Real Estate - Real Returns

              

Investing in real estate is crucial to Indians, especially owning the first house/apartment. In India, it is common to call it as investment but not to think of it as investment. Note this difference, since most people who “invests” in real-estate do not think about real return on investment (ROI) on real-estate investments.

I would be really wary of putting my hard-earned money in buying a house, unless I get a decent ROI especially when it needs so much efforts and also it may induce emotional trauma.

So what exactly is a ROI for a house and how to calculate it for real-estate investment?

If you are buying a house for purely emotional reason and if this will provide you satisfaction, then calculating ROI is useless. So if you are happy being a owner of a house, then you wouldn’t think of “returns” and ROI is immaterial. But, it is important to distinguish between owning a house for “satisfaction/being happy” Vs “showing-off/rat-race competition”.

But if you are the one who thinks buying a house will make you rich or it will make you financially stable, then you seriously need to calculate a real ROI on the investment.

Almost everyone must have heard about their lucky friends who bought an apartment for Rs 15 Lakhs almost a decade ago which is now quoting at Rs 50 Lakhs. This sounds like an amazing deal, isn’t it? Well not actually, since the CAGR return is just 12.79% which is not a great deal. So if the same 15 Lakhs would have been invested in BSE Sensex stocks, it would have ballooned to Rs 65 Lakhs, definitely better than real-estate.

Note that this is a simplistic view not considering multiple factors like efforts required for investment, overhead costs and risk factors. If these factors are taken into consideration real-estate investment will not sound attractive anymore. The graph below indicates that CAGR return of various asset class over past 10 year period. As indicated, stocks and gold out-perform the real-estate easily.

Some argue the virtue of real-estate investment by giving the leveraging logic. The idea is that if you buy a house, you would just give a 15-20% of cost as a down-payment (e.g. 2Lakh) and then see the real-estate price going up (say Rs 50 Lakh) and calculating the CAGR to be much higher (~45%). This is foolishness and simply twisting the truth to show-case an amazing returns. It is a fact that borrowing money is always costly (how would banks otherwise make money) and more risky. It is important to remember that the loan amount is owned by you, along with the interest to be paid to the bank. Also any decrease in the price of your house will in-fact be a huge loss rather than any gain at all. 

Let us compare some points while investing in Stocks Vs Real-Estate.

1) Performance: We already saw that the returns from stock are higher compared to Real-Estate investments.

2) Leverage Advantage: We discussed the leverage logic in real-estate. The same kind of leveraging can be done in Stocks as well.

3) Overhead Costs: The real-estate overhead cost is huge (10-15%) which consists of Stamp Duty, Brokerage Charges, Loan Processing Fees, Legal Fees, Utility Connection charges etc etc. The costs for buying stocks is much less.

4) Taxes: Stocks score over here since you just have the long-term gain (if held over more than a year) but in case of real-estate one has to pay property tax apart from long-term gain tax on selling the house.

5) Transparency: The biggest advantage while buying shares is that you can use the web to determine the fundamentals of stock easily. The same doesn’t apply to real-estate investment. It is so difficult to determine a handsome bargain with so many variables that investing is more dependent on luck than a logical analysis.

6) Efforts: The real-estate investments really gets killed in this parameter. There is not only enormous efforts to find a good house, but once you own it, a lot of effort is needed to keep it in good condition.

7) Diversification: If you invest in stocks, it is so easy to put your money spread across industries/companies/funds to give it protection. This can not be applied to real-estate investment at all.

I feel that the real-estate prices in India are not at all justified and the hype is driven by the artificial demand. Also most people can afford to get into this thanks to easy loans from banks. I hope the bubble does burst early enough to save lot of people who are not in the trap yet.

Forming your portfolio

Your portfolio is considered Good as long as it is Well structured, Diversified and it's risk does not exceed your risk-tolerance level.
Now, what do i mean by well structured? You see, investing is not walking in the park, it's full of dangers and it's always ready to take all your money and run! (Of course walking in park in the middle of the night is not too pleasant either, but at least a mugger can only take the money you have with yourself at that moment.) Now, don't cry, if you follow my advice, you won't need to worry about losing all your money. There are quite a few portfolio risk management tools that you must use.

First of all, it is structuring your portfolio. A well structured portfolio can save you a lot of trouble by itself. Structuring means, assigning a particular percentage of your money to one or another investment instrument. That would be stocks, bonds, real estate, precious metals, artwork, cash etc. The simplest way to structure your portfolio is buying only stocks and bonds. And usually that is more than enough. We'll talk about alternative investment methods later on. Now, bonds have much lower risk (almost risk-free) than stocks, also because the rate of return is fixed, you know precisely what your return will be, that's why bonds should make up a large portion of your portfolio. And then depending on your risk-tolerance, you can decide, how much stocks do you want. Even though stocks are sometimes volatile over the short term, they have proven to be the best investment for long-term growth. In fact, no other investment instrument has provided a higher return over the long term than stocks! That's why stocks should be combined with bonds. Bonds help to stabilise the volatility of stocks, cover short term stock losses and gives a tasty little profit when the times are good.

The second tool, and also one of the most essential is stock Diversification. Diversification is spreading stock investments into different stocks. You would not want to spend all your money on some company's stocks only to see it go bankrupt and lose everything you had. That's why diversifying your stocks is of key importance. Let's say you decide that 30 % of your portfolio would be bonds and 70% would be stocks. Now, you should diversify that 70% of your stocks. IT should consist of at least 5 different stocks in 5 different industry branches and possibly countries. Also it would be wise to choose investment with varying risk levels, as this would ensure that losses are covered by other areas of your diversified portfolio. Diversifying reduces the risk dramatically, which is exactly what we want.