Differentiating Asset Vs. Liability?
Asset Vs. Liability
Using this simple and practical definition, your home is a liability because it takes money out of your pocket each month in the form of a mortgage, taxes, insurance, and maintenance costs. It does not put money in your pocket. Only if you’re able to sell it at a profit does it become an asset. Many people impacted by the Great Recession discovered that their house was a liability when they were foreclosed, sold on a short sale, or sold at a loss.
Conversely, a rental house can be an asset, if you do your due diligence correctly and are able to collect more rent than you have costs each month. The difference between the rent and the expenses is the net operating income, and it is cash flow that flows into your pockets each month. Therefore, it is an asset.
There is a simple test: if the real estate pays you money, ( rents minus expenses and mortgage payments, leaving positive cash flow) it’s an asset.
If you pay out money for your real estate, such as a cottage you buy for your own use, and pay realty taxes, insurance, utilities, maintenance, repairs, and mortgage payments ( even if you rent it a tiny bit on Arbnb, but still have overall negative cash flow)it’s a liability.
So your real estate can be categorized as an asset or a liability depending upon whether it is helping you in generating money or hurting you by taking money out of your pocket. Let’s go through below examples to find it out.
John buys a ready-to-move in apartment in Bangalore with a mix of his own funds & bank loan (commercial in the table below) for self use.
As the apartment is for self use John will get a tax deduction on $ 1.5 Lakhs per year. Assuming he is in 20% tax bracket he will save $ 30,000/- pa or $ 2,500/- per month which is negligible when compared to monthly EMI of $ 35,800/- So there is a net outflow of $ 33,300/- per month for John, thus making it a “liability” on an ongoing basis. It is a classic case of bad debt which creates a liability on middle class which lasts for almost two decades.
John buys the same apartment for rental income & not for self use.
From the above table you can see that John is paying an EMI of $ 35,800/- against a rental income of just $ 12,000/- As the apartment is not for self use John will get tax deduction on the entire interest expenses. Assuming $ 3,00,000/- as interest expense for the first few years Rahul gets a yearly tax savings of $ 60,000/- (20% tax slab) i.e. $ 5,000/- per month. Thus, total monthly income for John is $ 17,000/-
We can see that this investment is taking out $ 18,800/- per month from his pocket! As the first table on Asset & Liabilities indicates that on an ongoing basis this property is a “liability” & NOT an asset. So those who wants to invest in an apartment for rental income only will find it a losing proposition! John would be better off putting his money in FDs or Debt Funds.
John invests for both rental income & capital appreciation i.e. he plans to sell the apartment after 5 years (makes him eligible for long term capital gains & freedom from reversal of tax benefits on interest expenses).
Let’s evaluate the investment from the other definition of asset which is “resource from which future economic benefits are expected to flow to the enterprise” or individual”.
Assuming an average property appreciation of 5% pa, the price of apartment at the end of 5th year shall be $ 4000*(1+5%)^5 i.e. $ 5100/- per sq ft.
As we can see in the above table return on investment over a period of 5 years zoomed to 21% per annum which is quite high. In Indian context Real Estate makes a good investment only when you exit your investment.
However there is a flaw in the above calculation – what if there are plenty of options available especially newer units in the same location at the same price of $ 5100/- per sq ft? In that case there would be a discount applicable to an older resale property which is typically around 5 to 10%. When you apply this discount to the current market price your entire gains would be wiped out!
As a thumb rule unless capital appreciation is equal to or more than cost of borrowing there is very little chance of making a significant return in real estate. People should not get into real estate investment without understanding the economics of returns. It is very important for the investor to understand not only the current market dynamics but also that of future to plan his exit. Real Estate is no longer a high return investment and wealth creator it used to be 5 years ago. On the contrary it could become a huge liability if bought during “wrong time” & at a “wrong price”.