Is Buying A Home Or Property A Good Investment

Prakash's investment in a property

Prakash has bought a flat worth Rs 50 lakh with a loan of Rs 40 lakh at 12 per cent interest per annum for 10 years. He is earning a rental income of Rs 15,000 per month by subletting the flat, on the maintenance of which he spends Rs 2,000 per month. Taking this as an investment in property, in this case a house, for a period of 10 years, what would be Prakash's returns in the end? Let's see. For a better comprehension, the calculation is divided into four steps as shown in the figure below.

What is Prakash's total investment?

A. Initial investment

• Prakash has to make a down payment of around 20 per cent of the cost of the house which is Rs 50 lakh. The cost comprises:
  • House price
  • Cost of registration, stamp duty, etc.
  • Transaction cost/Brokerage
• Prakash will also receive a rental deposit of Rs 2 lakh from his tenant.
• Prakash has stashed away some money which he can used to pay for the down payment, which is around Rs 10 lakh.
• The net initial investment for Prakash would, therefore, be

B. Monthly investment

• Let us assume that the loan was taken at a market rate of 12 per cent for a maturity of 10 years. The Rs 40 lakh loan would, therefore, have an EMI of Rs 57,338, i.e., Rs 6.89 lakh annually.
• Prakash would enjoy tax benefit on this loan in terms of both the principal repayment as well as interest payments. Click here to know more
• He also has to bear the annual maintenance charges for the flat, which approximately amounts to Rs 2,000 x 12 = Rs 24,000.

Taking all these into account, the net average monthly outflow for Prakash in case B would be -

* The money used for down payment will earn interest, but that is considered later.

What will be Prakash's returns on investment?

A. Monthly inflow

• The flat's current rent per month is Rs 15,000, i.e., Rs 1,80,000, annually.
• Let us assume that there is an annual hike of 6 per cent in the monthly rent.

Therefore, the monthly inflow for Prakash on account of his flat which he has rented would be as follows:

B. Terminal inflow
The main returns generated for Prakash on the property investment is going to be through the appreciation in property prices over the period. The initial price of the property was Rs 50 lakh and the time horizon we are looking at is 10 years.

• Let us assume that the property prices grow at an average rate of 4 per cent p.a.
• The amount of terminal flow calculated on above basis would, therefore, be Rs 74.01 lakh in Year 10.

Investment vs returns

Let us, therefore, consider the kind of returns Prakash might get based on the facts summarised below:

• Prakash has an initial investment of Rs 8 lakh as calculated earlier.
• There will be regular investments into the house adjusted by the rental inflow.
• The property can appreciate at around 4 per cent p.a. over a long period, i.e., 10 years.
• There will be tax savings on the interest of the loan taken to buy the house. (click here to know more)
• The interest rate on the loan is 12 per cent.

The chart below shows the overall Internal Rate of Return (IRR) generated by this investment for Prakash over a period of 10 years.

This means Prakash will be earning an implicit return of 6.83 per cent on his investment in the house, by buying it for investment purpose and then renting the same. To know its profitability, this return should be compared with the returns on other investment options like PPF, mutual funds, etc.

Risks to investment returns in case of a house purchase

Risk 1: Property appreciation
The inherent assumption here was that the property will appreciate at around 4 per cent per annum. However, the same may not hold true in reality. Let us, therefore, look at the various returns that Prakash might earn under different appreciation scenarios -

Risk 2: Change in interest rates
Another assumption made is that the interest rate on the loan remains unchanged at 12 per cent for the entire period. However, if the interest rate moves little up or down, the whole scenario might change for the returns generated as shown below (property appreciation is kept fixed at 4 per cent p.a.).

Risk 3: Change in annual rentals
One more inherent assumption has been that the rental growth would remain constant at 6 per cent per annum. However, sometimes the growth might be much higher or lower than that, depending on the way property prices have been moving in the given period. Let us, therefore, have a look at IRR changes w.r.t. changes in annual growth of rentals (assuming an interest rate of 12 per cent and property appreciation, 4 per cent).

Summing it up

• The rent received by Prakash is much lower than the amount he spends on the EMI and other costs, and therefore, there is a net investment being made every month.
• However, it is adjusted by the appreciation in the value of property at the end.
• It is important to buy property at the right price, otherwise in short term, it may be a loss-making investment. In short, it is not advisable to buy property at high rates for short term.
• It is important to keep loan rates to a minimum, so one should take a loan at a lower rate or wait for rates to fall.
• Floating rates may rise, and can put a pressure on Prakash's cash flows. So, he should be prepared for a 10-20 per cent increase in his EMI.
• In this case, it makes sense to invest in a house of Rs 40-45 lakh.

* The above recommendations do not take into account rapid increases in rents or property.