We reproduce a lucid piece authored by Ritesh titled " Why mutual funds may outshine real estate in the future", in which he discusses how some of the biggest drivers of real estate are now changing materially, perhaps signaling weak returns going forward from this asset class that Indian investors have traditionally favoured. Ritesh takes us through some useful data points that you may want to share with clients who have property-heavy portfolios, to encourage them to consider reallocating some part of these assets into equity funds.

WHY MUTUAL FUNDS MAY OUTSHINE REAL ESTATE IN THE FUTURE?

Security and safety has always been important to Indians especially with respect to their wealth. The earlier generations would scrape and save every penny in order to build a safety net for themselves. This financial security was often in the shape of a house. In spite of not having the option of taking a home loan in the old days, they still managed to somehow own a house. Things have definitely changed since then; now, borrowing in the form of home loans is commonplace. Many people not only borrow money to build their first home but also view property as a good investment for their future and build or buy a second or sometimes even a third home.

Why people choose real estate?

In India, buying a home is a culturally and socially accepted norm. Many Indians, especially the older generation Indians, will tell you that buying property is a sure shot way of gaining handsome returns in the long term; there may be some truth to their claim. Real estate has given above average returns compared with most other investments. However, not all people are attracted to real estate for handsome returns alone; real estate is also a safe haven for people who want to park their cash (black money) since nearly every real estate transaction has some component of cash.

Changing perception towards real estate

While in the past, people would simply put their illicit wealth into property thinking of it as a safe haven, things are now changing. Many people are now more aware of the low returns real estate investments have offered in the recent past. Today many investors would be wary of an overexposure to real estate because:

1. They seek positive investment returns which mean returns that are positive after adjusting for inflation

2. They are aware of the new government's determination to root out black money. The government wants to enact the Undisclosed Foreign Income and Assets (Imposition of Tax) Bill which would make tax evasion by owning unofficial foreign assets a criminal offence

3. They own sufficient amounts of property and may be already overexposed to the asset class

Returns from real estate (residential)

Real returns from real estate (city-wise residential)

What is changing in India?

More people are now choosing financial assets in India while in the past the distribution of household savings was roughly the same between financial and physical assets. After 2008, there was a spike seen in investments in physical assets because of an appreciation of nearly double digit in assets like gold and property. Now, with interest rates turning positive and inflation under control, investors may shift some of their investments from physical to financial assets.

The role of black money in the property cycle

India has a huge segment of its economy in 'black'. Some estimate that the shadow economy is actually larger than India's real economy. In terms of money moving abroad from India, the Global Financial Integrity Report ranks India at No. 4 with more than USD 400 billion leaving Indian shores between 2003 and 2012. Professor Arun Kumar of Jawaharlal Nehru University, pre-eminent expert on the black economy estimates that 50 per cent of the Indian economy maybe illicit and split equally between consumption and savings. While some 10 per cent of these funds are moved abroad where they are parked as savings, a significant portion of it is spent on high-end luxury items.

The link between the real estate industry and black money is an old one; builders accept payments in cash because they need to grease many a palm with cash. This 'income' that builders and bribe takers receive is then put back into real estate and a never-ending cycle begins. In the state of Maharashtra, steps are already being taken in this direction. The proposed new Development Plan (DP) 2014-2034 for Mumbai and suburban areas will provide higher FSI across the Mumbai area and end discretion vested with authorities.

Ending the black money cycle

While positive real investment returns adjusted for inflation can allow investments to return to financial assets which will, in turn, allow raising funds for infrastructure and industrial projects, the problem of black money flowing to real estate markets remains. A strict approach by the government alone has the potential to end this menace. The benefits are numerous; already the new Jan Dhan Yojana and the new strict rules surrounding black money have the potential to:

1. Plug leakages from public treasury (this is a source of black money)

2. Reduce the use of cash in deals and transactions

3. Make the tracking of the movements of funds in the banking system a reality

4. Put in place rules and regulations to deal with violations of law.

But is there a genuine demand for real estate?

Census data from 2011 indicates that India has more houses than households. This is a clear indicator that some people actually own more homes than they need and they purchased these as investments. This indicates a high possibility of real estate being used to stash away black money.

So what lies ahead?

There is already a realisation in the real estate industry that things are changing. The pinch of slowing demand for real estate is already being felt by developers who are turning to discounts and even freebies to attract buyers. According to data made available by Liases Foras, a Mumbai based real estate rating and research firm, residential inventory in Delhi, Mumbai and Bangalore has now reached its highest levels in the last five years. Declining sales and rising inventories are beginning to affect developers adversely.

In conclusion

The government seems to have its heart in place when it comes to dealing with black money. However, this spells a spot of trouble for the real estate sector. While a lot of household savings will now move to financial assets instead of real estate, the government's moves on black money will make the real estate sector suffer further. When a few people get caught, others freeze and we are talking about enormous sums of illicit money invested in the sector. The writing is on the wall -- mutual funds, insurance and banking products will see more inflows whereas for those who really dream of owning a house one day, might find it easier to do it in the future when prices adjust.

Disclaimer: The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. The views expressed are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Asset Management will not be liable in any manner for the consequences of such action taken by you. Please consult your Financial/Investment Adviser before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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