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Real estate: Buy or rent? - Views on News from Equitymaster
 
 
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  • Oct 8, 2010

    Real estate: Buy or rent?

    With equity valuations scaling new highs, investors have been worried about how to invest their money. In this article, we decided to take a step away from the equity markets and explore another asset class that has held investor interest, especially in India. This asset class is housing. In particular, we will talk about the high priced houses that are available in just about every metro in the country. These are houses valued at Rs. 10 m and above.

    Let us try and analyze whether it is worthwhile buying these houses.

    For the sake of our discussion, let us assume there are two identical houses in the same area of the same city. These are luxury apartments and have the same amenities. An individual, say Mr. X, who wants to live in luxury can enjoy equal benefits in both these houses. Mr. X now has the opportunity to either buy house 1 or to rent house 2.

    Case if he buys:

    Suppose Mr. X decides to buy house 1. He is under pressure from peers and family that buying a house is a much better option. Moreover, he can easily take a loan, which all banks are more than willing to provide to him. Therefore, he will have to pay Rs 10 m for the house.

    In this case, the bank would be willing to give a loan but it will not give the entire amount as loan. The banks agree to finance only 80% of the house value. This means that the bank will fund only Rs. 8 m for this house. Mr. X will have to fund the balance Rs. 2 m out of his own cash reserves or savings. Moreover, the banks would charge a rate of interest on the loan that they give. On an average, this rate is currently at about 9 to 12% per annum and will go up in the future as interest rates start to increase. Therefore, the interest component on the loan taken by Mr. X would be 12%x8 m = Rs. 960,000 per annum. Please note that this is only the interest component that Mr. X pays. His real loan installment would be higher than this as it would include part of the principal amount of the loan as well. However, in our example let us ignore the principal component for the time being.

    On this interest that he pays out, Mr. X would get a tax benefit. The income tax authorities allow Mr. X to deduct a total amount of Rs. 150,000 from his total taxable income. Therefore, the tax benefit that he gets is 30% of Rs. 150,000 = Rs. 45,000.

    Therefore, the total annual outflow for Mr. X would be Rs. 960,000 less Rs. 45,000 or Rs. 915,000.

    Particulars   Rs.
    Loan taken   8,000,000
    Interest Payment @ 12%   960,000
    Less: Tax Benefit @30% of Rs. 150,000 45,000
    Total Outflow   915,000


    Case if he rents:

    Let us now assume that Mr. X has decided to rent House 2. The monthly rent that he needs to pay would be Rs. 30,000. This means his total outflow on rent would be Rs. 360,000. Moreover, as he would also have the Rs. 2 m in his bank as he does not need to pay anything towards buying the house. He would earn interest on this amount. Let us assume he puts this amount in a fixed deposit. He would earn an interest of 7.5% per annum on this amount. (This is the average interest rate on fixed deposits currently being offered by banks). Therefore, he would earn Rs. 150,000 as interest on this amount. Therefore his net outflow per annum would be Rs. 210,000

    Particulars   Rs.
    Rent payment @30,000 per month 360,000
    Less: Interest on Fixed deposit @7.5% on Rs. 2 m 150,000
    Total Outflow   210,000


    Conclusion

    If we compare the outflows in the two cases, we realize that the outflow in case 1 is ridiculously high when compared to the outflow in case 2. One might argue that the outflow of case 1 is preferred as the house prices will appreciate. After all they always have been appreciating.

    This means that this difference of Rs. 705,000 (Rs. 915,000-Rs. 705,000) will be adequately made up by an appreciation in the value of the house. This implies that the value of the house has to go up by 7% (705,000 divided by Rs 1 m, which is the value of the house currently).

    Maybe this is possible. But with property prices tending to come down in most cities, it actually seems rather unlikely that the housing prices would actually appreciate by 7% in just one year. However, we are not saying that it won’t. But what if these prices were to come down by 7%? Would it still make sense for us to buy this house as against renting it?

    Let us hope that as an investor, you think carefully before going ahead with buying a house. Do compare your outflows carefully. After all it is a big decision.

     

     

    Equitymaster requests your view! Post a comment on "Real estate: Buy or rent?". Click here!

    14 Responses to "Real estate: Buy or rent?"

    mb

    Oct 20, 2010

    Very poor homework and should have taken long term view and not just 1 year, There are lot many factors we need to think here like - inflation, social value of owning/renting a house, more appropriate interest rate, tax component on the interest earned.

    I was reading this article with the hope that it would have some facts & figures which I usually see in EM articals. I am little concerned over reading articals in EM nowdays... because this is one artical which concludes with little or wrong information. 2nd artical on the Bharti Airtel scrip, some time back you guys said it is India's google and now you are confusing readers by not clearly specifying whether to exit or hold on to it.

    I am not sure where it is going wrong, but certainly EM is making me unhappy.

    Like 

    Rakesh V

    Oct 17, 2010

    There are certain mis-assumptions and omissions in the article. The writer may not have done his home work. (Administrator - you may remove this statement if you wish)

    1. Rate of interest on loan 12% - Actual around 9.5%. Even at the peak of interest rates in 2007-08 it went upto 13.5%, we are not yet there and not likely to be there any time soon.

    2. Annual rents for such luxury apartments are typically not less than 4.0% to 4.5% of value of property that is Rs 35000 - Rs 40000 pm.

    3. Effect of inflation on Rent not considered.

    4. Tax on interest earned has not been considered in eg 2.

    5. Also security deposit which typically in a city like Bangalore is as high as 10 months rent (a cool Rs 400000 as in example).

    Appreciation of property definitely depends on various factors like age of property, location etc. If you have bought the property at a reasonable price it would give decent returns.

    I would rather buy a property and rent it out, while staying in a rented apartment myself. The current tax laws give maximum benefit in this. Earn rental income, claim 100% interest(Rs 960000 in this case) for deduction from Income from HP, while claiming HRA for rent paid.

    Like 

    aab

    Oct 14, 2010

    I would rent as i need a place to live but would not buy when i know the system that is selling me is corroupt and fooling me.
    I am risk averse - i know some capital gain accrue but we havent seen a downside i bleive it will be like a snake bite and bring valuations down to multi-year lows.
    The other prime risk i see is that in mumbai when i buy a house i own something in air - if it crashes (we are in an earthquake zone) - all my momney will go and i will stay have a loan to repay! again maybe the house will last for 30 years then i have to build it again and renovate every few years as it would be mine - in rent none of that risk is there. besides i have mbility i want to change my country of work no sweat - if i won i can rent but not sure if i will get back possession.
    I can go on --finance is low donw in nay case i buy from an equity perspective fair value (in case of inflation 2020) prices today!

    Like 

    Amit

    Oct 12, 2010

    I agree that renting is a much better option.
    If you invest the additionaly money towards servicing the loan (in above case around 50K per month) in mutual funds or any other way, you can get atleast 10% returns from PSU or oter blue chips. Going by SIP way you could reduce the risk of market fluctuations. One will surely make more money in long term than house price appreciation. And the best part is liquidity. You cannot sell 10 sqft of house in case you need some quick money for emmergency, but you can sell 1% of portfolio and buy it back later. Yes rent might go up, but so the interest rates too. The banks offering flexible interest rate loans are licensed shameless robbery professionals. Ask anyone who has taken home loan in last 5 years how they are being looted too. then conseider other costs like property tax, maintenance charges etc. Renting is way too easy and cheap.

    Like 

    Amit Shah

    Oct 12, 2010

    There are some other flaws I noticed. When you buy a house, you effectively cap your outflow for next 15 years. With the inflation in rents, the rental outflow will increase for the same house... Hence from the 15 years cashflow and NPV perspective, you may be better of buying the house.

    Also, if you live in mumbai, giving 2 months/1 months brokerage after every 11 months adds to your costs. Then shifting cost etc adds up.

    Like 

    onkar

    Oct 12, 2010

    Loan burdon consumes lots energy ! Job uncertanty, fear of loosing job. Dring the last recession, I know some friends got BP and Sugar along with house.
    (Buy 1 + 2 Free). Now are you happy in the new house.

    You should keep some mony in hand say, you won't earn for 3 months)

    Like 

    vijay srivastava

    Oct 11, 2010

    In the long run having the property will always score over the renting in. Ask those elderly people who couldn't buy in their youth . Can they afford to buy it now? According to the cash flow they it should be a walk in the park for them to do so. Are they enjoying their life in a rented house and hail their decision not to buy one at their times so that they can pass it on to their children?
    Don't they have any regret about not being able to have a permanent house in their life time?
    More important, does renting in with all the terms and conditions designed to drive you out of the house in few years for deterrence against unauthorized possession, gives you a long term solution to one of the most basic need we have?
    Talk elderly members of your family for the answers.

    Like 

    chen

    Oct 11, 2010

    doesn't the person who is renting his property also bought the house sometime back??? is he not benefiting/ed from the ownership.so one can buy and then rent it? if everybody buys and wants to rent what would be the odds.....also if everybody wants to rent what would be the odds.....

    POINT1.---buy/own a house if you are going to live and enjoy for the rest of your life

    POINT2.If you have future thoughts...Have only one house/home to live and don't unnecessarily burden or go shopping for site/home/apartments if you already own one.

    POINT3.runaaanu bandha ruupeena pathi pathni sutha aalaya..means if destiny you will get life partner,children and house sequentially(though good)

    Like 

    Rajeev

    Oct 10, 2010

    Interest rate must reduce in our country for first time buyres. Like in most of the developed countries it is 2.5%.
    Then only housing problem can be solved

    Like 

    jkhanna

    Oct 9, 2010

    The reason the owner of house no 2 has no problem giving out his 10m property on rent and earning just about 30000 rs a month because it makes him feel proud that he owns a property and that's a huge thing for him. otherwise as a smart investor he also knows that he can sell his property and enjoy FD interest rate of 7.5% per anum which makes about 7.5 lakhs per anum as compared to 4.5 lakhs that he gets for lending his property.
    ITS ALL ABOUT MENTAL SATISFACTION AND THE PROUD FEELING YOU GET WHEN YOU OWN A PROPERTY. AFTER ALL THAT'S WHAT WE EARN FOR.

    Like 
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