Equity Mutual Funds Vs Real Estate investment
Disclaimer: I am NOT saying that real estate is a bad investment. What I am trying to say is Real Estate is just like any other asset class and make an informed bet when you put your life's savings into it. It may bring you handsome returns which no other asset class can but it can also give you lousy returns or worst put you in a debt trap.
The analysis below applies for “Residential Real Estate as an investment”. If you are buying your first home to live in, this is not applicable because then Real Estate for you in NOT an Investment, it’s an EXPENSE!
Returns
Equity diversified mutual funds
An equity diversified mutual funds could give you 15% compounded annual growth (CAGR) over the long term and that too tax free.
i.e. Money doubles every 5 years, i.e. 16 times in 20 years.
Some MFs (Like HDFC Top 200) have even given 25% CAGR from 1995 till today while many have not. If you do a little bit of reading, investing in good MFs and cashing out of lousy funds and investing into good ones from time to time isn’t difficult at all.
Residential Homes
Inflation Index for 1981 –> 100,
Inflation Index for 2009-10 -> 711 i.e. 6.75% CAGR
Real Estate is taxed @ 20% with indexation (considering inflation) or 10% without indexation.
So a property of Rs. 100 if becomes x in 20 years (1981-2010), would be taxed as if its cost price is 711 meaning the tax would be charged only on the appreciation above 711.
Because of the taxation, for real estate to match the expected MF returns, it should grow by 16.65% CAGR over 20 years.
i.e. 2 times in 4.5 years, 16 times in 15.4 years
This is when you have all the money today, in cash.
BUT
Unlike MF Systematic Investment Plans (SIP), Residential Housing is mostly bought with leverage, i.e. with a housing loan of average rate 10% which comes to 7% because of the tax benefits
So For Real Estate to match MF returns, it should grow by 16.65 + 7 = 23.65% CAGR over 20 years.
i.e. 2 times in 3.26 years, 16 times in 13 years!!
Buy real estate if you think it will be 16 times in 13 years.
i.e. the 50 lakh flat you are buying should be 1 Cr in 2013-14, or 8 Cr in 2023 !!!
Rentals
Rental income is minuscule compared to the property value. A 50 lakh (1000 sq. feet) 2 BHK flat in Pune may give you 10k at best, i.e. 1,20,000 per year.
Expenses:
Society Charges: Rs. 2 / Sq. Feet per month (Rs. 24000 per year)
Property tax: Rs. 4 / Sq feet per year (Rs. 4000 per year)
Maintenance / Repairs: Rs. 2000 per year
So Net Rental Income: 120000 – 24000 – 4000 – 2000 = 98,000 per year which is 1.96% per year which is also uncertain as flats remain unoccupied at times.
Interestingly, this rental income does not get compounded as it gets used for other expenses.
Risk
Real Estate has some inherent risks which are significantly more than equity mutual funds
1. Leverage
In Buying a home, you are on a debt of your lifetime, an Equity MF SIP is without debt.
2. Liquidity (How fast can you sell your investment and at what price when you want to) You may think Rates in a locality have risen from say 2500 to 5000 per sq. feet. But that does not mean you can sell your flat at 5000 rate. Just try it!
3. Diversification (not all eggs in one basket)
4. Price Discovery (Getting the right price in the market and not being fooled by a one off price by someone, somewhere)
5. Legalities & Possession (Eventualities like encroachment, irregular records, double selling of a single property etc)
6. Ease of dealing (Buying, selling, storage, renting and broker hassles)
Equity Risks are also great. Managing that risk is a topic in itself but most of it is being transferred to the Mutual Fund; you need to manage the rest.
The ‘Permanent source of income through rent’ argument
It is argued that a house would give me permanent source of income at retirement through rental income.
If you have 50,000 per month to invest,
Option 1:
Buy a house with a home loan at average rate of 10%. Grow it by 23.65% CAGR. Then get 2% rental yield at retirement pre tax.
Option 2:
Put that money thru a SIP in equity. Grow it by 15% CAGR. When you approach retirement, get all accumulated money slowly into debt & bank FDs and get 6 % post tax yield on your money.
No prizes for guessing which is better!
Both asset classes are co-related over a long term
If you believe Real Estate is going to grow no matter what, why do you believe so? The value of Real Estate could be thought of derived from two things.
1. The shelter it provides
2. The access to economic activity it provides
So, the second point actually gives us an idea why property in Mumbai / Pune is growing the way it is today. In the long term, if India grows at 8%, there will be tremendous economic opportunity created which in turn will make real estate costlier everywhere, more so in areas which provide better economic activity.
Enhanced economic activity in turn means growth of companies and hence growth of equity markets and also growth of jobs & salaries.
Speaking of averages, if you think equity markets may fail to give you returns over a 20 year term, don’t expect your real estate to give you returns as well. May be don’t expect your job to be there as well. And then what will happen to your home loan?
Look at Real Estate & Equity returns in USA or Japan over the last 20 years. And you will see clearly what I want to say.
Equity markets and Real Estate markets in the end are both dependent on the Indian growth story.
Conclusion
1. If you want to bet on Real Estate, understand that you are taking a BET, just like any other asset class (like stocks, bonds, Gold etc.).
2. Analyze, understand and invest. The property ought to become 2 times in 5 yrs (if you have cash) or 3.26 yrs(Loan) and 16 times in 20 yrs(cash) or 13 yrs(loan) at least!
3. Don’t over leverage. Too much loans can bring you down.
4. Treat Real Estate as any other asset class. If you wanted to buy 50 lakhs worth of stocks today, won’t you be targeting 15% CAGR over a long term? Think the same when you buy real estate.
5. Real Estate is for real, but the gains may or may not be, beware!
All this requires disciplined investment. Period. Saying that I require a ‘Home Loan Stick’ to make me save 50,000 per month, or it requires an illiquid house as an asset so that I do not sell it off like I would a mutual fund is making a fool of yourself.
Happy Investing!
P.S. I just used some basic concepts like compound interest, income tax and risk/return trade off to analyze the real estate asset class. I may be wrong and would be extremely glad if somebody points out logical errors in the argument. All figures used are approximate.
Disclaimer: I am NOT saying that real estate is a bad investment. What I am trying to say is Real Estate is just like any other asset class and make an informed bet when you put your life's savings into it. It may bring you handsome returns which no other asset class can but it can also give you lousy returns or worst put you in a debt trap.
The analysis below applies for “Residential Real Estate as an investment”. If you are buying your first home to live in, this is not applicable because then Real Estate for you in NOT an Investment, it’s an EXPENSE!
Returns
Equity diversified mutual funds
An equity diversified mutual funds could give you 15% compounded annual growth (CAGR) over the long term and that too tax free.
i.e. Money doubles every 5 years, i.e. 16 times in 20 years.
Some MFs (Like HDFC Top 200) have even given 25% CAGR from 1995 till today while many have not. If you do a little bit of reading, investing in good MFs and cashing out of lousy funds and investing into good ones from time to time isn’t difficult at all.
Residential Homes
Inflation Index for 1981 –> 100,
Inflation Index for 2009-10 -> 711 i.e. 6.75% CAGR
Real Estate is taxed @ 20% with indexation (considering inflation) or 10% without indexation.
So a property of Rs. 100 if becomes x in 20 years (1981-2010), would be taxed as if its cost price is 711 meaning the tax would be charged only on the appreciation above 711.
Because of the taxation, for real estate to match the expected MF returns, it should grow by 16.65% CAGR over 20 years.
i.e. 2 times in 4.5 years, 16 times in 15.4 years
This is when you have all the money today, in cash.
BUT
Unlike MF Systematic Investment Plans (SIP), Residential Housing is mostly bought with leverage, i.e. with a housing loan of average rate 10% which comes to 7% because of the tax benefits
So For Real Estate to match MF returns, it should grow by 16.65 + 7 = 23.65% CAGR over 20 years.
i.e. 2 times in 3.26 years, 16 times in 13 years!!
Buy real estate if you think it will be 16 times in 13 years.
i.e. the 50 lakh flat you are buying should be 1 Cr in 2013-14, or 8 Cr in 2023 !!!
Rentals
Rental income is minuscule compared to the property value. A 50 lakh (1000 sq. feet) 2 BHK flat in Pune may give you 10k at best, i.e. 1,20,000 per year.
Expenses:
Society Charges: Rs. 2 / Sq. Feet per month (Rs. 24000 per year)
Property tax: Rs. 4 / Sq feet per year (Rs. 4000 per year)
Maintenance / Repairs: Rs. 2000 per year
So Net Rental Income: 120000 – 24000 – 4000 – 2000 = 98,000 per year which is 1.96% per year which is also uncertain as flats remain unoccupied at times.
Interestingly, this rental income does not get compounded as it gets used for other expenses.
Risk
Real Estate has some inherent risks which are significantly more than equity mutual funds
1. Leverage
In Buying a home, you are on a debt of your lifetime, an Equity MF SIP is without debt.
2. Liquidity (How fast can you sell your investment and at what price when you want to) You may think Rates in a locality have risen from say 2500 to 5000 per sq. feet. But that does not mean you can sell your flat at 5000 rate. Just try it!
3. Diversification (not all eggs in one basket)
4. Price Discovery (Getting the right price in the market and not being fooled by a one off price by someone, somewhere)
5. Legalities & Possession (Eventualities like encroachment, irregular records, double selling of a single property etc)
6. Ease of dealing (Buying, selling, storage, renting and broker hassles)
Equity Risks are also great. Managing that risk is a topic in itself but most of it is being transferred to the Mutual Fund; you need to manage the rest.
The ‘Permanent source of income through rent’ argument
It is argued that a house would give me permanent source of income at retirement through rental income.
If you have 50,000 per month to invest,
Option 1:
Buy a house with a home loan at average rate of 10%. Grow it by 23.65% CAGR. Then get 2% rental yield at retirement pre tax.
Option 2:
Put that money thru a SIP in equity. Grow it by 15% CAGR. When you approach retirement, get all accumulated money slowly into debt & bank FDs and get 6 % post tax yield on your money.
No prizes for guessing which is better!
Both asset classes are co-related over a long term
If you believe Real Estate is going to grow no matter what, why do you believe so? The value of Real Estate could be thought of derived from two things.
1. The shelter it provides
2. The access to economic activity it provides
So, the second point actually gives us an idea why property in Mumbai / Pune is growing the way it is today. In the long term, if India grows at 8%, there will be tremendous economic opportunity created which in turn will make real estate costlier everywhere, more so in areas which provide better economic activity.
Enhanced economic activity in turn means growth of companies and hence growth of equity markets and also growth of jobs & salaries.
Speaking of averages, if you think equity markets may fail to give you returns over a 20 year term, don’t expect your real estate to give you returns as well. May be don’t expect your job to be there as well. And then what will happen to your home loan?
Look at Real Estate & Equity returns in USA or Japan over the last 20 years. And you will see clearly what I want to say.
Equity markets and Real Estate markets in the end are both dependent on the Indian growth story.
Conclusion
1. If you want to bet on Real Estate, understand that you are taking a BET, just like any other asset class (like stocks, bonds, Gold etc.).
2. Analyze, understand and invest. The property ought to become 2 times in 5 yrs (if you have cash) or 3.26 yrs(Loan) and 16 times in 20 yrs(cash) or 13 yrs(loan) at least!
3. Don’t over leverage. Too much loans can bring you down.
4. Treat Real Estate as any other asset class. If you wanted to buy 50 lakhs worth of stocks today, won’t you be targeting 15% CAGR over a long term? Think the same when you buy real estate.
5. Real Estate is for real, but the gains may or may not be, beware!
All this requires disciplined investment. Period. Saying that I require a ‘Home Loan Stick’ to make me save 50,000 per month, or it requires an illiquid house as an asset so that I do not sell it off like I would a mutual fund is making a fool of yourself.
Happy Investing!
P.S. I just used some basic concepts like compound interest, income tax and risk/return trade off to analyze the real estate asset class. I may be wrong and would be extremely glad if somebody points out logical errors in the argument. All figures used are approximate.
4 comments:
You assumed that the investment in MF and the returns thereby will continue to remain tax free in the future. That only time will tell.Past performance is no guarantee of future results. :)
And do i see a Wealth Manager writing the blog and marketing his financial products over here. Btw, you didnt mention what happened to your story. Whether you yourself are investing in Real Estate?
@Mahen
Volatility is obviously much more in equity. Also, I feel with India's demand for real estate, we aren't going to see a US like situ any time soon, but after 15-20-25 years, who knows!
@Nilesh
Good way to hit back :)
First, I am a wealth manager. I sell equities as well as real estate and advisory fees in real estate is much more, so there isn't a conflict of interest!
Secondly, the Direct Tax code which is going to be effective FY2012-13 still says long term capital gains on equity is zero. Hence atleast in the forseable future, my analysis holds good. Even if it changes, it would mean 2-3 % difference but still my argument would prevail.
Parikshit - Very cool post, and I don't have the mathematical chops to dispute the numbers for CAGR you've come up with... but I do think your analysis misses a few - well, elephants in the room.
1) The ROI on real estate (especially residential) is not only financial. Since the dawn of civilization, mankind has associated stability and "settling down" with owning a "home". People like me who invest in real estate FIRST decide they want to buy a home - it is not a rational decision based on the liquidity on your portfolio or computed CAGR, but often a function of self-image/ peer/ family expectations. It's ROI is emotional.
Residential real estate is never (by the lay man) compared with other asset classes (esp equity) as an investment option. As for the super-affluent who can afford to do so - they will in my estimation view it as a way to diversify/ lend stability to their portfolio, so it isn't an either/ or choice for them anyway. They will invest in equity AND fixed income AND real estate assets.
2) Residential real estate is always an ASPIRATIONAL investment. Around the world you will see a majority of the people investing in real estate as an expression of who they want to be, not who they are. Therefore, more often than not, investing in real estate is a function of how much CAN you invest, not of how much (or whether) you SHOULD invest.
I guess I'm saying while your math is sound, you assumptions are fundamentally flawed in that they are RATIONAL :) Whereas the people you are talking about obliquely are most definitely NOT.
Having said that... why isn't commercial real estate part of your consideration? I'd love to read some numbers on the CAGR per sq ft. for commercial vs. residential real estate!
@Hrishi, I was expecting a comment from you first up, and here it comes :)
The first para of my post says "If you are buying your first home to live in, this is not applicable because then Real Estate for you in NOT an Investment, it’s an EXPENSE!". So if you buy real estate for your own living then I agree with your non-financial ROI concept, even I aspire to to buy such a home soon. BUT, I have seen several people (especially the upper middle class neo rich) putting in all their saved as well as future earnings into residential houses (not 1 but 2,3 houses) purely as an 'investment' thinking that equity or anything else is 'virtual & volatile' while real estate is at least real. My whole criticism is towards this sort of blind faith in real estate.
Real Estate is called an 'aspirational asset' after you have done making your 'protection' and 'growth' assets, i.e money to help you in a rainy day and long term wealth creation. This aspirational asset class cannot and should not be your primary investment, according to financial theory.
And yes, I will try to analyze residential vs commercial real estate soon. Because commercial RE is a lot varied, it needs to be looked into much more in depth before we come to any conclusions.
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