Real Estate has traditionally been one of the most preferred asset classes when it comes to investment and it continues to be preferred asset class even today. Distinguishing factors about investment in this asset class are availability of a tangible asset, hedge against inflation, possibility to leverage and tax efficient.
Lack of transparency, different tax regimes across states and asset classes within RE requires an understanding of one-time and recurring costs associated with this asset. A prudent investor computes return on investment considering all these expenses over the holding period.
One-Time Costs (Transaction Costs)
One-time costs include the costs applicable at the time of executing the transaction. These include fees payable to the government as well as facilitation charges payable on closure of the transaction.
Following are the transaction costs associated with real estate investments:
1. Stamp duty & registration costs:
All investors need to incur stamp duty and registration charges which varies from state to state. For example, in Karnataka, the stamp duty and registration charges are 6.72% of the total sale consideration or government guidance value whichever is higher. Stamp Duty & registration charges also vary based on the ownership of the property.
2. Due-diligence charges:
Investor needs to conduct due diligence including title, regulatory, lease audit, physical check, utility audit and others. Type of due diligence required varies as per size and type of asset. DD charge can vary between nominal fixed fee to 2% of the sales consideration. DD charges also attracts GST of 18%.
3. Brokerage Fee:
If the transaction is sourced through brokerage firm. The transaction cost includes brokerage fee of 2% of sales consideration plus GST charges (if applicable).
4. Transfer Fee:
This is applicable in case of an under-construction property where in an existing property owner intends to sell the property to a new buyer, prior to registration of the property. This is usually charged by the developer or the Housing society. Ownership transfer fee is usually in the range of 0.5% - 2% of the property value under consideration.
5. Financing Charges:
If one intends to raise loan for the property, there are due-diligence charges and processing fee associated with the same. Some financial institutions charge a lumpsum processing fee while a few charges anything ranging from 1% to 2% (plus GST) depending upon the quantum of funding. And, if one has employed consultant to source the loan, there will be a brokerage fee of 1% - 2% of the loan amount exclusive of GST.
Transaction costs does not include any improvement costs and document sourcing charges if required for the property. As per our experience, investor can allocate 10% of the total sales consideration as gross transaction costs except leverage/ financing costs for all computation.
Note: If one purchases an under-construction asset, GST payable on construction cost is part of sales considered not transaction cost.
Annual Operating Expenses
1. Property Tax:
Annual property tax is payable for all real estate assets. The quantum of property tax varies based on age of the property, type of asset, jurisdiction, location, and other factors.
2. Insurance charges:
Investors are advised to take necessary property insurance for the property. The charge is based on risk covered and age of the property. In general, the insurance premium varies between INR 0.5 per sqft and INR 1.5 per sqft.
3. Property Management Fee:
If a property management firm is managing your investments, they charge an annual fee Largely based on the size and age of the property. The property management fee varies anywhere between 3% and 5% of the monthly rental value.
4. Security charges:
For land investments, one needs to employ a security agency or individual for security purpose.
As per our experience, for leased assets, one month of property rentals is annual operating charges. There are other intangible costs like vacancy costs (loss of revenue due to vacancy) and leasing costs (brokerage fee) for reletting of the property whenever required.
It is important to understand here, sinking fund: In a few instances, the developer or the owner’s association collects periodic sinking funds for structural / civil repairs or upgradation of the property. The funds collected as a part of sinking fund earns interest. The funds collected towards sinking funds is either collected annually or once in three / five years depending upon the age of the property.
Therefore, it is important for investors to compute Net Operating Income (NOI) for computing rental yield of the property. The one-time charges/ transaction charges are payable once and therefore it is spread over the period of investment. One time and recurring costs are unavoidable in case of a RE transaction. Understanding and accounting these prudently will help investors evaluate return on investments accurately.