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Reality of realty investment

Jayant Pai / Mumbai 12 Aug 12 | 12:49 AM

Many investors (especially high net worth) prefer real estate over the stocks as an investment option. They argue that that stocks are too volatile and the price rise in real estate is substantially more.

While it is true that property prices have risen over time, so have stock prices. Sure, properties in prime locations in the metros (where supply is scarce) have risen rather exponentially. Investors who compare this price performance with the rise in the broad stock market indices will surely feel that stocks pale in comparison. However, to counter this, I can also think of myriad stocks whose rise has been nothing short of spectacular. Hence both these examples are not really representative.

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There are some other features of the stock market which, rather perversely, have actually bolstered this rather erroneous belief in investors’ minds. They are:

Today, everyone can get virtually minute-by-minute updates on stock prices either on the television or internet. Watching prices bounce all over the place, fosters the impression that stocks are volatile.

On the other hand, in the case of real estate there is no mechanism to disseminate prices in this manner. In fact one hardly gets any update unless it is sought actively. Even after that, there is no one credible source of information. Often, one just averages the estimates of various brokers or websites in order to arrive at some figure. Since this is a relatively tedious process, one embarks on it rather infrequently (often, only once every few years). After that when one compares the period-on-period change, optically it may appear outsized, and consequently, impressive. However, if one drills it down to a Compounded Annual Growth Rate (CAGR) figure, it may not be much different from the CAGR offered by stocks during the same period.

Again, as mentioned earlier, as there is no single property index which is widely followed in India, one cannot make accurate comparisons vis-a-vis the stock market indices.

Undoubtedly, this is a positive feature for any investment. However, the flip side to it is that it may encourage over-trading. Benjamin Graham has often mentioned a fictional character known as Mr Market in his books. This person apparently visits you several times a day, offering to buy from you or sell to you. Constantly being in the company of Mr Market makes it difficult for you to resist the urge to trade. You are drawn to the flashing prices on the screen like a moth to a flame. Consequently, many a time you sell off good stocks on a whim, merely because you have earned a small profit, thereby foregoing any future potential appreciation. After that you will blame the stock market for not giving decent returns.

On the other hand, in the case of property, as there is no one who visits you daily with a quotation to purchase your house, you often end up holding the property for many years. When the time comes to actually sell it, you are pleasantly surprised by the price appreciation that has ensued in the interim. I often tell my friends in South Mumbai that if their parents (who had bought the houses in the 1980s) were visited by Mr Market daily in the mid 1990s they would have sold their houses long ago and missed out on the parabolic appreciation witnessed in the 2000s.

Lack of liquidity may cut the other way too. Investors who are overweight on property, sometimes end up being asset rich and cash poor. They may be compelled to to liquidate their property at a steep discount in case of emergencies.

You may be driven by the fact that property prices appreciate substantially. It easily rises 5-6 times in 6-7 years in any big city. But, remember all the increase is just notional! If you calculate the internal rate of return (IRR) for an investment in property, you will see that it isn’t great.

To calculate the same you need to factor in the maintenance costs, loan cost, tax and the rent you receive, if any. You will see that very often a three time increase turns out to be a 6 per cent return on investment. If a property is lying vacant, then the return may go down further.

Sample this, a person bought a flat for Rs 1 lakh in 1980s. Today the property is valued at more than Rs 1.50 crore. Some sample calculations will show that the IRR is not more than 10-11 per cent. You need the correct maintenance and accrual cost. This kind of return even fixed income instruments like fixed deposits (in some cases) and fixed maturity plans (FMPs) are giving today. Over such long tenures, stocks always give very good returns, easily 12-15 per cent.

Investment amount
To own a property, you need heavy investments while you can buy even one share if you don’t have enough cash. Assuming you want to buy a house worth Rs 50 lakh. A bank would be willing to lend you 80 per cent of this amount, or Rs 40 lakh. You will need Rs 10 lakh as down-payment. While in case of stocks you can buy even one, which depending on the price of the stock will be very less in comparison.

Your investments in stocks can be exempt from capital gains taxes if you hold the investment for one year or more. While in case of real estate the same increases to three years. A property held for less than three years is subjected to short-term capital gains tax.

I believe that both, property and stocks are an essential part of one’s portfolio. Both have different liquidity and volatility characteristics and are often a good fit in tandem. To be obsessed with one at the cost of another may therefore be sub-optimal.


The writer is vice president, Parag Parikh Financial Advisory Services

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