Investing in Rental Real Estate: Many a Slip Betwixt Cup and Lip

By admin | 18 May, 2014 7:23am

In India, investing in real estate with a view to renting it out is a popular practice. The biggest point in favor of such an investment is that it fetches you inflation-adjusted return: rentals get revised upward as time goes by. However, such an investment is not entirely without its pitfalls. We shall first discuss residential property and then turn to commercial.

Buying the right property

Before buying a residential property for renting, check out the level of demand in that area. If too many flats are lying vacant, you may not get the level of rent you expect.

Buying a property that is close to, or has good connectivity with, an important employment or educational hub ensures that you find tenants easily. Buying one in an area that is host to large multinational and Indian companies (e.g., the DLF area or Golf Course Road in Gurgaon) is also likely to ensure a ready stream of tenants and high rentals.

According to Pradeep Mishra, a Gurgaon-based real estate analyst, “A property developed by a high-quality builder is likely to fetch higher rental, since such builders provide better maintenance after handing over possession. Availability of public transportation also enhances rental value. In recent years, rental rates have shot up in all the colonies within the National Capital Region (NCR) that got Metro connectivity.”

Return on investment:Do not have exaggerated expectations regarding the return on investment (RoI) from residential property. In India the RoI usually ranges from 3 to 5 per cent.

A water-tight lease agreement:The landlord-tenant relationship is governed by the Rent Control Act. This Act is tilted overwhelmingly in favor of tenants. To circumvent it, go in for an 11-month lease, which you can subsequently renew. Any lease of 12 months or more comes under the Rent Control Act. An added advantage of a short lease period is that you can demand a revision in rental at the time of renewal.

With an 11-month lease, you are in a better position to evict the tenant in case of breach of agreement: if he does not pay the rent for three months, damages the property, or sublets it to another party.
Make sure that all the important elements of your contract with the tenant are mentioned in the lease agreement: the address of the property, the lease tenure, the notice period, amount of security deposit, mode of payment, responsibility for paying electricity and water bill and maintenance charge, and liability in case of damage to the property or furnishings. Whether the tenant is entitled to use the car parking space (exactly how many slots) and club facility should also be mentioned. The percentage enhancement in rental at the time of renewal may also be put into the document.

Police verification : Before giving the property on rent, get police verification of your tenant done by submitting the latter’s identification papers. In most big cities this has now become compulsory.

Mode of payment :You may ask for post-dated cheques for 11 months and security deposit equal to three or four months’ rent. When the tenant is leaving, inspect the property. If you find any damage, deduct the cost of repair from the security deposit.Let us now turn to commercial properties.

Renting commercial property
If you buy a commercial property that is still under construction (when the capital value is low) and possession is about three years away, you may earn a rental return of 12-14 per cent. If you buy closer to the time of possession, the capital value will have shot up. Your RoI will then not exceed 6-7 per cent.
Besides demand-supply dynamics, your rate of return will also depend on the nature of the tenant. For instance, landlords are willing to settle for a lower rate of return if they are renting their premises to banks, which are perceived to be safe and reliable tenants.

Check the level of demand before purchasing. According to Veer Sardesai, CEO of Pune-based Sardesai Finance, a financial planning firm: “In many parts of India commercial property is going abegging. Malls are ready but have no occupants. A property may look prime but you will find shops playing musical chairs within them because they don’t get adequate business.”

As in the case of all real estate purchases, give primacy to location. Says Mishra: “If the area is still under development, get to know what infrastructure and other facilities will be developed there. The future value of your property will depend on this. When the area is still under development, rentals tend to be low. Only when it is fully developed do rentals touch peak levels.”

Retail space: When purchasing retail space, make sure that it is easily accessible. Availability of parking facility is another important criterion. Within malls a shop on the ground floor is easy to rent and fetches good rental. Check the availability of residential housing in the vicinity. Only if there is a catchment area with lots of buyers within a radius of three to five kilometres will the mall get adequate footfall.
If the mall’s developer enjoys a reputation for quality, he will be able to pull in a large number of brands. Smaller builders have to work much harder to get leading brands to occupy their malls. Once a few good brands come in as anchor tenants, your shop will also manage to find a tenant at a good rental rate.
Office space: In most commercial properties, tenants look for a longer lease of three years or more, since they want a stable address for their business and would also like to get adequate time to recoup the expenditure incurred on doing up the interiors. Usually leases are done for 1+1+1 or 3+3+3 years.
Often large-sized floor plates are rented to big companies. The ownership of the floor plate may be divided among a hundred buyers. Buyers give up their leasing rights to builders, who in turn find a single large client for them. The developer charges a fee for his service. The advantage of this arrangement is that each individual owner doesn’t have to find a tenant for himself. However, in such agreements the owner does not have a say in the terms of the lease agreement. He cannot, for instance, refuse the rental rate that the developer obtains for him.
When buying a commercial property, find out its defined usage: is it an IT-enabled building or a commercial building? If it is an IT-enabled building, you will not be able to rent it out to non-IT companies. Will you be able to get IT clients in that locality?
If the building is new, does the developer have a completion certificate? Completion certificate takes a lot of time to obtain, so developers sometimes go in for self-certification from an independent architect. Be warned that this is not adequate.
Finally, make sure that you don’t buy a property at an exorbitant price. If you do so, you will perforce have to demand a high rental, and will then encounter problems in finding tenants.
Assured-return schemes: At the time of selling the property, the developer may offer an assured return to you for the period of construction and for three years (or more) after construction.
Remember that the assured return is only for a certain period of time. After that it will be your job to find a tenant. Do adequate due diligence to find out if the property will be able to attract a tenant at an attractive rental rate (once you are on your own).
Usually the capital value charged by the developer in an assured-return scheme is higher than the prevailing market price. According to Rajan Ahuja, director at Gurgaon-based Realty & Verticals, “What the developer pays out as assured return, usually he first extracts from the buyer as capital value of the property.”
Revenue sharing is also in vogue. Suppose that the developer promised you a rate of Rs 50 per square foot but is able to find a tenant at Rs 60 per square foot. In that case, he will take a part of the incremental rental. Before purchasing find out what will be your share in the incremental rental.
Besides higher costs, assured-return schemes have other disadvantages as well. The buyer hands over the leasing rights of the property to the builder and he also does not get physical possession for those years. He can also not dictate the terms of the lease agreement, which is signed between the developer and the tenant.
The advantage, however, is that the property gets leased out for a long period of time initially.
Pre-rented properties are also available for investment. Suppose that the property is of one lakh square feet and its ownership is divided among 50 people. Someone may want to sell 5,000 square feet. When you buy such a property, get it registered in your name. Also, check the lease agreement between the developer and the tenant for any clause that may be unfavorable to you.

Caveats for buyers of rental property
Before you buy a property—residential or commercial—with the objective of renting it out, acquaint yourself with the potential pitfalls. Most people, for instance, believe that rental income will pay for the equated monthly installment (EMI). Says Sardesai: “This does not usually happen. If that were true, the tenant would have bought the house and paid the EMI instead of renting it from you.”

Rental property sustains damages. Tenants are usually not as careful with rented property as they would be with their own. That is an additional cost that the owner may have to bear.

There is also a small risk of loss of ownership. Not every tenant will be a gentleman and will honor the rental agreement. If the tenant refuses to vacate the property when the lease expires, you will have to go to court and spend money on lawyers. You will also sustain loss of rental income during the period of litigation.
Finally, spend only a standard amount, and not excessively, on fittings and amenities. What is considered fashionable today loses its charm a few years down the line. You may earn a high rental for the first year or two, but after that your fittings will be considered outdated and the rental income will decline. Bear in mind that the price of land appreciates but the value of the building depreciates as time goes by. Hence, the larger part of your investment should go into the purchase of land, and less into the purchase of the structure.
Factor in all these aspects before you decide to invest in a rental property.

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