Tuesday, September 07, 2010

Real Estate, be Realistic!

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.