Real estate has always been a favorite investment for most of us. Unlike stocks and bonds, a piece of property is something you can see and touch and take pride in. However, you may be confused by all your choices if you are new to the real estate market. An owner of real estate holds legal title to the property they have purchased. Real estate investment includes family houses, duplexes, apartments, land, and commercial property.
At the end of this course, you will be able to understand the following:-
- Meaning of real estate
- Factors affecting the real estate market
- Real estate financing
- Real estate as an asset class
- Tax benefits in real estate investment
What is a Real Estate?
Real estate is the single most significant component of wealth in our society. Because of its magnitude, it plays a crucial role in shaping the economic condition of individuals, families, and firms. It can substantially influence a family’s ability to finance education, health care, and other essential needs. Changes in the value of real estate can dramatically affect the wealth of individuals and businesses and their capacity to grow.
Real estate has been estimated to represent approximately one-half of the world’s total economic wealth. In addition, it is often viewed as an important symbol of strength, stability, and independence. The prominence of real estate means that decisions about it are also important. For the individual, firm, and region, better decisions about the creation and use of real estate assets will bring greater productivity, more incredible wealth, and a better set of choices for life.
When people think of real estate, they often think of the homes in their community or the business of buying and selling houses. This is probably because the personal investment that most households make in their home represents their primary involvement in the real estate market.
Real estate includes our homes and places of work, commerce, worship, government, education, recreation, and our physical environments- natural and built.
In addition, it includes a wide range of business and institutional activities associated with the development, purchase, use, and sale of land and buildings.
Real Estate as a Property
Use of the term Real Estate.
The term real estate is used in three fundamental ways;
- First, its most common use is identifying the tangible assets of land and buildings.
- Second, it denotes the ‘bundle’ of rights associated with the ownership and use of the physical assets.
- Finally, real estate may be used when referring to the industry or business activities related to acquiring, operating, and disposing of physical assets.
Based on the above, a real estate could be:-
- A Tangible asset, or
- An Intangible asset.
These are physical things such as:
- Land, or
These are non-physical things and include the following:-
- Contractual rights (for example, mortgage and lease agreements)
- Financial claims (for example, stocks and bonds)
- Patents, or
Characteristics of the Real Estate Market
Real estate assets and markets are unique compared to other goods. The two primary characteristics of real estate assets are:
Because of these two factors, the market for buying, selling, and leasing real estate tends to be localized and highly segmented, with privately negotiated transactions and high transaction costs.
Real estate tends to be heterogeneous, meaning each property has unique features. For real estate, however, age, building design, and location combine to give each property distinctive characteristics. Even in residential neighborhoods with very similar houses, the sites differ. For example, corner lots have different location features than interior lots; their access to parks and transportation routes may vary, and the traffic patterns within the neighborhood create differences.
A home’s most influential site and structural attributes are typically observable and amenable to valuation (for example, pools, bedrooms, and garages).
Real estate is located and it is immobile. Although it is sometimes physically possible to move a building from one location to another, this is generally not financially feasible. Therefore, most structures removed from the land are demolished rather than forced. Another term for area is access. For households, it is access to school, shopping, entertainment, and places of employment. For commercial properties, it may be the access to customers, the labor force, or suppliers.
Factors Affecting Real Estate Market
The market real estate sector keeps on fluctuating, and this could be due to various factors comprising population, migration, customer behavior, and new policies by government and real estate companies. Certain broad-level factors are the critical reasons for the frequent fluctuation in the real estate market:-
The economic condition of the country is of utmost importance. If the economy is stable, it will attract investors. As a result, the real estate market will flourish. If a country has a good GDP, job security, financial stability, and high purchasing power, its people can invest in the real estate market. No matter how real estate projects are marketed, people do not want to put their money into crashing economies. In short, a healthy and stable economy is the foundation of a growing real estate market.
When interest rates are low, it generally encourages prospective home buyers to enter the market. In addition, since obtaining home finance is more affordable, those who may have been on the fence about purchasing a property are more likely to take a home loan and buy real estate.
In turn, this increase in demand for property may lead to a rise in property values as stock is snapped up and homes become more challenging to obtain. Interest rates play a significant role in property cycles, so potential home buyers must keep an eye on interest rates and where they may be heading.
Unemployment creates uncertainty in the consumer’s mind about their future. As a result, they show less interest in buying properties that reduce demand and finally shift prices towards the descending side. In contrast, if more people are employed, more and more people become interested in buying properties. As a result, property demand increases while prices get high.
Supply and Demand
Like other industries, supply and demand play an essential role in price determination. If more buyers show interest in property purchases, the prices will rise. Factors that are responsible for producing assets are population, availability of land, and availability of construction labor.
Location is the primary factor for property price shifts. If asset location allows easy access to amenities like shopping centers, healthcare facilities, and entertainment places, then the price would be shifted toward the high end. On the other hand, areas with high crime rates and unexciting neighborhoods don’t attract buyers and investors to do estate business. A lousy location adversely affects property prices to fall.
Real Estate Cycle
The real estate market, like any market, has cycles. Recognizing and taking advantage of potentially great investments through the ups and downs requires understanding how the real estate market works deeper.
Understanding the Different Phases of the Real Estate Cycle
There are four main phases of the real estate cycle. Understanding these phases and developing the ability to predict them helps one better navigate potential investments.
Stage 1: Recovery
Recovery is the first stage after a market pullback or recession. Here, investors will find low housing demand and high vacancy rates. Therefore, it is a great time to buy properties, as the prices are low.
Stage 2: Expansion
During this stage, the real estate market shows healthy recovery and expansion as GDP stabilizes and the housing supply and demand balance. Rental rates go up, and new construction projects begin. As a result, investors tend to be active during this time.
Stage 3: Hyper Supply
Hyper supply is the tipping point from a healthy balanced supply and demand to an oversupply. As a result, real estate for sale increases, and it exceeds the market demand, eventually causing the prices to decrease.
Stage 4: Recession
A recession is the result of overgrowth. A declining market soon follows when jobs, rental demand, and construction projects sharply decrease. For investors, this is an excellent time to get in, as prices are at their lowest.
Remember that the four real estate phases do not occur in equal periods. Recovery can be brief and transition quickly to expansion, or it may last for years. The real estate cycle also varies according to geographic and asset class factors.
Real Estate Financing
Real estate financing generally describes an investor’s method of securing funds for an impending deal. As its name suggests, this method will have investors secure capital from an outside source to buy and renovate a property.
A vast majority of buyers require loans when purchasing a home. These loans, and the terms that come with them, are often overwhelming and confusing for homebuyers. For that reason, they’ll likely turn to their real estate agent or financial advisor for help. Many things come into play when it comes to when applying for loans, such as credit reports, asset, and income verification, appraisals, titles, etc.
Characteristics of Real Estate Finance
- Real estate finance is traditionally the process of borrowing or lending, often involving a third party that is neither the buyer nor seller of the property in question.
- From the borrower’s point of view, a loan is a debt and liability, while from the lender’s point of view, a loan is an investment and an asset, with the property serving as collateral for the loan.
- Financing a real estate transaction involves significant risk to the real estate owner (the borrower) and the lender.
Real Estate Financing Methods
Investors with almost finalized real estate deals would now be looking for finance. However, finding a viable deal is only one piece of the puzzle. Financing a real estate deal tends to send new investors into a fit of anxiety or is even enough to compel them to pack up their dreams and retreat to earlier plans to decide not to go ahead with the finalized real estate.
What next, then?
Even when you think making a deal is impossible, real estate professionals or financial advisors can guide you and help make it happen.
Buyers should investigate their options. Getting the right kind of loan can help increase buying power, boost cash flow, and increase the potential return on investment. But with thousands of lenders to choose from and various real estate financing options to research and evaluate, borrowers can quickly become overwhelmed.
Here are a few ways to structure real estate deals :
Great for investors who have access to a significant amount of capital, either personally or through their network, and wish to purchase properties free and clear.
Also termed a Mortgage loan. A conventional loan is right if you are moving into a new or old home but don’t need repairs and have fair-to-good credit. Traditional mortgage loans take into account the following information about a borrower:
- credit score
Buyers typically need to make a 5-25 percent down payment of the purchase price. In addition, conventional loans must meet strict guidelines before they are issued. However, since there is less risk associated with traditional loans, borrowers usually benefit from lower interest rates.
Hard Money Loan
Funded by private businesses and individuals, hard money lenders provide short-term, high-rate loans for real estate investors. This financing option, which doesn’t conform to bank standards of creditworthiness, is typically used by buyers to renovate a property. However, hard money lenders charge much higher interest rates – sometimes double the amount of a traditional mortgage, plus fees. Ultimately, all hard money lenders will have different requirements, and real estate investors must be fully aware of what they’re getting into.
Private Money Loan
Private money lenders will provide investors with cash to purchase real estate properties in exchange for a specific interest rate. The terms will generally be established upfront and with a specified payback period – anywhere from six months to a year. These loans are most common when investors believe they can raise the value of a particular property over a short period, typically through a conventional loan. It’s also important to understand that private money should only be used when you have a clearly defined exit strategy, like hard money.
Buyers and sellers can sometimes strike up a mutually beneficial agreement, allowing the investor and seller to avoid going through a private lender altogether.
A mortgage loan is a loan taken out against a property you own. The property in question could be your house, a shop, or even a non-agricultural piece of land. Banks and non-banking finance companies offer mortgage loans. The lender provides you with the principal loan amount and charges you interest. You can repay the loan in affordable monthly installments. Your property is your collateral, and it stays in possession of the lender until the loan is repaid in full. As such, the lender has a legal claim over the property for the tenure of the loan, and if the borrower defaults in paying off the loan, the lender has the right to seize it and auction it off.
What’s The Difference Between A Loan And A Mortgage?
The term “loan” can describe any financial transaction where one party receives a lump sum and agrees to pay the money back. A mortgage is a type of loan that’s used to finance a property. A mortgage is a type of loan, but not all are mortgages.
Mortgages are “secured” loans. With a secured loan, the borrower promises collateral to the lender if they stop making payments. In the case of a mortgage, the collateral is the home. If you stop making payments on your mortgage, your lender can take possession of your home in a process known as foreclosure.
Types of Mortgage Loans
Different types of Mortgage Loans
The most commonly sought-after home loan in India is a home loan. Consumers apply for small, medium, and real big-sized home loans. This is because the interest rates are competitive, durations are comfortable, and one gets a tax benefit. In addition, one can refurbish, renovate, and rebuild their house. One can take a home loan to purchase land to build a house, construct a house on land purchased, or even buy an under-construction property. This can be done for new or resale properties. However, the funds taken as a loan by the borrower must be used only for the house. Such funds cannot be used for any other personal or business needs.
Business people and entrepreneurs popularly take commercial purchase loans. They take such loans to buy commercial properties like a shop, office space, and commercial complexes. This loan is apt for such purchases. The interest rates offered by banks and NBFCs are competitive. Moreover, funds from this loan must only be used to buy the property.
Loan against Property (LAP)
A loan against property is commonly known as LAP. LAP is offered for commercial and residential properties. The borrowers have to mortgage their property to get funds from lending institutions. The original property documents must be deposited with the lender until the loan is repaid. The repayment of such loans is made on an EMI basis. Borrowers can use the loan amount for any personal or professional needs. These loans usually have a tenure of up to 10-15 years.
Second Mortgage Loan
Banks and NBFCs offer Second Mortgage loans for properties already under a loan. If a borrower purchases his property by taking a loan today, he can take an additional loan on the same property for personal needs. When a borrower applies for a Second Mortgage Loan, it is commonly called a top-up loan on a home loan. Based on the borrower’s credit score and loan repayment history, the lender will give additional required loans. The borrower must start paying the EMI of the second mortgage loan and the first mortgage home loan.
A reverse mortgage has been recently introduced in India. It is a particular loan that is submitted for senior citizens. Many senior citizens do not have a steady or adequate monthly flow of income. However, many of them own real estate in some form or the other. So they can opt for this. A reverse mortgage works exactly the opposite of a mortgage loan. It works because they must keep their property as a mortgage with the bank or the NBFC. The lender then pays them a steady income every month, like EMIs. On the death of the senior citizen, the bank or the NBFC has the right to sell the property. The loan amount paid to senior citizens is directly deducted from the amount in which the real estate is sold. The residual amount is given back to the legal heirs of the deceased senior citizens.
Lease Rental Discounting
Lease Rental Discounting (LRD) is a term loan availed against the future expected rentals from a
commercial (office space) or retail (mall/shops) property. The loan is provided to the lessor based on the
discounted value of rentals and the underlying property value. Generally, companies convert the
construction loan availed at the time of project implementation to LRD loans post the completion of
construction, tying up of tenants, and commencement of rentals. This often helps reduce interest costs as banks view LRD loans as a safer exposure than project loans due to the predictability of rental cash flows and mitigation of execution and marketing risks to a large extent.
Interest in Mortgage Loan
An interest rate is a percentage that shows how much you’ll pay your lender each month as a fee for borrowing money. There are two types of mortgage interest rates: fixed rates and adjustable rates.
Fixed interest rates stay the same for the entire length of your mortgage. For example, if you have a 20 years fixed rate loan with a 7% interest rate, you’ll pay 7% interest until you pay off or refinance your loan. Fixed-rate loans offer a predictable monthly payment, making budgeting easier.
A fixed-rate mortgage is the most popular type of financing because it offers predictability and stability for your budget. However, lenders typically charge a higher interest rate for a fixed-rate mortgage than an ARM, limiting how much house you can afford.
Adjustable rates are interest rates that change based on the market. Most adjustable-rate mortgages begin with a fixed interest rate period, usually lasting 5, 7, or 10 years. During this time, your interest rate remains the same. However, after your fixed interest rate period ends, your interest rate adjusts up or down every six months to a year. This means your monthly payment can change based on your interest payment.
Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed-rate loans challenging to obtain. The borrower benefits if the interest rate falls but loses if the interest rate increases.
- ARMs tend to have lower interest rates in the early part of the mortgage term, which is the fixed period. This is because the rates are traditionally lower than fixed mortgages. This benefits home buyer looking to own a home for a shorter period.
- Flexibility in selecting the fixed interest rate period is an advantage. This allows prospective homeowners to benefit from lower rates for longer.
- ARMs increase the purchasing power of homeowners. This is because ARM rates are based on shorter-term interest rates. Short-term interest rates are traditionally lower than long-term interest rates. The lower interest rate allows applicants to buy more expensive homes due to the lower rates.
Risk Diversification through Real Estate
Investment in real estate can help an investor to spread the risk and diversify the portfolio efficiently and profitably. The general rule of investment is ‘spread your risk,’ and a model portfolio would therefore be made up of different asset classes, such as:
- Cash, and
- Real estate.
Significant Factors Contributing to Real Estate
- Attractive Total Returns.
- Inherently Low Volatility
- Inflation-Hedging Potential
- Portfolio Diversification Benefits
Real Estate as a Conventional Asset Class
Real estate is a conventional asset class that offers a variety of unconventional investment strategies. However, it has long been a standard asset class and a viable alternative to traditional fixed-income and equities. Real estate investing may entail direct property ownership, mortgage lending, or purchasing financial instruments that derive all or a majority of their value from the underlying real estate.
Real estate investments have a minimal correlation to the equity and fixed-income markets. They are a low-volatility alternative by which to diversify portfolios that have significant traditional holdings. The property market is not exposed to daily price fluctuations. Investing in real estate-backed securities can shield an investor from the complications often associated with directly owning and managing a property.
The most common real estate investment strategy is direct property ownership. However, alternative real estate investment strategies have gained traction to satisfy a growing demand for property exposure among individuals, institutional investors, and pension funds. Examples of such alternative real estate strategies include investing in the debt or equity of companies that derive a majority of their value from the underlying real estate; Real Estate Investment Trust (REIT) securities and property funds are an example of such alternative strategies in real estate.
Real Estate Fund
A real estate fund is a mutual fund that invests primarily in residential and aandcommercial real estate to produce income and capital gains for its unit holders. Real Estate Fund is a significant component of the Indian realty market flooded with Indian and foreign financial institutions.
The growing increase in industrial, commercial, and residential projects has boosted the real estate market in India. This has thrown open unlimited scope for Indian Real Estate Funds. Moreover, the profits have encouraged financial assistance from domestic funds and lured many foreign investors to participate in Indian Real Estate Funds.
The cooperating assistance from the government has further encouraged liquidity flow into the Indian real estate market sector. The foreign contributions to the Indian Real Estate Fund have been witnessing a steady rise of 40-45% per year. Domestic financial institutions have also built up their investments like their foreign counterparts. This collective participation from both, along with contributions of the corporate houses, has accelerated the growth of the Indian Real Estate Fund.
Goals of Real Estate Funds
Real estate funds can be of various types but have a common goal. They all invest in real estate ventures. These may include companies on the stock exchange, funds on the stock exchanges, buying or selling real estate stocks, or directly in developers. They can also invest in Special Purpose Vehicles (SPV) for large infrastructure projects.
Advantages of Real Estate Investment
Certain types of real estate investments enjoy several advantages:
Hedge against Inflation
When inflation rises, your purchasing power decreases. Therefore, both direct and indirect investments in areas such as real estate are wise because they provide some protection against inflation. Historically, real estate continues to increase or at least hold its value, thus protecting investors from declining purchasing power.
By making an indirect investment in a real estate fund, you can quickly become a part owner of an apartment building or a shopping center. You can purchase the commercial property by combining your money with other investors.
Limited Financial Liability
An indirect investment in a real estate fund allows you to be a limited partner. That means you are not liable or responsible for losses beyond your original investment. This advantage is iessentialif the fund is investing in a risky venture.
Financial leverage is the use of borrowed funds for direct investment purposes. By using borrowed money, you can purchase the more expensive property. If property values and incomes are rising, this can be an advantage.
For example, Divya buys a building for Rs 50 Lacs with no borrowed funds. She then sells the building for Rs 60 Lacs. Profit earned by Diyva on the building, i.e., Rs 10 Lacs, is 20% return on Rs 50 Lacs investment (Rs 10 Lacs / Rs 50 Lacs= 0.20 or 20%).
On the other hand, suppose Divya invested just Rs 10 Lacs of her own money and had a Rs 40 Lacs mortgage with an interest rate of 8% per annum. After two years, she sells the property for Rs 60 Lacs with a profit of Rs 3.6 Lacs (Rs 10 Lacs – Rs 6.4 Lacs in interest). Her profit would be a 36 % return on her Rs 10 Lacs investment (Rs 3.6 Lacs / Rs 10 Lacs = 0.36 =36%).
Disadvantages of Real Estate Investment
Investors cannot be sure that their real estate investments will pay off. There are several possible disadvantages to real estate investments:
Real estate is an illiquid investment, which means that it cannot be easily converted into cash without a loss in value. Selling commercial property or shares in a limited partnership may take months or even years.
Declining Property Value
As discussed earlier, real estate investments usually offer some protection against inflation. However, when interest rates fall or if the economy is in decline, the value of real estate investments may decrease. As a result, if you own property, you may have to decide to sell your property for less than you paid for it and accept a loss.
Lack of Diversification
Because real estate is expensive, many investors can afford only one or two properties. Subsequently, building a diversified real estate investment portfolio may be challenging. Keep in mind, however, that Real Estate Mutual Funds, ETFs, REITs, etc., offer various levels of diversification.
Capital Gains Tax in Real Estate
If the holding period is more than three years, the capital gain arising from the sale of the house property will be taxed as a long-term capital gain.
If the holding period is less than three years, the capital gain arising from the sale of the house property will be taxed as a short-term capital gain.
Capital gains tax on the sale of house property may be long-term or short-term. It depends upon the holding period of the house property.
Exemptions are available only in case of long-term capital gains.
Short-Term and Long-term Assets
|Equity shares, mutual fund unit, zero coupon bond:||Held for 12 months or less.||Held for more than 12 months.|
|Other assets such as jewelry, land, and property:||Held for 36 months or less.||Held for 36 months or more.|
Tax Exemption in Real Estate Investment u/s 54
Capital gains arise when selling or transferring a capital asset like property, which is taxable in the hands of the assessee/taxpayer. Under Section 54 of the Income Tax Act, an individual or HUF selling a residential house can claim exemption from such capital gains if they invest the proceeds in the acquisition, i.e., purchase or construction of another residential house property. To claim this tax benefit, certain prescribed conditions need to be satisfied.
Essential conditions for exemption under section 54 are as follows:
- Only individuals and HUF assesses eligible for this exemption.
- In addition, the owner should hold the residential house property transferred for more than three years.
- The assessee should purchase a new residential house property within one year or two years after the transfer of the previous residential property or construct a new one within three years from the date of transfer of the last residential property.
Section 54 of the Income Tax Act allows the lower of the two as an exemption amount for a taxpayer:
- Amount of capital gains on transfer of residential property, or
- An investment made for constructing or purchasing a new residential property.
The balance amount (if any) will be taxable as per the income tax act.
Mohit sold his house property and earned a capital gain of Rs. 40 lacs. With the sale amount, he purchased a new house property for Rs. 50 lacs. The exemption under section 54 would be the lower amount, Rs 40 lacs. Therefore, there would not be any tax on capital gains.
Rohit sold his house property and earned a capital gain of Rs. 40 lacs. With the sale amount, he purchased a new house property of Rs. 30 lacs. The exemption under section 54 would be the lower amount, Rs 30 lacs. Therefore, the capital gains liable for tax would be Rs 10 lacs (Rs 40 lacs – Rs 30 lacs).
Exemption u/s 54 EC and 54 F
Exemption under section 54 EC
Capital gains derived from selling house property may also be invested in certain specified bonds covered under section 54 EC. Institutions such as the National Highways Authority of India (NHAI) and Rural Electrification Corporation (REC) issue-specific bonds for this purpose.
The assessee should invest the whole or any part of the capital gain in ‘specified long-term assets’ (specified bonds) within six months from the date of transfer of the asset.
Exemption U/s 54 F
Capital gains derived from a real estate property can be subject to tax exemption under section 54 F only if it is a long-term capital asset other than a residential house property (for instance, it may be a plot, commercial house property, etc.)
To claim an exemption under this section, the assessee will have to purchase a residential house property (old or new) or construct a residential house property. It may be in India or outside India. The new house should be purchased or built within the time limit given below:
|For purchasing a new house:||It should be purchased within one year or two years after the original asset’s transfer date.|
|For constructing a new house:||The construction should be completed within three years from the original asset’s transfer date.|
On the subject to the fulfillment of the conditions specified under section 54F, the exemption is available on the following basis:
[Cost of new house * Capital gains] / Net sale consideration.