Real Estate vs Mutual Funds – Which is the Better Option?
Last Updated : June 18, 2020, 6:38 p.m.
Traditionally, we, as a country, have loved investing in real estate and gold. Primarily, this is because of these being tangible assets, perception of being risk-free and high returns in certain time frames. Over the years, there has been a gradual shift from investing in physical assets like real estate and gold to financial assets like mutual funds and stocks. Let us look at two of these investment options-real estate and mutual funds and understand which is better.
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Before we get into comparisons, we need to be very clear about why we are investing in these two in the first place. People invest in real estate either to stay, rent out or hold on for capital appreciation. Let us look at all three.
Buying a House to Stay – If you are buying real estate in the form of a house to stay then it is not an investment, it is a consumption item like buying a car or an air conditioner. So, you should not consider this as an investment or an asset because it is unlikely you are going to sell it till you are staying in it. Many people commit the mistake of considering the house they live in as part of their net worth, but it is not.
Investing to Lease Out – Now this can be considered as an investment, many buy a residential or commercial property to lease out and get rent from it. Let us evaluate this in the Indian context. In most of the major cities in India, rental yields are around 2-3% that means you get 2-3% of the capital value of the real estate as annual rent. For e.g. a 2-BHK flat in Delhi NCR would cost anywhere between INR 80 lakh-1.50 crore depending on the locality and the rent is around 16,000-35,000 monthly or about INR 2 lakh to 4.50 lakh annually. Many of us take a bank loan to fund this investment which comes with an interest cost of 7-8%.
So just to break even, this property must appreciate by 5-6% every year. To generate a 10% ROI (return on investment), it must appreciate by 16% annually. We have witnessed that in the last 7-8 years or so property prices have actually come down which means an annual loss of 4-5% on this investment without considering the capital value erosion and the opportunity loss. So, investing to earn rent does not make sense until the gap between the rental yield and bank loan interest rate decreases sharply or both are at the same level. This is so in the US and most of Europe which makes buying real estate attractive. If and when this happens in India, it will make for a strong case to buy real estate for renting. For this to become a reality, home loans have to drop to 2-3% or rentals should increase to 7-8%. Looking at the current demand and supply situation, this looks far fetched.
Investing for Capital Appreciation – This is the major reason why people buy real estate. The period between the mid-90s to 2012 saw a sharp appreciation in real estate. You could hear from friends, colleagues, the real estate industry that prices multiplied anywhere between 10x to 30x. A 20 lakh house in the 90s became 2crores, even more in some cases, anything you touched became gold. This is a reality with one flaw of looking at these returns. When it comes to real estate, we talk in terms of 2x-5x-10x, etc, but seldom look at the returns in % terms. If you bought a property in the mid-90s and it is 10x today, the return is roughly 10% per annum, mind you this does not include taxes, construction cost, paperwork, brokerage and other costs associated with real estate. Fixed deposits have returned 8% during this period with zero risk. There are many who have not seen their buying price from the last 8-10 years and some who have not even got possessions of the real estate. This can be attributed to squeeze on cash transactions, the burst of the price bubble, higher interest rates, lower purchasing power, unaffordability, and shift towards financial investments.
Let us now compare real estate with mutual funds on six important parameters:
Liquidity – This is one of the factors which is understated or not given enough importance while investing. In fact, before looking at the returns from your investment one must look at liquidity in the investment options available. In times like these of COVID-19 when cash is king, you would have been or will be much better off being in an asset class which is liquid i.e. you can sell it at a time when you need the money most. Real estate, to a large extent, is illiquid, while mutual funds are completely liquid. You can withdraw your mutual fund investment anytime with a click.
Returns – As we talked in brief about returns from real estate in the earlier part, most of the people who have bought real estate in the last 10 years and held on to it are witnessing capital erosion or negative returns. There could be exceptions, but this has been the case largely. In the case of mutual funds, if you had invested 10 years back, equity funds have returned between 9-12% on an average. These returns are in fact lower due to market correction due to Covid-19. If one would have looked at these returns in January, they were more like 13-16%.On the earlier argument of 10x-20x returns in the last 20 years or so from real estate, most of the equity mutual funds have grown 50-100x in the last 20 years. Going forward too, mutual funds should do better than real estate considering growing financialization, ease of withdrawing, and low penetration in mutual funds which is bound to attract more investors.
Price Discovery – There is no index for real estate where prices are scientifically discovered and listed basis demand and supply. You do not know the price of your property yesterday and what it will be tomorrow. This makes it difficult to value real estate, we might put an x value to it, but the actual value could be very different. Making a financial plan basis an investment whose value you do not know is like shooting in the dark. Mutual funds, on the other hand, disclose NAVs daily, you can view your portfolio every day. There will be times when that value would be down and at times it will be up. But at least a price discovery happens daily, and you are in a position to make a financial plan based on this investment.
Compounding – Mutual funds give you the benefit of compounding to your investments. Returns are generated every day, so your money multiplies. Mind you for compounding to have a real impact on your portfolio, one needs to give it time. In the case of real estate, there is no compounding.
Convenience – Managing mutual funds is much simpler, once you invest for a certain period you just need to look at it occasionally. Also, investing in mutual funds is completely paperless now making it very convenient. When you buy real estate, there are various phases of managing this investment. You need to get it registered, find tenants, handle litigations, spend money and time on upkeep and multiple visits to sell off. This makes real estate an inconvenient investment.
Mobility – Unlike mutual funds, real estate is an immovable asset. If you shift from one city or country to another, you cannot take it with you. When you give it on rent, we explained earlier the difference in rental & mortgage yields making it unviable. Mobility is a very important factor these days with frequent location changes in jobs and businesses. There is no point in investing in an asset which is not movable, it is better to be asset light.
Which is the Better Option?
We believe buying real estate in the form of your own home is vital. A roof above your head is an aspirational and an emotional want, it keeps you in good stead during bad times. One should plan for buying a house and take it as a consumption good rather than an investment. With falling incomes due to Covid, purchasing power will further decrease, putting more pressure on real estate prices in the near future. Real estate might be a good investment in the future when prices come down sharply and rental & loan rates converge. Till then, one should avoid investing in real estate. Mutual funds, based on all the factors discussed above, are certainly a better option. However, one needs to be mindful of investing with understanding, following asset allocation and implementing the right advice when investing in mutual funds. Investments in mutual funds done without any of these could lead to a bad investing experience and return below expectations. Mutual funds offer a range of products from being an alternative to a savings bank a/c to superior wealth creation over the long term.