Comparing Real Estate as an investment for Rental Yield vs Fixed Deposits and Index Funds

[matt4]

I have made a comparison of Real Estate as an investment option to earn yield via rent, versus a traditional FD and also an index fund.

For this, I am using a 3 to 5 year old 3BHK apartment which is available for sale at 1.4 cr. Assuming no loan, although that may not be the case for everyone, and a home loan will certainly eat into one's yields if they are opting to go for a home loan to buy an apartment, even though there are some tax sops for home loans.

Cost of home: Rs 1.4 crores.

Rent for 3BHK - Rs 50,000 per month

Rent Escalation rate - 5% (conservative, though it can be 10%)

Period
Cash Flow (-)
Cash Flow (+)
Description
Yield

01-June-2023
1,40,00,000

Purchase of property


01 June 2023 to 01 May 2024

Rs 5,50,000
Rent for 23-24
3.93%

24-25

Rs 5,77,500
Rent for 24-25
4.13%

25-26

Rs. 6,06,375
Rent for 25-26
4.33%

26-27

Rs 6,36,693
Rent for 26-27
4.55%

27-28

Rs 6,68,528
Rent for 27-28
4.78%

28-29

Rs. 7,01,954
Rent for 28-29
5.01%

29-30

Rs. 7,37,052
Rent for 29-30
5.26%

30-31

Rs. 7,73,905
Rent for 30-31
5.53%

31-32

Rs 8,12,600
Rent for 31-32
5.80%

32-33

Rs 8,53,230
Rent for 32-33
6.09%

So The total rental yield in 10 years = Rs. 69,17,840

Now if the seller wants to sell this property after 10 years, and assuming conservative property escalation rate of 4% a year, he will get :

Sale proceeds: Rs. 2,07,23,419

So rent over 10 years, the initial Rs 1.4 cr has now become Rs 2.07 Cr (sale proceeds) + 69.17 Lakh (rental yield) = Rs 2.76 Cr

Now instead, if the initial 1.4 Cr is invested in a FD at 8% PA or index fund assuming 10% PA,

The returns are as follows:

Fixed Deposit:

FD Rate 8%

Capital Rs. 1,40,00,000

Period (years) 10

Return 2,88,54,441 (Rs 2.88 cr)

For Index Fund,

Index Fund Returns: 10%

Capital Rs 1,40,00,000

Period (years) 10

Return 3,63,12,394 (Rs 3.63 cr)

So it seems that even a simple FD and also an index fund hands down beats the returns from investing in property, including the rental income.

Are these assumptions and conclusion correct , i.e its better to invest in mutual funds/indices over buying a property as an investment for rental yields?

Under what conditions will a property be a better investment, if one wants to diversify their asset allocation?

A higher property escalation rate like 10% would definitely turn the tables in favor of the property investment, and this can happen in areas where new roads/metros/IT infrastructure corridors are planned. But even if we assume a 10% property escalation rate, I'm skeptical that someone would buy a 10-15 year aged 3 BHK for 3.6 Crores, when there is likely to be new property offerings in the same area at a much more reasonable price?

Edits:

Reinvestment of rent into equity index scheme:

By reinvesting the yearly rental into equity index, this adds to the overall returns of the portfolio.

In this case, I am investing the yearly rent at the end of 12 months into an index fund. Of course, one can do it monthly as well, but for yearly re-investments, the numbers are as below:

At the end of the first year, Rs. 5,50,000 is invested into the index fund.

At the end of the second year, the index fund will have 10% (theoretical) returns from the first year's rent + new corpus of second year's rent. So the fund balance will now be (5,50,000*10%)+5,50,000 + second year's rent (5,75,000).

Overall, for 10 year period, the rental re-investment index fund's balance at the end of the period is: Rs. 1,06,13,326.

Compared with the rent alone (Rs 69.17 lakhs), reinvestment of rent into index brings much higher returns.

Taxation:

I have ignored taxation, as the investor will fall under the top taxation category. Thus, rentals will be taxed every year, and fixed deposit interest will also be taxed every year - thereby both will reduce the compounding effect. However, equity funds taxation will be taxed only on withdrawal.

 

[jaz6773]

@matt4 For equity or FD you are assuming you would invest the money at the beginning and let it grow or compound. Implying you can in theory live with not regularly withdrawing from your investible corpus.

While for Real Estate, you are taking the monthly rent and not reinvesting it anywhere. What happens to that money since you obviously don't need it as per the above case.

Hence the underlying calculations is slightly flawed.
You can consider the monthly rent as cash flow and then calculate XIRR for Real Estate and compare that with XIRR from Equity or FD (for these since there is only single investment and withdrawal, it is essentially CAGR).

A better way to compare Property with Stocks mentally is to think of it as a dividend paying investment (rent being the dividend). For stocks, you can mostly reinvest the dividend and buy more shares/units. For Property you can't generally take the rent and then use only that amount to pay EMI for newer property. But you still need to account for it. Hence comparing XIRR helps instead of amount.

 

[matt4]

@jaz6773 Thats a great point, the reinvestment from rentals must be considered

 

[resjudicata]

@matt4

• Rent money reinvestment not considered.
• Tax on rent not considered
• Tax on FD reduces rate effective rate to 5.6% or lesser.

If you have cash in hand AND patience AND ability to sit thru a COVID like downturn, index funds are the way to go.

With a bank loan (staggered payout for the investor, similiar to a RD), subsidised interest via tax benefits on rent, RE would be a good option.

 

[resjudicata]

Also renting out to tenants is a big headache and Op completely missed out on some expenses like maintenance and brokerage which makes a RE investment a tricky affair

 

[matt4]

@resjudicata Agreed that there are some upkeep issues in renting like maintenance. But they can be resolved at very low cost. In tier 1 cities, once the flat is put up for rent either the tenants clear the maintenance separately themselves, or additional maintenance is charged on top of the rent. A good society maintenance also goes up every year, and tenants understand that aspect

Regarding brokerage, with apps like nobroker and some effort on your part, you can avoid paying brokerage at all. These days most who are aware go through this route. Only a few who arent aware go through a broker

 

[resjudicata]

@matt4 I have equity+ properties.

I am getting out of a tier 1 city property which I had purchased preconstruction. The appreciation is approx 6% pa. However the purchase payments have been staggered so the IRR will be higher.

The net rent yield is normally 2% of the current value. Net of tax I would have managed a return of 9% +.

Having said that, the property was a diversification move for me.

I will be reinvesting the funds in equity - Index mf. RE will never be my first preference.

I would have loved to live in a rented house and avoid a lot of hassles but .. family

 

[foxie]

@resjudicata Yaha pe Survivor1338 pighal gaya

Same story here man! Family - ghar le lo, ghar le lo!