I have always been partial towards equity investment and my Father, towards real-estate investment. We keep debating on this topic.
Finally, last year we did some number crunching and I convinced him that equity was better.
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Returns on Investment
Dad: We sold a house in 1998 for 6 lakhs and now it’s valued at 4 crores, so it is almost 70x. Will equity ever give you such returns?
Me: Let’s look at Sensex in 1988, it was ~400 and now it’s ~ 28,000. Suppose you had invested in Sensex, you would have got 70x. You would have also been free from the unnecessary hassle that surrounds real estate.
Dad: That could have been a coincidence as well. We bought a commercial plot in Gurgaon for 8 lakhs in 1989 and now it’s valued at 4 crores. It is almost 50x.
Dad: See, real-estate generates much higher returns than equity!
Me: That is not a fair comparison, mainly due to 2 reasons:
- You are not taking tax impact into account.
2. You are looking at the best property investment, whereas I am looking at Sensex, which is a generic measure.
I really liked one stock, Eicher Motors (bullet fan), do you know what amount this stock was priced at? It was ~50 in 2000 and today, its price is ~24,000 that’s ~ 500x!
Dad: Okay, But I don’t know which stock can perform as good as Eicher Motors. Whereas in real-estate, I will understand the dynamics.
Me: I know, that’s why I have never recommended you to invest directly in stocks.
Instead, you should buy equity mutual funds. There are so many funds which provide you with exemplary returns.
- Aditya Birla Sun Life Tax Relief 96: Invested amount from Mar-1996 to Feb-2017 would be 110x, which is ~25% YoY. The tax benefit would be over and above this amount.
- Franklin India Prima Plus Fund: Invested amount from Dec-1993 to Feb-2017, It would be 81x which is ~21% YoY.
Overall, mutual funds have provided 3-7% extra returns. I recently did a study of this,which you can check out here.
What is The Risk of Investment?
Dad: These returns look great. But what about the risk? Real estate rarely goes down, you know?
Me: That’s not true. Do you remember 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%, which is slightly higher.
Also, if you think about the other issues like :
- Liquidity: Buying/Selling a house is difficult, especially when the market is down.
- Transaction cost: It is very high due to registration cost (~5%)
- Capital Requirement: You need to have crores of rupees to invest in real-estate and the possibility to diversify is almost NIL.
What About the Future?
Dad: Historically, this is fine. But how can you be sure the record will continue in the future as well?
Me: That comes down to the basics! Both real-estate and equity are investments and their returns can be divided into two parts:
|1.||Rental Yield||Dividend Yield|
|2.||Capital Appreciation||Price Increase|
Dividend yield :(Dividend earned on shares divided by the value of shares). For Sensex, it is around 1.5%. This is net of all taxes.
Rental yield :(Rent earned on the property divided by the value of property). In India, it is around 2-3%.
Let’s assume it to be 2.5%, after deducting income tax, property tax, maintenance, etc, it goes up to ~1.5%. Almost same as dividend yield.
Price Increase : It depends on two factors P/E (Price of share, divided by profit per share) and earning growth.
If we assume P/E to be constant, we only need to project earning growth. It is assumed that in the long-run, earning growth will affect the sum of real GDP and inflation.
(GDP + Inflation)
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 the increase in rent.
I have mostly seen a growth of 5-10% in rent. Therefore, if you believe that rent can grow by more than 12%, real-estate can perform better but it’s unlikely.
|Rental/ Dividend Yield||1.5%||1.5%|
|Price/ Capital Appreciation||8%||12%|
Reasons to Buy a House:
Dad: But, there are other benefits of buying a house.
- It provides a sense of security
- It provides stability (no need to vacate the house)
Me: That was my point all along, investing in real-estate might not be a great idea, but I completely agree that buying a house is!
I think in a country like India, we can’t depend on the country to provide you the basic necessities. Hence, everyone wants to be secured in some way or the other, especially with respect to food, clothing, and shelter (Roti, kapda, makaan).