Real Estate: the giant quagmire
For most Indian investors, real estate is the biggest asset by value in their portfolios. Its large transaction size and value have meant that real estate has remained one of the largest components in most investors’ portfolios. Most Indians associate property with safety, status and prestige, given the feudal traditions of India. And yet, whilst real estate has traditionally been perceived as the safest asset class, it is anything but that.
Until the late 19th century, in India, houses were built for staying and were never seen as an investment. In the opening decade of the 21st century, there was a paradigm shift in the way retail investors started looking at residential real estate. For most of 2003–13, house prices seemed to be on steroids with prices moving up almost on a monthly basis. The rise in price established real estate as an asset class by itself. Along with the price rise, the other factor that led to a massive interest in this asset class was affordability. Interest rates came down significantly over these years. Along with that, a collective increase in the household income plus tax incentives from the government made it possible for affluent middle-class households to afford a house.
Figure 1: State Bank of India’s deposit rate is representation for interest rates in India
Despite the positive association of Indians with real estate, there are certain properties of it which make it a dangerous asset class.
Investment size: You can buy a stock for Rs 500 and a mutual fund for Rs 5000, but you need to have a few lakhs with you for investing in the cheapest of properties. This makes real estate a rich man’s asset class where high-ticket sizes prevent widespread adoption of the asset class.
Liquidity: Compared to financial assets such as stocks and bonds, and even compared to physical assets such as gold and silver, real estate is an illiquid asset class. You can sell a stock on the exchange, sell gold to buyers, or even barter a goat, but it is very difficult to sell a plot or a house. It takes several months, sometimes years, to arrange a buyer.
Non-standard asset class: It varies across macro markets, micro markets and even across streets and neighbourhoods. This makes it a very unpredictable asset class and returns are driven as much by luck as by thought-out investment decisions.
Besides the above-mentioned peculiarities, the real estate sector in India is highly expensive due to various transaction costs and very murky due to the participation of venal and powerful dignitaries, as it involves multifarious regulatory clearances to buy and develop a land.
In spite of the drawbacks in residential real estate as an investment class, it remains the single biggest asset class for affluent Indians. The biggest portion of most people’s net worth is invariably in one or more of the houses they own. There are several reasons for this.
Until the stock market came to the fore over the past decade, buying a house, buying land or buying gold was the only known way to save and invest money. Compared to the familiarity of buying land or gold, investment in any form — either in mutual funds or in stocks or bonds — is alien to most Indian investors. Only 5 per cent of India’s household savings is invested in financial assets as against 77 per cent in real estate. As a result, residential real estate occupies a much larger mind share for Indian investors than any other asset class.
Source: RBI Household Finance Committee Report, 2017
Figure 2: Allocation of resources in India show significant skew towards real estate
‘House prices only go up’: Unlike other asset classes like equity and debt, which can have a cycle of three to five years (i.e. price movements change their trend every three to five years), real estate runs into super cycles of more than ten years. So, most people who made significant profits in the bull cycle of 2003–13 don’t have any experience or memory of a downward cycle. As a result, they get caught in the belief that real estate prices can only go up. The fact that there are no reliable real estate price indices helps to propagate this myth in India (one that is held by millions of Indians). However, veterans who saw the real estate crash of the late 1990s know better.
The lure of magnificent returns: One of the reasons even the most hard-nosed investors find it hard to ignore real estate is that the asset class made a tremendous amount of money over 2003–13 as house prices in most locations went up by as much as five to ten times. Outsized gains on this scale leave a lasting imprint on not just those who made the gains, but also on their friends and relatives — envy is a powerful emotion. However, as we learnt subsequently, 2003–13 was the best period for residential real estate in India and, in all likelihood, it will be a long time before we see another such period of price appreciation. In fact, in a downward pricing spiral, investors in an illiquid and tax-unfriendly asset class such as real estate can really get squeezed on their mortgages, as their modest equity is wiped out by the drop in the price of the property (a phenomenon known as ‘negative equity’).
Absolute return versus Compounded return: Most real estate investors are usually satisfied simply because they look at absolute returns in isolation. Thus, an investor may have a very fond memory of his property going up by five times in the last twenty years. But the compounded annualised return that property has generated over the last twenty years is just 8.3 per cent. In that same period, the Indian stock market’s benchmark index is likely to have risen at 15 per cent per annum which, compounded over twenty years, translates to a sixteen-times return!
Commercial real estate also has two sets of buyers: the end-users and the investors. With end-users, it is a simple equation. For them, real estate is simply a capital expenditure or a cost which has to be incurred, and these costs have to be seen relative to the return that the business generates. If businesses don’t want to incur the heavy upfront cost associated with real estate, they end up renting the premises or moving to a cheaper location. On the other hand, for investors, commercial real estate is a really interesting asset class as it offers a mix of rental yield and capital appreciation. For most affluent investors, investment in commercial real estate is in the form of shops, office units and small warehouses. This mimics their residential realty investment style in the size and locality of investments. Ultra HNW investors also have access to what are called the ‘Grade A’ office buildings. Grade A offices are large, modern and top-of-the-line buildings, typically built in the most prime locations. These are typically occupied by blue-chip Indian corporates or multinationals and are the benchmark of commercial realty in any country. Thus, one would measure growth in a Grade A property area to ascertain how commercial property as an asset class is doing.
Rental yields from commercial properties are a function of property prices and the underlying interest rates in the country. At 7 to 9 per cent today, these gross yields are far higher than the 1.5 to 3 per cent yields that residential real estate has to offer. Whilst an investor in commercial real estate also hopes for capital appreciation over time, given that the capital appreciation associated with this asset class forms a lower proportion of the overall gains, commercial properties are far safer investments than residential real estate (where capital appreciation is pretty much the only source of gains). Commercial real estate prices have been less volatile in India than residential real estate prices primarily because of the interplay between two forces. Firstly, the end-users of commercial real estate have been businesses. For these businesses, it is imperative to make profits and if the cost of a particular building or location is too high, they will consider moving to some other building or location. This rational frame of mind is very different to the mindset of the residential real estate investor who invests in an overvalued asset and still expects future price appreciation (irrespective of the current cost of the property). These contrasting mental frameworks have created a remarkable anomaly in the Indian real estate market.
Investors across the world, especially in English-speaking countries, have a fascination for real estate as an asset class. However, we have far more comprehensive data for the developed markets than for India and, thus, it becomes far easier to apply cold logic to these markets. In the US, for example, data is available from the early years of the twentieth century and throws up some startling findings. Since 1900, real estate in the US has given an annual compounded return of 0.4 per cent as against an annual return of 5 per cent from the Dow Jones — the standard benchmark of the US stock market.
Figure 3: Dow Jones vs Real Estate returns in the US since 1990
$1 invested in the Dow in 1900 would have become $30,447 in 2017. This compares to only a return of $161 if the dollar was invested in real estate. The story is not unique to the United States. As can be seen in the exhibit below, real estate hardly gives returns over long periods of time. Since 1980, American and German real estate have given compounded annualized returns of 3.8 per cent and 2 per cent respectively, while Japanese investors have hardly made any money at all from real estate.
Figure 4: Real Estate returns in other developed markets
In fact, real estate has time and again gone through boom-bust cycles across the world. Unfortunately, because these cycles are long, investors tend to forget the previous bust when they are in the middle of a boom, and the length of these cycles (alongside poor data availability in an emerging market like India) prevents them from developing a deeper understanding of this tricky asset class.
In India, most residential real estate is unaffordable. Adjusted for earnings, Indian property is easily among the most expensive in the world. The exhibit below shows the price of one square meter of residential property as a multiple of GDP per capita. Judging by this simple measure of affordability, India is the most expensive residential real estate market in the world by a gigantic margin. Clearly, these levels are unsustainable unless of course India’s GDP per capita skyrockets tomorrow morning. In the absence of such GDP growth, residential real estate prices in India have nowhere to go but down.
Source: Global Property Guide
Figure 5: Affordability measured by price/square meter as a multiple of GDP per capita
Another measure of affordability is rental yields, i.e. the rent from the property divided by the price of the property. The exhibit below shows that at 2.4 per cent, Indian rental yield is among the lowest in the world. A 2.4 per cent rental yield means that for a property worth Rs 1 crore, the annual rent that the house owner gets is Rs 20,000 per month or Rs 2.4 lakh per annum.
While commercial rental yields have always been higher, residential yields have been traditionally lower because of an in-built expectation of property appreciation. This also has to be seen in the context of underlying interest rates in the countries. For most developed countries, rental yields are far higher than their policy or ten-year government bond rates. In India, it is the reverse. Ten-year bond yields vary in the range of 6 to 7 per cent in India compared to the 2.4 per cent rental yield.
Source: Global Property Guide
Figure 6: Internal Rental Yields among the lowest in the world
Almost by any yardstick, the residential property market in India is significantly overvalued. Some of the micro markets are stretched to a bubble proportion. Today, a small house in the suburbs of Mumbai costs anywhere between Rs 1.5 and 2 crores. The equivalent monthly instalment (EMI) for a loan of that amount is roughly Rs 1.5 to 2 lakh per month. To be able to afford a Rs 2 lakh EMI, a professional has to earn at least Rs 3.5 lakh per month. This corresponds to a pre-tax salary of about Rs 60 lakh per annum. As per Income Tax returns filed for FY17, there are only 1.7 lakh people in the country earning more than Rs 50 lakh annually. So, it is not clear who exactly will buy these tens of thousands of flats.
Having understood all this, you have to ask yourself: does real estate deserve a place in your portfolio? We have seen, in isolation, the answer is an emphatic NO.
Let us look at the only other plausible reason: does it offer diversification? It is established wisdom to have a diversified portfolio because it brings the volatility or risk of the portfolio down without compromising returns significantly. It is worth going into a bit of asset allocation theory at this point to understand how diversification works. When two asset classes are mixed in a portfolio, while the combined performance is a weighted average of the performance of the two underlying assets, the combined risk is not such a straightforward calculation. Typically, the combined risk is lower than the weighted sum because some risks cancel each other. Thus, diversification offers the same return with lesser risk. However, 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, then the diversification of risk simply does not happen. For example, adding bonds to your equity portfolio reduces your risk significantly without a proportionate reduction in returns. However, buying a stake in private equity funds does not reduce your risk in a meaningful way because the prices of both asset classes (equity and private equity) move in a similar way.
Given that backdrop, let us now study the correlation between equity and real estate. Given the lack of data in the Indian milieu, we again looked at data in the US. The long-term correlation between Dow Jones and US property (as measured by Robert J. Shiller’s Real Home price index) was a staggering 78 per cent, implying that American stock markets and American real estate prices, more or less, move in sync. In comparison, according to consulting firm Aon Hewitt, the long-term correlation between US equity and bonds is around zero.
Therefore, in India and developed markets, real estate has given far lower returns compared to equity over long periods of time. Along with that, its high correlation with equity means that real estate offers little by way of diversification. A combination of these two factors means that this alternate asset class does not really deserve a place in most investors’ portfolios.
By Divyansh Agrawal - Analyst at King's Global Markets
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