As I write this article in 2019, I am happy that a lot of people have started to look away from real estate as an investment opportunity, especially the residential real estate, thanks to the price stagnation post 2012.
However, there was a lot of euphoria during the 2002-07 period regarding investing in real estate to double your money in 3 years. While, no doubt the returns were good but were they the best among other available options? Let’s have a look.
Why is residential real estate in not the best investment, especially in India
Reason 1: Poor rental yield
Before we get into how poor the rental yield is, let me summarise what rental yield means. Suppose the current price of your property is Rs. 1,00,00,000 and the rent it fetches you is Rs. 30,000 a month or Rs. 3,60,000 in an year then the rental yield is 3.6% or annual rent/current property price *100.
Usually, a rental yield of anything greater than 7% is considered to be a good. Now, let us look at one of the prime real estate market in India i.e. Gurgaon. A 3000 sq. ft or so 3BHK apartment in Sushant Lok (a good residential locality in Gurgaon) costs around Rs. 3.5 Cr ($466 K) in 2018. However, the rent is roughly Rs. 80K per month ($1066) or Rs 9.6 Lakhs p.a. ($12,800). Rental yield comes out to be 2.7%.
In fact on an av. rental yield in India on residential properties is ~3% according to MagicBricks (https://timesofindia.indiatimes.com/business/india-business/residential-assets-fetch-3-rental-yield-in-india/articleshow/63788363.cms)
Commercial real estate is still a better option with rental yields of ~7-8%, however, it requires much finer knowledge of the commercial real estate market unless you want to be stuck with a space no body wants to rent.
Reason 2: Residential real estate does not give the best returns (Real estate vs mutual fund)
I will take the example of 2002-2007 when real estate market was booming life it hasn’t in the past couple of decades or more.
Following are the Y-O-Y growth rate numbers from government source (https://www.indiabudget.gov.in/es2008-09/chapt2009/chap45.pdf) (feel free to add another 5 percentage points or so, considering Indian real estate has a fat black market underbelly) from the period of 2002-2007:
Delhi –20.4% per year , Bangalore- 21.6% per year, Mumbai- 18% per year, Bhopal- 17.6% per year, Kolkata- 15.7% per year
During the same period if someone had blindly invested in index fund tied to Sensex they would have made far more money. Sensex at the start of 2002 was at 3262.01 and by the end of 2007 it had reached 20286.99 i.e Y-o-Y growth rate of 36% (https://www.bseindia.com/indices/IndexArchiveData.aspx)
Reason 3: Real estate is not a liquid asset
You cannot go and sell a property at your whim, especially when the markets are tumbling. Same is not true for equity markets, even if the markets start to slide you can liquidate your assets at the click of a button.
Reason 4: Real estate requires maintenance
Either you buy a swanky apartment in a high rise or a plot of land, all types of real estate require constant maintenance either in the form of monthly maintenance charges, or constant upkeep and monitoring of an empty plot.
Reason 5: Real estate portfolio is not diversified
For a common man like you and me, we would most likely own 1 or 2 real estate properties at a given time. This makes your investment highly risky with all of your eggs in one basket. Think about the homeowners who invested in Noida, their money is stuck in half finished projects for more than 5 years.
But I can get loan to invest in Real Estate
That being said, people still provide one argument in support of real estate which is that they can easily get home loans for lakhs or crores of Rupees, but they won’t get loans for investing in mutual funds or purchasing stocks.
Let us use early retirees’ best friend: Mathematics and see if the argument holds in our real estate vs mutual fund discussion. I would be taking some simplistic assumptions, but that should give you the idea.
Let’s say you decided to buy a property worth Rs. 3 Cr ($400K) in 2002 when real estate market was growing let us say at 20% p.a. (see above for numbers in different cities). Also, you decided to finance 80% of it using a home loan@10% (round-about the home loan rate prevailing in 2002) for 15 years. While the rest Rs. 60 lakhs ($80K) you pay as the down-payment from your own pocket. Hence, the EMI you would be paying would be around Rs. 2.57 lakhs per month or Rs. 30.84 lakhs in an year. Suppose you manage to get a rent of Rs. 80K (~3% rental yield) per month and increase the rent amount by 10% every year.
Now after 5 years when the property price is, wait for it, Rs. 7,46,49,600 (20% p.a. growth) you want to sell it and realize the gains.
At this time, you have already paid Rs. 1,55,59,104 (Rs. 60,00,000 down payment + Rs. 1,54,20,000 in EMI – Rs. 58,60,896 you made in rent). However, you still have to pay Rs. 1,95,15,989 i.e. the remaining loan amount at the end of 5 years. Hence, the net amount you have gained after 5 years is Rs. 3,95,74,507 (Rs. 3.95 cr or $527K).
However, your friend decided to take a different route. She had a starting sum of Rs. 60 lakhs ($80K), same as the amount you paid for down payment.
She bought an index linked fund from it in 2002. Also, at the end of every year she invested Rs. 30.84 lakhs (same as your EMI amount for the year) in the same index linked fund.
Remember, I stated above that from 2002-2007 the Sensex grew at 36% per annum. Let us see, how much did your friend end up with after 5 years.
Her Rs. 60 Lakhs, grew to Rs. 2.79 Cr ($372K) in 5 years. Additionally, the Rs. 30.84 lakhs she invested in the index fund for 5 years are now Rs. 3.13 cr ($417 K). Hence, after 5 years the total amount your friend has is Rs. 3.78 Cr ($503K). So at the end there isn’t too much to choose between the earnings, however, the real estate option is a debt option with your entire folio concentrated in one asset. And with other risks associated with real estate the rewards are not in the same ratio.
You would notice that I have deliberately kept things simple, by not accounting for different growth rates across different years, not including maintenance costs, loan pre-payment charges etc. That is because, it was not important to be absolutely correct on the numbers but give you an idea that there are better alternatives to investing in real estate.
Real estate vs mutual fund
One might still argue that it is not necessary that stock market will outpace real estate in annual returns. I agree, it is not necessary but highly probable. Considering real estate growth would typically mean people have more money to buy and invest in real estate which essentially means that the country is growing and hence fundamentally the stock market would be growing and more often than not outpacing the growth in real estate.
Again, if you still are sure that under some circumstances real estate growth will outpace the index, then you do have an option to buy real estate stocks or sectoral funds investing in real estate companies. That ways your risk is also diversified among different companies and hence projects. All in all, I would say in the battle of real estate vs mutual fund in India, mutual funds win.
You might want to read my post on best mutual funds in India for 2019.