Saturday, September 13, 2014

Why real estate my friend, why not stocks?

The article below is intended to educate the investors on the option of Equity Investing. This do not make any investment recommendations. There are many options for investing your funds. Equity investment is only one of the options. Equity investment is risky. Pl. discuss with your investment adviser before investing in equity market)

1. It is recommended that if you are venturing into equity markets, you do it through Mutual Funds
2. Unless specified otherwise, all the references to the markets relates to Indian Equity Markets.

Now to the article....

I overheard my friend Raj talking to a friend about potential investments

Raj: I have some money to invest in. Where should I invest?

Friend: Why don't you invest in Real Estate?

Raj: That's what I have also been thinking.

This kind of discussion is all too common among middle class in India who has an investible surplus.

This always puzzles me, this fascination for real estate. Being a hardcore follower of equity market, and knowing that any day equity will outperform real estate, it is very hard to curtail the impulse to butt in when I listen to similar conversations.

On one level I can understand this fixation with real estate. I can think of the following reasons why people find it comfortable when investing in real estate.

They are in control of the transaction: When it comes to real estate, most of us are dealing with a tangible item. There is a parcel of land, or a block of apartment, you can touch, you can feel, you can meet up with others who have purchased similar property, you can meet up with and negotiate with the seller regarding price....
You are investing a large amount of money and you feel that you are in control, that you are taking charge of your investments. You have an emotional connect with the purchase process.
Buying a stock is just an unemotional transaction. You are dealing with an invisible entity, the stock exchange. In these years of Demat, you are buying something which you don't see and feel (earlier, you used to get a physical share certificate for your investments), price is given to you, you are a price taker. There is no scope for negotiations. None of your traditional purchase habits work when buying stocks.

Tangible vs. Intangible: As mentioned before, real estate is a tangible asset which you can see and feel. Stocks on the other hand is intangible. You can feel its presence only by the upward or downward movement in its price.

Parents have set example: Most of the people who buy property have seen their parents or some significant elders in their life go through the process of buying real estate. That is not the case when it comes to investing in Stocks. Despite phenomenal, mind-boggling returns from equity, many people of the previous generation were afraid of investing in stocks.  Culture of equity investing is a recent phenomenon in India. This has started only in the 90s with the advent of the new middle class. The first stock exchange was set up in India only in the late 70's. So for many people, buying stocks is a new experience and they have no one to look up to.

Friends have made money: Everyone out there has a friend who bought a house at 1500 per square feet, which is trading at 3000 (or 6000, whatever number) per square feet. It creates a visibility and removes the aura surrounding real estate investing. It is also possible that all their friends also invest in real estate and are not aware of equity investing (remember that birds of the same 'Investment Habits' flock together). Coupled with the fact that significant elders in their life had never invested in stock market, this leaves them with no examples of people having made money in any investment other than real estate.

Appreciation in real estate prices are highly visible: People can see and feel the appreciation in the price of real estate. Almost every real estate property advertisement presents the price information. This helps people to compare prices. Raj can say things like "Six months ago price was 1000, now it is 1250. It is a 25 percent appreciation in 6 months'. However, the price information on equity market is relegated to the pink papers and even here it is relegated to some esoteric language like '450, 475, 444, 453, 22'. One can't make a head or tail out of this information. (Information seen in Tickers in Financial Channels are only related to a few stocks and their prices are normally beyond the range of a retail investor)

Emotional value: This is a no-brainer. World over there is an emotional value attached with real estate. Having a home of one's own is considered a symbol of safety. Society (which mostly consist of people with similar aspirations) look up to people holding real estate. (It is a different matter that while doing the spring cleaning, you come across a share certificate of 100 Shares of Wipro bought in 1980 (purchased by your dad) at 10000 and see that the market value of that investment is currently 440 Crores (44000000000) and you have unclaimed dividends of about 118 Crores!!!!)

However there are some obvious disadvantages to buying real estate.

Your returns are not what they are: There are lots of taxes and duties associated with the purchase of real estate. Assume that you buy a 1500 square feet of house at Rs.1000 per square feet  and sell it at Rs.2000 per square feet. At the time of purchase you have to pay an overall tax of about 5% which inflates your purchase cost to 1050. At the time of selling, again you have to pay a tax of (let's say, 2.5%) which decreases your sales price to 1950. So your net return will be 900 per square feet, 100 (10%) lower than what is visible. Remember that I have not considered the time element here. If you had kept your house for 10 years before selling, that is a measly return of about 6% per year, lower than the inflation rate, which means that you have lost money in the transaction. (You could argue that you would have got rental returns, see my point below about rental returns)

Additional charges that lower your returns: Real Estate calls for two additional annual charges, vis. Maintenance charges and Property taxes. Those will further lower your returns. No such charges exist in case of Equity Investing.

The profit on your first house is always notional: One may pride himself saying that the house that you had purchased 10 years ago has quadrupled in value. But my question is, are you going to sell the house? Most of the time, your answer is no. This means that the returns are only notional.

Rental incomes are meagre: As I had mentioned in this post about Kambles the rental returns are measly. For instance, if you purchase a house for about 60 lakhs, which gives you a rent of 25000 per month (3 lakhs per year), the annualized return is only 5% which do not beat the inflation. Which means, as I mentioned in this post about Two Thieves, is a net annual loss for you. A bank deposit at 10% interest rate would have given you 6 Lakhs on the above.

You are not the real owner: Till you pay off the final installment of your EMIs (Mortgages), you are not the real owner of your property. The lender, usually the bank, is the real owner of your property. This was amply demonstrated by the recent housing bubble in US where the banks had to resort to distress sale of many properties where the owners could not pay back the mortgage.

Now let us talk about Equity Investing. It is a known fact that only about 3% of the annual savings in India are invested in equity markets. While there are many aspect as to why this rate is very low, including regulatory aspects, there is no question that attitude and perceptions of the people with respect to equity investments has got a lot to do with such minimal savings rates in equity in India.

The basic perception is that the Stock investing is esoteric and that it needs some expertise which many of us do not have. There is talk of PE, PB, Cash Flow, Balance Sheet...Not all people have the requisite knowledge to handle stock investing and hence are discouraged to invest in equity markets. However, expertise is required for any kind of investment, not just for investments in equities. If you don't have the requisite knowledge, you could either make sub-optimal investment decisions or worse, you could lose a lot of money. I remember once standing in a 'Tanishq' shop. One lady brought her gold jewelry to check it Caratage (Gold Content). When told that it was 18, she was inconsolable. The vendor who sold it to her had told that it contained 22 Carats and was charged her accordingly. How many of us know of people who purchased real estate and found that it was not what was promised? It is important to do due diligence no matter whatever the investment.

Despite above drawback, even when someone invests in equity markets, the make the following mistakes. 

They enter the market late in the cycle: This is the first mistake that most people make. Before a stock comes into the public domain, it would have already run up quite a lot. This means that an average investor is purchasing an expensive stock and as anyone know, an expensive item can only come down in value. This leads to investors losing money which reinforces their perception that equity investing is only for experts. (Read my post on 'Chaiwalla (Tea Vendor) Threshold')

Sell winners and keep losers: This is a peculiar habit of retail investors. They invariably sell the winners at the earliest opportunity and keep the losers all the way down to significant loss. Since the profit is limited and loss is unlimited, the investor ultimately lose money. Some time they compound the loss by buying more of the losing stock in the name of 'Cost Averaging'.

(I can go on. I have made more equity investment mistakes than I care to remember). 

If you put the effort to learn the basics, equity investing is much more lucrative (and intellectually satisfying) than any other form of investing. Following are some of the benefits of Investing in Stocks over Real Estate:

Easier Purchase and Disposal: Equity investment is very easy to enter and exit. You can get into the market for amount as low as 1000 rupees. Also it is very easy to exit from your investment. This provides easy liquidity. So if you have a requirement for liquidity, it is better to have some investments in equity markets 

Zero tax on long-term capital gains: This is the most important benefit of investing in equity markets. Long-term capital gains taxes are zero. This means that if you keep your stocks for more than 365 days and then sell, the profits are totally tax free. Compare this with investing in real estate where short-term capital gains tax is applicable if it is sold within 36 months and long-term capital gains tax applicable thereafter, unless you buy another property within a year of disposing off your previous property.

Much faster appreciation: Invested properly, Equity Markets can provide significant returns if an investor identifies and invests in the correct stock at the correct time. Just an example, a stock like 'Avanti Feeds' has quadrupled over the last one year.

Cycle turnarounds are much faster: This is another major advantage of investing in equity markets. Even when they fall, they recoup their losses very quickly, much more quickly than real estate. For example, in 2008, the market fell from 21000 to 8000 and in the last 6 years, it has recouped all those losses and then some. 

With all these benefits of investing in equity markets, my question to friend Raj is, 

Why real estate my friend, why not stocks?

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