Risk Analysis of investment: Real Estate vs Equity

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

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

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.

Leverage

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.

Fraud

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.

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6 Comments »

  1. businesspandit said

    My favourite Indian real estate article yet : http://new.valueresearchonline.com/story/h2_storyview.asp?str=100872

  2. rcfnj said

    The fact is that stocks’ performance, wth the re-investment of dividends received, have done much better than real estate over the last 30 years!

    http://www.forbes.com/2005/05/26/cx_sc_0527homeslide.html?thisSpeed=65000

    Dividends are real, fungible money that can be spent, re-allocated, re-deployed, or re-invested. They also provide much needed cash flow to those who are retired. They are liquid and can be sold quickly and inexpensivly versus real estate which is illiquid, has a high spread between bid and offer, and has high sales transaction costs. Can a primary residence produce needed cash flow to the owner? IMO a reverse mortgage is not the answer as only ~30% of all homes are mortgage-free and the remaining 70% have on average only ~33% equity versus 67% debt.

    Housing may appreciate a bit faster than inflation, but so do property taxes which confiscate a portion of the homeowner’s equity, reducing the net return from real estate, and in high property tax states, make it more difficult to sell a home as property taxes impact a potential buyer’s ability to afford the monthly payment.

    Residential real estate is a liability to the mortgagee and an asset to the mortgagor.

    How do you explain the collapse in real estate prices in Japan? Europe? Australia? and the U.S.?

    Have you considered the costs associated with maintaining a primary residence i.e. home owner’s insurance, property taxes, maintenance costs?

    Have you considered that residential real estate prices are coupled with the borrower’s income which determines their ablitity to afford and service a mortgage?

    Have you considered the impending price declines in the commercial real estate market?

    As in all markets, they can be irrationally high or irrationally low, but eventually they will correct back to their historical norms and ratios. That, IMO is what is happening now.

  3. rcfnj said

    A few more things to consider:

    Housing is never in short supply as technology allows producers i.e. home builders to produce homes in excess of demand driving the stock of existing home prices downward.

    Moreover, income has not kept pace with productivity growth or inflation thus keeping a lid on higher home prices.

    Last, we are at the bottom of the interest-rate cycle, therefore, as interest rates rise, home affordability will go down further suppressing home prices and sales.

  4. pradip said

    Nice write up. Good and indepth analysis People ignore the importance of diversification of portfolio.

  5. Pradip said

    Sirji, when is the next post???
    Waiting for it 🙂

  6. Prakash Vaidya said

    Very well presented , for a middle class person, busy with own job/assignments , MFs present a very good avenue . However as much as one may recommend SIP , fact remains that you are committed to buying something not knowing the price . If someone has time / has a good sub-broker available ( at a nominal brokerage ) , it is better to invest regulaly in MF , varied amounts depending upon P/E ratio of Sensex , to generate better returns than SIP . At higher P/E , say more than 20 , you may simply not invest & wait for it to come lower than say 19.50 , and progressively invest larger sums as P/E goes down.Historically , P/E does give you you opportunities to invest every 2/3 years , when it goes below 17.50 ( long trm average ).

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