Top 7 reasons why people lose money in Real Estate
While all of us know and hear about the risks of share markets, real estate investment looks so simple to all of us. Every one of us has an opinion on property markets and every second person is ready to advise us on property transactions. This is mainly because we use real estate every day and feel so connected to it. The banks and the developers add to the illusion by making it sound so simple and nice. This enables most people to take a huge bet on real estate without even questioning the basics and the rationale behind it.
This post tries to identify some common reasons which affect the real estate transactions. The list includes some of the most common factors which I have observed in the last 10 years and factoring them will definitely will increase your chances of success in your biggest investment.
1) Clarity of purpose
Unlike stock market investments real estate investments are not just financial investments. They are also emotional investment for most of the people and have different usage for different investor. So a clarity of investment will help the person to choose the right parameters for their investment.
Some people invest to own a home now or after retirement. If someone is investing for his/her own usage then they should only look at the affordability and usability of the property without worrying about rental incomes or future gains/losses.
But if one invests to get return from property than they should be clear about investment tenure, leverage value and other factors. So clarity of purpose should be there before investment and the investment should be done accordingly.
2) Timing of purchase and luck
While we can analyse any number of factors we need to acknowledge the role of luck in our investments. The timing of investment is probably the biggest reason why most make profits in real estate. I have followed Mumbai market for 13 years and I have seen the markets go through 2–3 phases in this tenure. The rental yield in 2007 for my rented unit was around 5.5% which dropped to around 2.5% in 2010. This was mainly due to the huge rise in price of property between 2007 and 2010. Even though the markets were getting unaffordable in 2010 itself the boom continued till 2013–14. The warning signals were there from 2013 itself but the industry sustained the price due to multiple factors. Although the prices have stagnated in the last 2–3 years, the future also looks uncertain.
What this clearly tell us is that someone who invested before 2007 definitely made a fortune while investors who bought before 2012 have also made decent profits. The calculations and assumptions by the investors in all these times were almost similar and some just turned lucky in this game.
Similar stories with different timelines have happened across different micro markets. I bought one property in Pune in 2010 while I purchased my second property in 2015 in the same locality. Even though I had much more experience in 2015 compared to my first investment, I have made much higher returns from my first property. So even with all the experience and analysis I have not matched my first investment. This clearly shows that despite our best analysis and efforts, the luck or external factors need to be in our favour else even the best plans can give poor returns or loss.
3) Ignoring factors other than Price rise in calculations
For most of the real estate investors price rise is the only way to earn from real estate. This results in huge dependence upon external factor and the investor is just sitting at the mercy of markets.
The two key factors which are not generally ignored are
a) Tax savings — Most of the people are unaware about the tax implications of purchasing property, it can also result in paying higher taxes if not planned properly for people who have high HRA benefits. People can reduce their annual taxable income by upto 3.5 lacs if invested in affordable homes.
So we can see that people can save a lot if they also factor the tax benefits of the investment. Most of these benefits are not applicable for under construction properties but a majority of real estate investors ignore tax implications and loose out in the process.
b) Rental income: While rental income should be the main driver of all the property valuations, unfortunately people can’t get the difference intuitively. Lets assume a person has choice of buying a 75 lac property in two micro markets with rental value of 15,000 and 20,000 per month. Most of the people perceive the return difference as only 5,000 per month and may be willing to ignore the rental difference if they like the property with lower rentals. They don’t understand that a property with 1% difference in rental can make huge difference.
While the actual difference may be only 5,000 per month, the property with higher rental yield will be much more stable in the long term due to huge difference in affordability factor.
4) Everyone is an expert
When we purchase a property generally everyone has a view about it. The list of unsolicited advisors ranges is huge and muddles the decision making. While most of them try to help us, the decision making becomes much more difficult. Sometimes we have to ignore the financial aspects due to family or social pressure. This ensures that the final decision may not be financially sound and lowers the potential return.
One major reason for people getting sucked into real estate is the success stories of their social circle. Most of us share our good stories everywhere but very few of us want to discuss our bad experiences. This creates an image of almost everyone earning successfully in real estate and pushes us to buy one too.
Another big reason why people get stuck is past success. Some people have good experience of real estate investment and they expect it to keep continuing. The big problem comes when people reinvest the entire profits in the next investment. This ensures that when property prices stop rising their investment is totally stuck and the profit from previous investment is also lost.
Most of the people can’t value a property independently and depend on the market for price clues entirely. They are unable to judge the property cycle going at macro level and get sucked due to herd mentality. This also ensures that they can’t decide about their exit independently.
5) Managing and understanding leverage
Since most of the properties are bought with loan today, managing and understanding the loan is important part of real estate investment.
Unfortunately most people don’t understand the nuances of leveraging and pay a huge price to banks by taking long term loans. Infact leverage cost are a big reason why most of the people end up with minimal return on their real estate investment. Usually people buy with the highest possible loan and end up with a long tenure. It ensures that if they want to sell the property in 6–7 years, the loan repayment is minimal and the loan principal is intact.
The size of loan EMI compared to the monthly income determines your comfort to continue the loan in bad times. This means that even if one is bullish on a property he/she may be forced to sell your property due to cashflow problems while a person with lower leverage ratio may be able to navigate the property cycles successfully.
Most of the people put all the liquid money in down payment and have little liquidity left for bad times. In such cases they face huge problems in paying EMIs in bad times and may be forced to sell the property before their plans. If one has a property loan then he/she should have liquid corpus of 4–6 months to tide over bad times.
6) Huge purchase cost (stamp duty, registration, GST)
The combined purchase cost of property is almost 11% for under construction property and 6% for completed units. Since the purchase costs is paid at the start of investment, it increases the loan amount for under construction units.
So while this difference may not matter much in bull market, the cost pinches a lot in bearish market and lower investment tenure. Hence under construction units will have much higher sunk in costs and should be generally avoided in bearish markets or shorter tenure investments.
7) Ability to book loss
Even the best laid plans can go bust due to various reasons. So any investment should have a stop loss strategy to get out of the investment if things go wrong. But humans by nature are very averse to loss. This tendency is common across various investment types and pushes us towards inefficient decisions.
A buyer typically counts all the amount paid for the property and wants to recover that cost in most of the cases. The situation is exaggerated when the property has a loan over it and the instalments keep adding to the costs. This ensures that the breakeven cost for the property/land keeps rising and people keep holding to properties.
It can be explained by a simple example. Lets assume two friends bought a property worth 70 lacs each with one investing the entire amount without loan while the other has a loan and pays 52,000 net from his pocket. Their summary will be as follows:
Now lets assume that the property price increases to 80,00,000 and prices looks stagnant after 5 years. Although both should quit the investment in such a case, the person without loan is much likely to quit because his total cost is 70 lacs compared to 89.6 lacs for other person.
So while the person without loan has also lost due to loss of opportunity cost most of us only include the cost that we paid and want to avoid loss at any cost. Hence the person with loan may keep waiting to cover his costs and get deeper into the problem.
Conclusion
Although the market is the biggest factor in deciding the return for real estate investment, the returns can be amplified by factoring rentals and taxes calculation. A well prepared strategy helps to tide over the bad times easily and prepares to reap the benefits when the markets recover.
But whatever is the plan we need to remember that anyone of us can go wrong and we need to book our losses even if its painful. Remember hope is never a strategy.
We will cover further points in our next blog in this series.
