Which asset class has provided the highest historical returns in India?
Most statisticians answering this question will likely gravitate towards equities as the best performer. Though equities have beaten most (if not all) other assets in terms of long-term returns, this has not necessarily translated into widespread investment success for the average (non-professional) investor. Not surprisingly, if the question is flipped as the following:
Which asset class has created the maximum wealth for most people in India?
The response would likely be an overwhelming inclination towards real estate. While there is no conclusive data to assert real estate’s return supremacy, it would be safe to conjecture that returns from real estate in India would not have either under-performed or beaten equities by any significant margin. Given equities perceived edge in terms of returns, it would be interesting to explore why this has not resulted in extensive wealth creation for the average (individual) investor as compared to the numerous long-term success stories one comes across with real estate investing.
To bring context to the discussion, let us first look at the numbers:
The above table reflects long term returns for asset classes where credible, verifiable and representative data is available. Clearly it shows that equities have beaten all other asset classes in terms of pre-tax returns. The one important asset class not represented in the table is real estate. This is because statistically precise and representative data for real estate is not readily available. Nonetheless, we may work with some relevant data and statistics to arrive at approximate long-term returns from property markets in India.
Real Estate Data and Returns
To understand investment returns from real estate in India, it would be prudent to segregate property markets into residential and commercial and look at each separately. This is because both residential and commercial real estate have very different characteristics in terms of investor profile, tenancies, risk and returns.
Given the heterogeneous nature of property markets, it is difficult to use any particular data set as representative of broader market returns. However in case of residential real estate in India, we may use National Housing Bank’s RESIDEX as a credible source of housing price movement over the years. This data is available 2007 onwards.
Estimating Residential Property Returns: while assessing the residential market returns, it would be advisable to note that a lot of micro-markets and cities (50 currently) covered in RESIDEX are not well developed. Thus, price reporting-valuation in those markets may not be consistent. To circumvent this problem, we may use housing price movement in Mumbai as an approximate reflection for the residential real estate market in India.
*NHB’s RESIDEX is not available for periods prior to 2007. While the above data captures price changes during 2013-2018, a period of protracted pain for real estate, it does not reflect important periods of out-performance in residential property: 2002-2007 & early-mid 1990s. Thus, any estimates of long-term returns (over 15-30 years) in residential real estate should be modified suitably with an upward bias.
Estimating Commercial Property Returns: as opposed to residential market, there is no central or statistical data source to track price movement for commercial properties in India. To approximate commercial property returns, we may thus use commercial property yields as estimated (reported) by credible international property consultants along with historical inflation in India.
The total return from commercial real estate is a function of rental yield (or cap rate) plus a growth factor. Over the long-term, property rentals are noted to increase at the rate of inflation. Thus, total returns from commercial real estate in India would roughly mirror the average rental yield + average inflation. The rental yields on commercial property in India typically range from 8%-11% (Investment Guide: India, Knight Frank). Over the last 30 years (1989-2018), the inflation rate in India has averaged 7.4% (IMF DataMapper). Putting the numbers in place suggests the long term (30 years) returns from commercial property in India can be approximated as:
~ 8.5% (avg. rental yield) + 7.4% (avg inflation) = 15.9%.
Note: The rental yields and cap rates on commercial property assets have shown a compression 2011 onwards (Realty Asset Monetization, Knight Frank). Any review of long-term commercial property returns should thus be suitably adjusted upwards for an accurate assessment.
From the above analysis we can infer that the average long-term returns from residential property in India have ranged between ~10%-15%. In case of commercial real estate, the returns have likely been closer to 14-17%. Comparing this with the 30-year BSE SENSEX returns of 14.2% + ~ 1.4% (avg. dividend yield, CEIC Data Dec1996 - Aug2019) = 15.6% confirms that property returns have been more or less at par with equities. This suggests that wealth creation from an asset class is not necessarily dependent on returns out-performance. There are other variables like investor behavior, nature of price movement, return constitution (income v/s capital gains) which play an equally important role in determining investment success. The below discussion explores if the inherent characteristics of real estate investing align favourably with desired investor behavior and leads to more probable wealth creation for the average (individual) investor.
Easier to Understand (and Manage)
According to investing legends, one of the key determinants of investment success is to be able to make well-informed independent decisions. For an average investor, this is a lot easier to do with real estate than with equities. Successful stock investing requires the training and knowledge to understand a business which involves having a comprehension of accounting, corporate finance, governance standards and mechanics of stock market. Moreover, to be able to make sound decisions, you also need to make a judgment on management competence and industry outlook. A lot of these skills are technical in nature and out of bounds for most individual investors.
On the other hand, the two primary skills needed for understanding real estate are basic maths and a commitment to do on-ground research. Real Estate being a tangible asset lends itself to physical inspection and appraisal. An investor with a willingness to hit the roads can develop a solid understanding of the key drivers of price appreciation like infrastructure development, commercial agglomeration, and transport connectivity. Similarly, they can also physically inspect the project or a particular property to asses its construction quality, maintenance and desirability from a tenancy or livability perspective.
Another important aspect of this simplicity in real estate is that it allows greater control in the hands of the investor. Being a tangible asset with straightforward revenue and costs, makes real estate easy to manage. In essence, you are the CEO of your property and can make and execute all decisions to optimize investment returns. This, however is not possible in case of equity investments where as a minority shareholder, a common investor will not have a voice in decision making. You are largely dependent on the company’s CXO’s and third party analysts to provide you with transparent information and guide you on important business undertakings.
Given the ease of analyzing and managing real estate, it is much more likely that an average investor can make informed decisions and thus earn superior returns in property investments as compared to equities.
An often-cited advantage of equities is the liquidity it offers on account of being traded on an exchange. While liquidity is undoubtedly a cherished investment characteristic, being exchange traded comes with its own set of challenges. The price of a security or instrument listed on an exchange is affected by the divergent views and transient emotions of different market participants. The ensuing volatility can cause confusion to the average investor who may not have the requisite training or nerves to absorb the swings of the market.
What compounds the problem is the very high media visibility of stock markets. Most media outlets extensively cover stocks listed on an exchange and constantly bombard their viewers with the ever-changing prices and over-enthusiastic views of experts. This adds to the troubles of the unsophisticated investor who is unable to make sense of the market noise and ends up making wrong entry and exit decisions- often in panic!
This is not the case the case with property market where prices are not published publicly and not under constant media gaze. Real estate investors are usually not cluttered by short-term price fluctuations or incomplete views of TV experts, thus allowing them to make unemotional and independent decisions. This ability to act calmly on a well-informed decision is a critical ingredient which defines investment success.
Long term Holding
A long holding period is the core of prudent investment planning. This is because the mathematics of generating long-term wealth is based on the power of compounding which works in our favour when we carefully choose an asset and let time do its work!
Out of all investment options readily available to the average investor, real estate usually carries the highest ticket size. This large upfront commitment creates a certain investment barrier which makes real estate less amenable for short-term trading. The sizeable investment requirement combined with low liquidity causes people to be more thoughtful while making a property decisions and causes the average holding period in real estate to be higher as compared to financial securities. In case of residential real estate, the long holding period is even more pronounced because for most individuals, a property investment is actually a purchase of their primary residence. The decision of home ownership is closely aligned with a family’s long -term settlement plan. Given the sense of security and emotional connect a home provides, people tend to hold it for a long period, sometimes forever!
Contrary to this, an investment in financial securities like equities is readily accessible to even average investors at very low-ticket sizes. The low investment barrier combined with ample liquidity and large doses of visible volatility causes regular investors to not hold on to their investments for long even when they originally intended to do so.
The tendency of property investors towards a long holding period is a key differentiator in wealth creation. By making a large initial investment and holding it for long, they benefit immensely as the magic of compounding ticks in their favour.
Income Yield and Leverage
A beneficial attribute of real estate as an asset is that it has a substantial income component. Even after a compression in rental yields over the years, residential real estate still yields 2%-4%, while commercial real estate provides a healthy yield of 8%-11%. This steady source of income is very valuable for the average investors since it is an important and often a more reliable component of total returns. A healthy income yield means investors are not dependent on capital appreciation alone and can patiently tide over periods of price stagnation.
The other more significant advantage of a good income yield is that it makes it easier to draw leverage on your investment. The relative stability of asset (property) prices combined with its income generating capacity means banks are very amenable to providing high loan to value (LTV) ratios for real estate investments. Typically, for residential properties one can get an LTV of 80% while for quality commercial real estate in India, the LTVs are ~60%-70%. This means that for an investment of Rs 1 Cr, an investor needs to make a down-payment of Rs 20 lakhs (residential)- Rs 35 lakhs (commercial), and get the remaining as credit from financial institutions.
This leverage can significantly enhance the returns from investment. For example, by using an LTV of 80% on a residential property, a 4.0% net return (total return-recurring cost) gets multiplied to an effective return of ~20%! In contrast to this, due to the volatile nature of stock price movements, it is difficult and sometimes inadvisable to get leverage (margin) for making long term stock investments.
More importantly, the leverage in real estate is structured as a loan which is repaid through pre-set monthly installments whereas margin-based leverage in stocks always carries the worry (risk) of an unfavourable liquidation on account of an untimely margin call. The ability to enhance return through leverage on quality property assets means that investors do not have to lean towards riskier instruments in search of augmenting their gains. This is an extremely favourable arrangement which places the average investor in the sweet spot of achieving higher risk-adjusted returns.
A lot of discussion in mainstream investment profession is centered around identifying instruments with the highest return potential. However, as we can note from the above discussion, higher mathematical returns do not necessarily translate into higher realized gains for investors. Human beings are fallible creatures who are often driven by their emotional impulses than the statistical beauty of an investment design. In choosing the correct investment tools and strategy, investors should also assess if the behavior of an asset class aligns with their psychological make-up and financial training.
Real Estate with its relatively calm (but handsome) price changes, simple structure and income generating capacity closely matches the requirements and temperament of the average investor. Not surprisingly it has been the preferred weapon of wealth creation for generations of gold laced, grey-haired men!