Tuesday, 25 January, 2011

Real Estate as an Investment - Part 1

Real Estate as an Investment - Part 1

The great Indian Middle Class has one major dream - Buy a house for posterity. This has further led to a logical extension: Real Estate, especially in our urban centres and growing cities, is a great investment.

While it is indeed a logical extension, is it a valid one? If real estate is bought for emotional reasons such as "A roof over my head", "A nice home to leave behind for my spouse and children after my time", etc., it is a different matter. If however, it is viewed as an investment, we must analyse the same from the point of total returns from the time of procurement till the time one exits the investment.

I decided to delve a bit deeper into the subject, and found something interesting.

Here are the details:

  • I did a quick, completely unscientific random sample-based study. Checked out from a few of my friends about the price they paid for the flats that they bought 10, 15, 20 and 30 years ago in the cities of Chennai, Coimbatore, Bangalore & Hyderabad. I also asked them about the estimated present resale value of the very same flats.
  • Without exception, the rental yield on each of the properties was much less than 1-2% per annum on an inflation adjusted basis for ALL the persons. And here, I'm talking about the official inflation figures rather than the real inflation faced by you and me when we go out to buy groceries, vegetables, toothpaste, movie tickets, etc.
  • Taking into account the PRESENT resale value, the rental income accrued, and the interest cost incurred on Home Loans over the years, the effective annual yield on the original investment ranged from a low of around 7% to a high of 16%. The "16% per annum" yield had materialised for someone who had "Got lucky" by entering into a location which was completely undiscovered, which later on turned out to be a hot-spot due to the establishment of offices of several Infotech companies in that area.
  • In almost all cases (except one instance, in fact), the net present value of the rent collected over the years was less than the corresponding net present value of interest cost incurred on home loans.
  • In each and every case, Real Estate had proved to be better than stuff like fixed deposits and had also generated inflation-beating returns.
  • In each and every case but one, the friends had not sold off the property that they had bought for "investment" purposes. In the solitary instance of the person who sold it, he did not regret the decision, as it had helped him to fund the professional education (including overseas education) for his children, without any loans.
  • In each and every case, the returns generated from Real Estate was LESS than the returns generated from a hypothetical investment made in benchmark Indices / reasonably performing mutual funds

Moral of the story:

  • Real Estate is an excellent investment for ordinary investors to beat inflation. It is much better than routine bank deposits
  • Real Estate generates CONSISTENT returns
  • Real Estate UNDERPERFORMS stocks and equity mutual funds

Theoretically, savvy investors ought to have a significant preference for Real Estate over Bank Deposits. At the same time, they must have a strong bias for investments in shares and equity mutual funds over real estate.

However, in practice, we've found that EVERY person who invested in real estate for investment purposes has done extremely well financially. In contrast, most stock market investors have ended up "burning their fingers" and ended up with ("At best") mediocre returns. This is based on anecdotal evidence that I gathered by interacting with several friends and relatives about their experience with their investment in shares and equity mutual funds.

Intuitively, our Middle Class Indians seem to have got the conviction about the validity of the above "Practical reality". This is corroborated by

  • the limited number of persons who invest in shares as well as
  • the limited percentage of their net worth being invested in shares and mutual funds.

Why? Why is it the case?

Why does Sensex outperform real estate consistently, but stock market investors underperform real estate investors?

For answers, please visit this blog again after a few days. There is a very interesting basket of reasons for this paradox!



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