You must have heard people saying: investment in real estate is risk free. Stocks may crash, but real estate always goes up in price. After all, they aren’t making any more land, are they? You might also have heard, from the same people or different, that stock market investment is nothing but gambling. Let us today try to find out how real estate and equity shares really compare in terms of risk. Like this guy was confused about the returns comparison of real estate and equity, are some others confused about risk comparison of real estate and equity?
One thing is certain: real estate prices are actually less variable than share prices. The reason for this has 2 aspects:
1. Stocks are in themselves useless to a retail investor, who is unlikely to hold more than 0.001 percent of any decent company’s stocks. He has negligible voting rights and even less awareness. So, at any sign of trouble, stocks are sold en-masse and hence their prices crash.
2. Houses, on the other hand must be lived in, trouble or no trouble. One residential abode per family is almost essential. So, when there is economic trouble, people stop buying new property but they won’t sell their own home. This partial clinging to real estate makes its prices more stable than stocks.
Now, when financial “experts” speak in their confusing jargon, they call variability of prices as “risk”. This is misleading as, in colloquial usage, risk is a word that is used to convey a related but different concept. Let me point out risk factors that real-estate investment has even after a lower variability of prices. All this is for a middle class family, and these risk factors may not be applicable to rich people. An example middle class family headed by Mr. X will be our protagonist.
Object diversification in this context refers to investing in multiple different objects. It reduces risk for the investor because different objects might give different returns: positive or negative; so that overall returns are relatively stable. By committing less than Rs. 3000 a month, Mr. X can invest in about 5 well-rated mutual funds and hence have exposure to shares of about 75 companies. These companies do varied business like banking, mining, refining petroleum, newspapers, construction, power production, consumer goods etc. Some companies will be big, some small. The highest exposure to any company he will have will be less than 5%. That is to say, even if that company mysteriously vanishes from the face of the earth(an unlikely event, to say the least) he will lose less than 5% of his money. A mere Rs. 1000 per month more, and he can invest in international equity mutual funds and buy so much diversification as is not possible to describe in this small blog of mine.
Mr. X can buy only one house per half-century. Diversification is just not possible. To have similar diversification as of the above share portfolio through mutual funds, he will have to buy a commercial complex in Kolkata, a small residential house in Mumbai, a mine in Jharkhand, a second larger residential house in Gorakhpur, agricultuaral land in Tamil Nadu, and many more. He has to remember to buy buildings built by different builders. Forget about ANY object diversification: Mr. X has bought just one house, one location. If it is discovered (an unlikely event, to say the least), that a volcano will erupt at the place soon, he will be severely impacted financially. Even a simple thing as the city water supply board quoting problems in supplying water to the area might impact real estate prices of the area. Such are the perils of ignoring object diversification.
Time diversification means investing in a single object at different times. If the price of the object keeps changing, this technique can average out the overall investment price for the investor, thereby reducing risk. In investment arena, this can be achieved by, e.g. SIP. The tubes of the internet are already choking with information about SIPs so I will not go into further details. The point is, through the years when prices of shares dance to the tunes of FIIs, Governments, International events etc., Mr X buys shares every month. So there is no risk of buying the full portfolio when the prices are at their peak.
I have said before, and I will say it again: Mr. X can buy only one house per half-century. Asking him to buy a house every month would have been funny, if it weren’t so inconsiderate. We will not advice anything of this sort. If this house purchase is done at a time when real-estate prices are near their peaks, bad luck. The long term returns from real estate appreciation will be reduced if initial purchase was at peak prices. Note that like every one else, Mr. X thinks he can time the market but actually he can’t. Since in this case since time diversification is not possible, he will try to time the market and fail. Moreover, price of the house is just part of the cost. Mr. X has taken a loan for 20 year, during the course of which he will pay more as interest than as principal . If he is paying peak prices for house, he has to proportionately pay higher for interest too.
Being in the middle class, Mr. X does not have enough money in the bank to buy a house unless he finances it with a housing loan. This makes his real estate investment a highly leveraged one. Leveraging in any business increases risk. Many books have been filled with details how leveraging increases risk, I will only give a few links.
Haha. Property developers are masters of fraud and of subsequent litigation. Project cancellation with non-refund, project delays, cost escalation, non-standard and confusing methods for size calculations are routine tactics of real estate business. Realtors encourage their buyers to go to court because they know it will be decades before any meaningful justice can be provided to the buyers. Realtors have lawyers in their employment whereas the buyers would be unable to afford the services of lawyers for long.
Mutual funds are regulated by SEBI: the second best regulators of India in my opinion (best is RBI). There haven’t been many instances of mutual funds (SEBI registered ones, of course) denying, or delaying redemption significantly. Upstream, in the stock markets, whenever we have a Harshad Mehta, Ketan Parikh, or Satyam, we improve our regulatory procedures so that similar occurrences are not repeated.
Fraud is the aspect of risk overlooked by most financial experts. Of course, when their definition of risk itself is different from the common man’s definition, such misunderstandings are bound to occur.