians therefore, real estate is a sound investment choice and a great vehicle to reduce their tax burden. Although India has significantly liberalized its economy, developed mature financial markets and continues to seek foreign direct investment, the average Indian has little faith in financial institutions to preserve the value of his savings. He is concerned that inflation is often high and government tax policies are unreliable (and can even be made retroactive to suit the issue of the day). In real estate, he sees an unmatched level of value preservation, capital growth and financial stability - not dissimilar to buying and holding gold. And so, he invests.
So, as a returnee, should you rent or buy? David Leonhardt, the Economics Editor of the New York Times, says in a May 28, 2008 article that “one of the big lies of the real estate business is the idea that renting a home is tantamount to throwing money away. It's a useful fiction for real estate agents, because they make vastly bigger commissions on house sales than rentals. But the comparison isn't nearly so straightforward for the rest of us”. Leonhardt goes on to say that “renting involves one obvious, recurring cost that can never be recouped: the monthly rent check. Buying, on the other hand, involves multiple expenses, some of which aren't so obvious. On top of closing costs, there are repairs, property taxes, mortgage principal and mortgage interest. And when you own, you also lose the ability to invest your down payment elsewhere, like the stock market”.
Although Leonhardt is talking about the US housing market, the basics apply to India as well. To answer whether you should rent or buy, let’s analyze the economics of the decision.
Leonhardt talks about a concept called “Rent Ratio”. “You find two similar houses, one for sale and the other for rent. Divide the sale price by the annual rent. You can call the result the rent ratio”. He goes on to say that this is the “real estate market's version of a price-earnings ratio — a measure of how expensive an asset is, relative to the underlying economic fundamentals. Like a P/E ratio, the rent ratio provides something of a reality check”.
Let’s say the rent ratio of a property is 20. This means that if you put aside all the rental money that this property generates for 20 years, you should be able to buy the property with that rental money. Leonhardt says that historically, and throughout the 1970s, '80s and '90s, the average rent ratio in the US hovered between 10 and 14. In the early 2000s, though, it broke through that historical range and hit almost 19 by the time the housing market peaked, in 2006. In Boston, New York, Los Angeles and south Florida, it topped 25. In Northern California, it approached 35, higher than it had been in any city, at any point on record.
And we all know what happened to US housing in 2008. The bubble burst.
Let’s look at India property and rental values. A 2,100 square foot villa in Bangalore’s posh Whitefield area sold in May 2001 for INR 2.1 crore. This family was paying INR 28,000 a month in rent (i.e. INR 3.36 lakhs) for a home which was an exact copy, in the same community, two houses down the same street. What was the rent ratio? Divide 2.1 crores by 3.36 lakhs and the result is a whopping 62.5!
In fact, the rent ratio is actually worse. Remember that for most of 2012, the 30-year fixed mortgage rate in the United States has hovered around 4%. In India, the 15-year fixed mortgage rate (the longest fixed term available) is nearly three times this rate - about 12%. So, expect mortgage payments in India for a property of similar value to be almost six times that in the US. Assuming real estate taxes and maintenance are the same in the two countries, the rent ratio should be adjusted upward by a factor of six - to 375!
This means that on the face of it, investing in India real estate to generate rental income is a terrible idea and renting beats buying every time. But government policies on income recognition from second homes fully distort the market and encourage massive investments in real estate. It is no wonder that newspaper advertisements hawk new developments and the real estate section of the weekend newspaper is often fatter than the main section! There is no question that the Indian real estate market is in a bubble and the only difference from the bubbles of other countries is that there appears to be no end in sight for the India bubble. .
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