The Real Estate Trap

Real estate remains the biggest asset by value in most Indian portfolios. Though it is perceived as the safest asset class, that's not true. Until the mid 1900’s owning a house was restricted to very few families. However by 2003-13, the scenarios changed. Due to the rise of this asset affordability and interest rates coming down significantly, real estate became the flavour of the season. An increase in loan by value from 65 % to 95%, increase in household income and tax incentives from the government were all the factors that contributed to make houses affordable for the middle class.

But despite all positive publicity given to this asset class, and despite of how some people have made fortunes by real estate investments, This asset class is uniquely dangerous for the following reasons:

1. Investment size-  To enter into real estate, one needs a huge corpus unlike stocks or mutual funds. This makes real estate a rich man's  asset class. High ticket size prevents widespread adoption of this class.

2. Real estate is a highly illiquid asset class- Finding a buyer can be very difficult at times, sometimes almost impossible.

3. High Expenses- Transaction costs, stamp duty, registration and other charges associated with buying property now exceed 10% of the cost of the property. These costs make residential real estate the most expensive asset class to trade by a long margin.

Short term capital gains is at the marginal rate but long term capital gains are 20%. This implies that most of the gain from investment in real estate is lost via transaction and taxation.

4. Non-standardardised asset- Real estate is a very non-standard asset. It varies across macro markets (Mumbai Vs Delhi) and micro markets (Bandra Vs Lower Parel). It is a very unpredictable asset class and returns are driven by luck as by thought out investment decisions.

5. A murky sector- Residential real estates are marked within requirement of regulatory clearances. Many real estate developers have realised they might as well work in partnership with politicians,regulators and civil servants. It is these people who are the first in the queue to cream the gains from real estate investments. The middle class, no matter how affluent, is the last to benefit from any upside associated with real estate development in India.

Why do so many investors get trapped in residential real estate?

1.A Head start: Gold and land were the most familiar asset classes amongst people. Stock markets came in much later. Only 5% is invested in financial assets against 77% in real estate.

The allocation of household assets in India shows significant skew towards Real Estate. Take a look at the pie-chart below:  

2.One way trend-prices going up: Real estate runs into super cycles of more than 10 years. So most people who made significant progress in the Bull cycle of 2003-13 don't have any experiences or memory of a downward cycle.

3.The lure of  magnificent returns: This asset class made a tremendous amount of money over 2013 as prices went up by 5 to 10 times. For most buyers, the return on the amount invested is mind-boggling. However, as we learn subsequently, 2003-13 was the best period of real estate in India. It'll be long before we see another such period of price appreciation. In fact in this illiquid and tax-unfriendly asset class, investors can really get squeezed on their mortgages as their modest equity is wiped out by drop in the price of property.

4.Absolute Returns vs Compounded Returns: Most real estate investors are usually satisfied simply because they look at absolute returns in isolation. Thus, investors also invest in real estate because most of them burnt their fingers in stock markets. Investors don't realise that property prices go up 5 times in the last 20 years, but the compound annualized return the property has generated for the last 20 years is just 8.3%. In the same period, the stock market benchmark index is likely to have risen at 15% per annum which compound over 20 years translates to a 16 X return!

5.Coffee Can in real estate: Investors also invest in real estate because most of them burn their fingers in stocks. The reason behind this is, the inadvertent coffee can style of investing they adopt in real estate as against the trading style in their stock portfolios. When it comes to real estate, investors are happy to buy and hold for long periods of time. As a result, they end up holding the properties through thick and thin which is why they are able to see an appreciation in the value.

Busting the myth: Real estate as an asset class is safe as a house.

a.Lesson from the world: Since 1900, real estate in the US has given an annual compounded return of 0.4 % as against an  annual return of 5% from the DOW JONES. The same story is applicable for Germany where the return is 2%. In Japan real estate goes through a boom-bust cycle but since the cycles are long, investors tend to forget the previous bust. 

b.In India most residential real estate is unaffordable: Indian property is easily among the most expensive in the world. Price per square meter as a multiple of GDP per capita India. It is the most expensive residential real estate in the world by a gigantic margin. In the absence of GDP growth, residential real estate prices in India have nowhere to go but down. Rental Yields/ Price of property is lowest in the world at 2.4%.  Most developed countries' rental is far higher than their 10 year government Bond rates. In India, it is the reverse. The 10 year Bond rate is 6.7 % and rental yield is just 2.4 %.

By any yardstick, residential property in India is significantly overvalued.

Portfolio allocation: Does it make sense to invest in real estate?

Does real estate deserve a place in your portfolio?

In isolation, the answer is an emphatic NO. Even in terms of diversification this asset class is not worth investing.

Diversification only works if the Asset classes are less than perfectly correlated with each other. If both asset classes behave in a very similar manner, the diversification of risk simply does not happen. 

The long term correlation between Dow Jones and US property was 78% implying that American stock market and American real estate prices move in sync. 

Investors will have to throw their preconceived notions regarding real estate out of the window if they want to have any hope of generating healthy post tax returns.