One of the most prominent alternative investment options today is Commercial Real Estate (CRE) which offers a wide range of benefits to the investors like recurring annuity income, a hedge against inflation, the safety of capital, favorable tax treatment and an opportunity to make an upside on capital appreciation. Here are a few reasons why CRE should be in every investor’s portfolio:
CRE is one of the few asset classes that provide regular monthly income to the investor. Most multinationals and Indian corporates lease commercial properties that pay rent in advance at the beginning of every month. More often the tenants in India sign a nine-year lease with a three-year lock-in and spend significantly on the fit-outs, which means that the instances of them vacating is very low.
This regular rental income can be channeled further into equity SIPs or used to meet certain household expenses.
The rental yields (also known as capitalisation rates) gained from CRE investments are 7 to 10 per cent per annum depending on the quality of the location and asset. These returns are way higher than fixed deposits and at par with AAA-rated bonds issued by blue-chip companies.
Over a certain period, CRE also appreciates, in addition to the rental yield. The value derived from any real estate asset is through ownership of the underlying land, which appreciates steadily over time. CRE in India has returned 16 per cent and 15.3 per cent CAGR over the past five years and 10-year period while the Sensex has returned only 13.4 per cent and 10.8 per cent over the same periods
Commonly, investments fail the test of inflation, (the rate of the cost of goods and services increase in the economy). The effects of inflation are often imperceptible as it erodes the value of investments slowly over time and is therefore ignored by many investors. The lease of commercial properties is structured to factor inflation with a built-in escalation clause that sets the rate at which the rent increases every year or every three years (generally per cent per year or 15 per cent every three years). This means that the return on investment goes from 8 per cent in year 1 to 8.4 per cent in two years and 8.82 per cent in three years and so on. As in the case of CRE, there are very few products that link returns to inflation.
From a tax perspective, a CRE investment is categorised under income from house property where investors get a standard deduction of 30 per cent on rents. This means that the effective tax rate for rental income reduces to 21 per cent (On rents of Rs. 100 after an Rs 30 standard deduction, 30 per cent tax needs to be paid on Rs 70 = Rs 21, which is an effective tax rate of 21 per cent). Further, the interest can be set-off against rent, thereby reducing the tax to zero per cent, if a loan is taken by the buyer. Furthermore, the capital gains on the sale of commercial property are taxed only at 20 per cent, which is after allowing for inflation indexation. From a tax perspective, this makes this asset class very lucrative.
The author is the Co-founder and Chief Executive Officer at PropShare Capital.