India has been growing at over 8% for the last five years. This growth has created a large section of people who have good disposable earnings and are investments conscious. They are different from the previous generations, who only invested in PF, PPF or fixed deposits. Today’s youth want more return and are willing to take additional risks. Hence, this section of people has become a target of all the investments companies who promise them great return through equities and mutual funds. What type of investment will give the best performance over the long haul?
Many financial “experts” argue that over the long term, the stock market has outperformed all other investments. In India this claim is based on the fact that the stock exchanges gave an average return of around 20% between 1979 and 2008 while in the US, the S&P 500 returned an average annual 10.5% gain. Putting aside for a moment the authenticity of that assertion, we would argue instead that real estate has been and, in fact, remains the world’s best investment. A real estate investor uses small properties to grow wealth in five ways:
1. Collecting a dependable and growing income (rents)
2. Value increases or appreciation
3. Value creation or property improvement
4. Instant gain (bargain purchase price)
5. Tax benefits
In the sections that follow in this article, we’ll take a brief look at the components of a “good” investment. What factors must you consider as you strategically try to grow your wealth? How can you evaluate an individual investment opportunity? We will then use these criteria to compare a typical investment in small income properties and investments in stocks. You will see how real estate can offer you a much better and stable return.
What Makes a Good Investment?
A shrewd investor looks carefully at several aspects of each investment opportunity and considers relative price, return, and risk. Remember this – investments which offer higher returns also have higher risks. While market trends and indices can provide some helpful information, you certainly shouldn’t base your investment decisions on such broad markers. Your goal as an investor is to protect and grow your wealth by making individual investment decisions that help you achieve your own unique goals.
Let’s examine the factors that help determine what kind of a return you’ll earn on a particular investment and how likely that investment is to help you achieve your personal investment goals:
• Income flow
• Accumulation of equity
• Protection against inflation
• Preservation of capital
Income flow
The worth of an investment is measured in part by the amount of annual income it can be expected to generate—now and in the future. Many investors have the explicit goal of creating a healthy annual income during their retirement years.
One component of the total return earned by an investment is the value of any cash flows that asset is expected to produce over time. For instance, in the case of stock ownership, income is obtained through the distribution of dividend payments. In the case of a small income property, income is obtained through rent paid by tenants.
When evaluating the overall value of an asset, an investor will consider both the expected price appreciation and the present value of expected future cash flows. That is, estimating the current worth of an asset based specifically on the amount of cash the investor expects to receive in the future by virtue of owning that asset.
Accumulation of equity
The overarching goal of investment activity is to build your wealth by accumulating equity over time. Several factors impact how well and how quickly a given investment helps move you toward this goal:
• Appreciation: One fundamental way to earn money on an investment is to purchase an asset then sell it at a later date for more than you paid for it. Appreciation refers simply to the increase in the price of an asset over time. Appreciation is one component of total return on an investment. For instance, a stock purchased for Rs. 1,000 in 2007 and sold for Rs. 1,500 in 2008 has appreciated Rs.500 (50%) in one year.
• Leverage: In physics we have read the meaning of leverage as a pivot or lever used to apply mechanical force to another object. We generally use a lever to lift an object which is quite heavy to lift otherwise. The ability to leverage in finance refers to an investor’s ability to control an asset of greater value than the cash invested, generally by using borrowed money. Hence, we use leverage to buy a property of higher value which we could not buy otherwise. Shrewdly using leverage is a powerful way to magnify returns. Leverage also helps in tax benefits.
• Creating value: An investor may be able to increase the value of his or her investment by altering the asset in a strategic manner. Such improvements might increase the price others are willing to pay for an asset, or increase the income that asset produces. Thus, asset allocation is extremely important for long term investments goals.
• Tax advantages: Certain types of investments and investment techniques allow an investor to take advantage of opportunities to avoid undue taxes. The less tax you pay, the higher your return will be on a given investment.
Protection against inflation
One of the single biggest threats to long-term investments is inflation (the general increase in the overall level of prices over an extended period of time). As we know inflation reduces the value of money over a period of time. Historically, inflation can be counted on to reduce the value of Indian currency by about 7% per year. When considering the value of different investment options, you must account for the impact inflation—any expected future returns should be net of inflation.
Preservation of capital
Volatility refers to the tendency for an asset price to fluctuate sharply within a given time period. Assets that experience rapid rises and falls in price over short time periods may be difficult investment choices for individuals with a low risk tolerance or for those who are looking at a shorter investment time horizon. Stocks especially those of small and mid caps companies fall into this category. The relative volatility of an investment impacts the risk that the price of the asset will actually fall below your purchase price. For instance, had you invested in a BSE index fund around the time of the market’s peak in August 2007, you could have lost a significant proportion of your original investment as prices declined dramatically and (effectively) permanently in 2008. Average loss of value in stocks in this one year period was over 60%!!
How Does Real Estate Stack Up?
Let’s take a look at how an investor can evaluate different types of investment opportunities according to the components of a “good” investment that we just described.
Income flow
Let’s first look at the income flows generated by stock ownership. What do we know about the dividend yields (dividend paid divided by price of stock) of stocks (the annual income that stocks can be expected to provide)? In June of 2006, average annual dividend yield for the BSE 100 index was 4.3%, while that for S&P 500 (US stocks) was at 1.8%. The average dividend yield of the Dow Jones Industrial Average was 2.3%. The owner of a small income property, by contrast, can expect to earn an annual net operating income of between 10-15% in India while 5 to 10% in the US. With careful property selection and management, rents can provide a generous and steady annual cash flow.
With low dividend yields, how are stocks going to provide you with an inflation (an average inflation of 7%) adjusted annual income for a long retirement? To draw a significant retirement income, you would need to invest a tremendous amount of capital. Rs. 50 Lakhs invested in top dividend paying Indian stocks might pay you Rs. 200,000 per year; that same amount invested in a small apartment building could pay you Rs. 250,000 or more (Rs. 20,000 per month rental for 3 BHK flat) each year. This is apart from the fact that the net value of investments in real estate does not go down while it can easily happen in the case of stocks.
Accumulation of equity
Appreciation
When we look at the past to inform our future decisions, we often give more weight to the events of the more recent past. Our collective memory, therefore, tends to emphasize a period of incredible price appreciation in the stock market. The years between 2002 and 2007 saw tremendous price growth (the BSE Sensex grew by nearly 4 times from 5000 to 21,000) in the stock market. During such periods, shrewd investors are able to take advantage of rapid price appreciation while focusing on preserving their capital. Over the very long haul, however, we see that there are periods in which stock prices appreciate much more slowly, or even fall. From 1979 to 2008 the BSE Sensex experienced about 20% compound annual growth. From 2003 to 2007 stock index went up almost 300%. However, in the last one year itself, stock investors have lost more than 70% of their portfolio value.
So how does real estate price appreciation compare to the observed appreciation in the stock market? Because of the private and unique aspects of the ownership of small income properties, it’s far more difficult to generalize about price appreciation. However, we use the appreciation of property prices of a locality to find out the appreciation or capital gain of those properties held by individuals in those areas. In the last thirty five years between 1979 and 2008, where the average stock return was 20%, property prices (those in Bangalore, Pune, Mumbai and NCR) increased over 700%.
However, appreciation alone does not tell the whole story. Although overall long term growth in price is comparable, investors in income properties can accumulate equity much more quickly and predictably than investors in stocks. To understand why, let’s look at the effects of leverage.
Leverage
Leverage is a powerful reason for investing in small income properties. If an investor uses 100% cash to acquire a house worth Rs. 50,00,000 and the house increases in value by Rs. 5,00,000 in one year, the investor makes a return of 10% (assuming no other costs). However, if the investor obtains 80% financing (standard home loans), only Rs. 10,00,000 cash is required to buy the property, and a bank or other lender loans the remaining Rs. 40,00,000 to acquire the property.
Assuming the same Rs. 5,00,000 increase in value, the investor’s cash contribution of Rs. 10,00,000 yields an increase in equity of Rs. 10,00,000 in one year—a 50% return. In good economic situation, readily available financing at favorable terms helps the real estate investor buy, and earn, significantly more than he or she otherwise would.
Imagine this fairly conservative scenario: Rahul purchases a small apartment building in Bangalore. He puts 20% as down payment and finances the remaining 80% of the purchase price with a 20-year home loan. Rahul’s rental revenue is just enough to cover his EMI and operating expenses. He isn’t bringing home any additional income from owning the property. Isn’t Rahul merely breaking even or in a way losing money in a bad investment?
Far from it, Rahul has purchased a predictable accumulation of equity. Even in the most unlikely scenario that the property doesn’t appreciate, and rents do not go up in the future, equity is built up with each loan payment – i.e. ownership of property is growing. As Rahul’s equity i.e. ownership grows, he can consider borrowing against it (putting it as collateral) and using those funds as a down payment on another income-producing property. In this way, Rahul and other real estate savvy investors - can convert equity into more wealth.
Leveraging cannot be applied so effectively when investing in other types of assets, such as buying stocks on margin. At around 2.1% to 4.3%, the dividend yield from stocks is generally not sufficient to cover interest payments on the debt (typically around 10%). This means an investor will have to pay money out of pocket to cover finance charges. Further, if a stock price falls enough, even temporarily, the lender may demand that you provide additional capital. If you fail to provide the additional capital, you will be considered in default and the broker may sell your shares. A mortgage lender, by contrast, cannot require that you provide additional capital if the market goes into a temporary downturn.
Creating value
It’s not possible for the typical small investor in stocks or bonds to exert any substantial control over the performance of the purchased asset. The savvy owner of a small income property, on the other hand, can take advantage of opportunities to create value by making strategic improvements or employing a shrewd market strategy such as signing different lease contracts or renovating the property to suit the taste of different customers.
Tax advantages
A real estate investor is able to take advantage of a number of tax benefits. If a small investor sells stock to purchase more, he or she will lose a part of the investment through taxation. A real estate investor, on the other hand, is frequently able to reinvest the proceeds of a sale to take advantage of certain favorable rules and avoid capital gains taxes. As per Indian law, if an individual sells a property and buy another property within six months of the previous transaction, he or she does not have to pay tax on any capital gain. However, this is not valid for stock investments – an investor has to pay tax on any capital gain on stocks.
Protection against inflation
No investor should underestimate the investment-eroding power of ever-climbing prices i.e. inflation. Even moderate rates of inflation can significantly diminish the buying power of your future income.
Because stock market investments offer such low dividend yields, an investor must count on price appreciation that consistently outpaces inflation rates. Historically, inflation rate in India has been between 7% and 9%. So the real rate of return on BSE Sensex was around 13% (real rate of return ~ nominal return – inflation).
Unlike stocks, real estate can offer dependable increases in both price and income—even during inflationary periods. While no national index can capture these trends perfectly, it’s clear from experience that home prices rarely sink like stocks and rents persistently rise. In fact, a reasonable estimate of an annual rate of rent increase is 20-25%, especially in the last few years. Typically, property prices only fall temporarily during periods of serious recession or unemployment, during times of local overbuilding, or after periods of increased speculation. This is what we are seeing in the current environment. Still, the property prices haven’t fallen below 25% and that too in primary market.
Not only do properties maintain their value during periods of rapidly rising prices, they also maintain value during times when prices rise more slowly. When the inflation rate is high, value is maintained because costs increase and the supply of new property are restricted. When rates of inflation are low, values still rise as lower interest rates increase affordability.
Preservation of capital
As we’ve seen in recent years, it’s possible for stock prices to soar beyond the biggest optimist’s predictions. It’s also possible (and probable) that prices will suffer unimaginable downturns. Stock prices are comparatively volatile, with lots of dramatic up- and downturns.
The prices of small income properties, on the other hand, show a more gradual, steady rise through time. While real estate prices are certainly subject to cycles, it historically takes some very special circumstances (such as large-scale recession or unemployment) to make residential prices and rents fall significantly. In addition, while some of the value of real estate investments is found in price appreciation, much of the worth of the investment is tied to the annual cash flows (rents) it can generate.
Recall that a key component of successful investing is making sure that an investment preserves your capital as well as returns beat inflation rate. Imagine a stock market investor who has the unfortunate timing of investing a good amount in a Sensex index fund in early 2006. Stock prices of almost every stock were rising as if they were never going to cone down. Analysts were as optimistic as were the investors. The market reached previously unimagined heights and investors thought they have found gold mine in the stock exchange. People ignored the fact that those prices were extremely high and without any rationale.
Then, suddenly, investors were hit with staggering losses. In the last one year, the value of stock portfolio sank by 70%. This plunge in stock prices is possible because the prices are not tied closely to the income-producing power of the asset.
Unlike companies that can “go broke,” well-selected properties and locations are rarely subject to permanent declines in prices. As we saw earlier, housing prices are much less volatile than stock prices and, as such, are better able to help you preserve capital.
Conclusion
While no single class of investment is always a better choice than another, it’s easy to see how investment in income generating properties can help you build your wealth and meet your investments goals. Real estate investment offers steady appreciation and delivers a strong, inflation-adjusted annual income. In addition, leverage and tax advantages are powerful investment tools.
A small investor who takes the time to build his knowledge and skills is much more likely to make good, fact-based buying and selling decisions about investment properties than he is about stocks. No small investor is going to beat fund managers or research analysts who have more information compared to others or be able to buy stocks below market value. The knowledge and influence required is simply not accessible to the small investor. The process of evaluating and researching stocks is cumbersome and requires sophisticated technical skills.
In real estate investing, on the other hand, a small investor can conduct thorough research and analysis of individual properties. An investor can learn about a market by walking the neighborhood, talking to friends or relatives and/or property owners. If one has the patience or enthusiasm to know land value rates, they can check recent registrations of properties at the registrar office. Access to such information and knowledge helps people to acquire properties at bargain prices. The small real estate investor is even able to negotiate price with sellers— something inconceivable in stock market investing! On the other hand, a stock market is more like plutocracy i.e. very few and powerful funds control the market. Retail investors like you and me can not do anything to influence pricing.
As more and more individual investors recognize the wealth building potential of investing in small income properties, earning high returns will become more and more challenging. To succeed, an investor must be more educated and more entrepreneurial than his competitors. Knowledge is the key to your achievement in real estate investments.
In order to grow the value of your real estate investments, you must be able to:
• Buy properties at strategic locations
• Use leverage wisely
• Research and analyze local markets
• Negotiate sensibly
• Timely investments
• Manage properties strategically
• Stay in touch with customers
