$11 MILLION. 1422 Nelson Avenue (between West 172nd Street and Edward L. Grant Highway). Highbridge, Bronx. A private investor has bought this 1928 six-story, 70,500-square-foot elevator building with 72 large rent-stabilized apartments: 48 one-bedrooms, 18 two-bedrooms and six three-bedrooms.

How is buying a plot/house in India better than investing in mutual funds/shares?

Buying a plot or house is NOT better than investing in mutual funds purely for investment reasons.

Checkout this conversation posted by Ishan Bansal on evaluating real estate vs equity investments.

“I am always for equity investment and my dad is for real-estate investment. We had this debate multiple times.

Finally, last year we did some number crunching and I finally convinced him that equity is better.

Returns on Investment

Dad: We sold a house in Chandigarh for 6 Lac in 1988 and now it’s valued at 4 Cr so almost 70x. Can equity give such returns?

Me: Let’s look at Sensex in 1988 it’s was ~400 and now it’s ~ 28000 so almost so if you would have invested in Sensex also you would have got 70x

Dad: Might be a coincidence, We bought a commercial plot in Gurgaon for 8 Lac in 1989 and now it’s valued at 4 Cr so almost 50x.

Me: Let’s look at Sensex in 1989, it’s was ~700 and now it’s ~ 28000 so almost so if you would have invested in Sensex also you would have got 40x

Dad: See real-estate generate higher returns than equity

Me: This is not a fair comparison, due mainly 2 reasons

  1. You are not taking into account tax impact

So, if you consider 20% long term capital gain tax your 70x will go to ~60x and similarly that 50x will to ~43x

2. You are looking at best of the lot property investments whereas I am looking Sensex which is a generic measure

I really liked one stock Eicher Motors (bullet fan) do you know that this stock was priced at ~50 in 2000 and today it’s price ~24,000 that’s ~ 500x.

Dad: Ok, But I don’t know which stocks are going perform like Eicher Motors whereas in real-estate I understand the dynamics.

Me: I know that’s why I never recommend you to put money directly in stocks. You should buy equity mutual funds. Let me give example of couple of old funds to show their returns

  1. Birla Sun Life Tax Relief 96: Invested amount from Mar-1996 to Feb-2017 would be 110x which is ~25% YoY. The tax benefit is over and above this.
  2. Franklin India Prima Plus Fund: Invested amount from Dec-1993 to Feb-2017 would be 81x which is ~21% YoY.

Overall, mutual funds have provided 3-7% extra returns. I recently did a study of this that you can check-out here.

Risk on Investment

Dad: These returns looks great. But what about the risk. You know real estate rarely goes down.

Me: That’s not true. Do remember that we checked the price of the same house that gave you 70x returns before and during the recession. It was almost down by 50%. Equity mutual fund was down ~60% so slightly higher but not a huge difference.

Also, if you think about other issues like

  • Liquidity: Buying/ Selling house is very difficult especially in down market. Sometimes it takes almost a year.
  • Transaction cost: It very high due to registration cost (~5%)
  • Capital Requirement: You need to have crores of Rupees to invest in real-estate and possibility of diversification is almost NIL.

Future

Dad: Historically, this is fine but how can you say if this could continue in future as well.

Me: After spending hours to think through this, it comes down to basics. Both real-estate and equity are investments and their returns can be divided into two parts:

Real-Estate

Equity

1.

Rental Yield

Dividend Yield

2.

Capital Appreciation

Price Increase

Dividend yield (Dividend earned on shares divide by value of the shares) for Sensex is around 1.5%. This net of all taxes etc.

Rental yield (Rent earned on property divide by the value of the property) in India is around 2-3%. Let’s take 2.5% but after deducting income tax, property tax, maintenance, etc it goes to ~1.5%. Almost same as dividend yield.

Price Increase depends on two factors P/E (Price of share divide profit per share) and earning growth. If we assume P/E to constant, we only need to project earning growth. It will fair assumption that in long-run earning growth will be at least sum of real GDP and inflation.

GDP

7%

Inflation

5%

Earning Growth

(GDP + Inflation)

12%

Capital appreciation (increase in the price of the property) depends on rental yield and increases in rent. If we assume rental yield to be constant, we only need to understand an increase in rent. I have mostly seen a growth of 5-10% in rent. So, if you believe that rent can grow by more than 12% real-estate can perform better but it’s unlikely.

Real-Estate Rental/ Dividend Yield

1.5%

1.5%

Total Returns

9.5%

Equity Price/ Capital Appreciation

8%

12%

Total Returns

13.5%

Dad: Hmmm, I suppose equity looks better as an investment option.

Why buy a house

Dad: But, there are other benefits of buying a house.

  • It provides a sense of security
  • It provides stability (no need change houses)
  • You will create memories

Me: That was my point all along that investing in real-estate might not be a great idea but I completely agree with you that buying a house to live in is.

I think in the country like India, we can’t depend on the country to provide for basic necessities. Hence, everyone wants security in their life especially with respect to Food, Clothes, and House (Roti, Kapda and Makaan). I think it’s that instinct that plays a huge role when we make real-estate investment especially a house.

Happy Investing!