Sunday, May 11, 2014

Real estate vs equity markets: Value strategy

Often I find myself in discussions with family, friends and professionals on whether value investing is possible in the real estate markets. Several who are having this discussion believe that the equity markets have lots of cases of fraud and high risk whereas real estate is a monotonically increasing function. While this is not exactly true one can understand why people think so.

Volatility

Real estate prices are very specific to the unit you own. Despite the advent of online websites like magicbricks.com and 99acres.com accurate prices are not available daily. Bid ask spreads can be as high as 10% and even if there is volatility in the market it is very difficult to experience it as an investor. Equity prices on the other hand are experienced daily on TV, on websites, in the newspapers and all around by investors and thereby lots of volatility is experienced by the investor.

Volatility as you know is the value investor's friend and enables you to buy cheap businesses in several situations and is the reason why value investors typically stick to equities.


Leverage & Risk

Typically real estate leverage comes from 2 sources:
  • Locking in a price on launch and then paying as construction goes along - in this case typically the capital outlay becomes smaller by virtue of the construction linked plan. Many speculators use this to get in, pay 20% or so of the capital and get out. Too much of this activity in Noida has of late has subdued the market for partially constructed real estate.
  • Bank loans - The government wants everyone to own their own. With this objective several housing finance companies (HFC) have shown up and the National Housing Bank (NHB) is also supporting the banks and HFCs in this goal. Using this as a return enhancing measure is fraught with risk and I typically do not recommend it.
Equities on the other the other hand are typically levered by the operation company already. Brokers of course are happy to fund margin accounts with LTVs upto 60% (sometimes even higher) but this is a recipe for disaster as the market can stay irrational longer than you can stay liquid.

Risk from equities typically comes from the underlying business earnings and over pricing. The real estate risk comes from:
  • Builder efficiency, ability and intent to deliver - Too much leverage, approval issues and unbridled expansion have been issues that prevent builders from delivering
  • Probability of increasing occupancy rates
  • Supply in the neighborhood relative to the amenities available
  • Quality of the maintenance services of the particular unit and the neighborhood
  • Approach road quality, metro access if any are kickers to value 

Inflation, Capital gains & liquidity

Inflation is the big argument in favor of real estate. Typically real estate is considered a hedge against inflation. Stocks are typically hit by inflation as their sales or margins do not go up with inflation and for most businesses margins go down due to inflation. Beyond a point inflation will drive up equities as well as the customers will have to start providing price increases.

Long term capital gains on real estate is 20% and equities is 0%. This means that the absolute return on real estate has to be 20% higher for it match the equities return.

Liquidity on real estate is typically low and a transaction will take up at least a quarter of searching and a couple of full working days for the transaction, agreements, execution and registration. Equities on the other hand take only a few hours to trade at the most but you could have mis-priced equities at the time when you want the liquidity and thus the liquidity is not that different between equities and real estate.

Returns

Finance theorists will tell you that real estate returns cannot match equity returns over the long run and most Indian investors will disagree. The bottom line is that real estate, due to acute shortages in the past and lack of infrastructure, has done exceedingly well in pockets. The NHB has started an index called the Residex with its inception from 2007. Unfortunately I could not get quarterly data from 2007 so I built this little comparison chart between residex average return across 15 cities and the NIFTY: 
As you can see the returns from 2011 till 2013 are pretty much level with equities taking a nose dive in the middle.
Real estate return drivers:
  • Income levels of people in the area
  • Occupancy rates - the more the place is occupied the higher the demand. Sometimes this is also referred to as the location premium. The occupancy rates get driven by proximity to offices, industry, malls, schools, hospitals and other amenities.
  • Rental rates - this is the huge issue with residential real estate in India. Cap rates (annual rent as % of market value) run around 2% to 4% depending on area and furnishing status. Typically for a fairly priced piece of real estate cap rate should be a bit higher than bank fixed deposits. The reason for this low cap rate is the expectation of growth driving the denominator up.

The verdict

As a retail investor the right answer is probably some split between real estate and equity. Typically to get better internal rates of return (IRR) it is better to invest in new projects with builders who you trust, have a track record and are financially sound. Real estate is more sure shot as long as you are sure of getting the asset delivered to you. Equity is a more involved exercise and takes up some of your hobby time or you have to find a rational asset manager who you trust. The ratio between real estate and equity is one that depends on your liquidity needs, income sources, utility curve, retirement planning and savings needs.

Irrespective of strategy the only form of leverage that should be used on investments is a construction linked plan for which you already have carefully planned funding not involving loans. Buying a fully built unit as an investment is unlikely to keep pace with a well run equities portfolio. Any other form is going to the increase the probability of going bust along with the increase in expected returns.