Tuesday, June 22, 2010

Analysis of Stock Market vs Real Estate Investing

Have you ever wondered, how does investing in stock market compares with real estate investment? Well they both have their merits and demerits and are suitable for different sections of people.

While stock market is accessible to mass retail investors and is far more liquid, real estate investment requires more upfront commitment and may not be liquidated that easily.

Stock investing and real estate investing have the same basic financial objectives. People invest money in both to make money from growth and/or income. Growth through price appreciation (increase in value or market price) is where you really make the big bucks.

Here we have tried to compare these investment options from a very objective perspective and have considered both these avenues from pure investment vehicles.

For simplicity, we have assumed that both stock and real estate investment grow at same rate of 10 percent per annum. Further, same amount of investment at same periodicity is considered in both the options. The time horizon for investments to mature is taken to be 5 years.

Suppose you decide to buy a real estate house valued at 50 lacs by taking maximum i.e. 85 percent financing. This means you put 7.50 lacs as down payment and rest spread out as equated monthly installments at 9% reducing rate of interest for a period of 15 years, which comes out to be Rs. 43,106 per month. Further an additional Rs. 385,000 would be required for covering registration of your house property and loan processing costs. An additional cost of maintenance of house property at the rate of 1 per cent per annum of the value of the house is considered.

You on the other hand invest the same amount of Rs. 7.50 lacs in stock market index fund i.e. 7.50 lacs starting investment and a regular investment of Rs. 43,106 per month during the investment period.

After acquiring your house property, you decide to rent it out at prevailing annual market rent of 2 to 3 percent of the property value to start the income stream. Although you can get dividends in stock investments, we have kept it out of consideration as dividend rates and assurance of dividends are not guaranteed. Further, dividends are paid out on the face value of the stock rather than on the market value of single share of that stock.

At the end of 5 years, you decide to sell off your investment in both these asset classes. The net value in real estate investment means the realized value after repaying the balance loan amount.

Stock Investing vs. Real Estate Investing

Let’s compare the profitability of these investment options.

Year Invested Amount Stock Investment

Real Estate Investment



Net Value

Net Value

Income

Costs

Year 1

1,267,276

1,370,190

1,414,042

156,000

438,250

Year 2

517,276

2,055,323

2,146,086

168,000

59,000

Year 3

517,276

2,812,197

2,953,109

186,000

65,000

Year 4

517,276

3,648,327

3,842,805

210,000

71,667

Year 5

517,276

4,572,010

4,823,658

234,000

79,083

Total Value

3,336,380

4,572,010

4,823,658

954,000

713,000

Particulars

Stock Market

Real Estate

Total Investment (Amount Invested + Costs)

3,336,380

4,049,380

Total Amount Realized (net value + Income)

4,572,010

5,777,658

Return

37.04%

42.68%

Stock investing: The stock investment would generate a return of 37.04 percent in 5 years. Over the long term the stock market provide a return close to 10 percent plus per year. In this example our assumed growth rate was 10 percent per annum, plain and simple.

Real estate investing: The real estate investment yielded a return of 42.68 percent in 5 years. You may however decide, not to rent out your property but in such case your returns may also drop considerably as the costs involved in maintaining the property will have to be borne by you as out of pocket expense. Although, we have assumed a 10 percent per annum growth in property prices, however, real estate has shown far greater appreciations in the past. Investments in property is considered a safer bet when it comes to investing as you are investing in a “real” asset.

Investment Liquidity

Most important differences in these two investment options is liquidity. Selling a property can be costly and time consuming. On the other hand, stocks offer high liquidity, meaning that you can sell a stock investment quickly and easily with low costs.

This difference is critical, as you need to have a very high holding capacity in case you are not able to sell your real estate investment at the desired price.

Further, Real estate properties require active management, and lack good liquidity as an investment. Although, active management is required if you are investing in individual stocks and have not invested in an Index fund (as in this example) or have taken the Mutual Fund route to invested in stock market.

Awareness is the key to maximize returns

You and I both know that when you invest money to make money your success really depends on how well you know and play the game, no matter what arena you invest money in. For example, if you are good at selecting, improving, managing and financing real estate properties you can do much better than the above example.

You can also make over 10 percent a year in stock investing if you know how to invest in the stock market. The problem for most of us is that we don’t know how to invest in stocks, we are uninformed. Hence, stock investing for most of us is a risky business.

On the other hand, traditionally many of us are comfortable with real estate investing because we are more familiar with real estate market (we see it every day and better understand the factors that affect the real estate prices around us). Real estate properties have historically gone up in value without many violent downswings. The stock market usually experiences a greater degree of volatility.

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