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.
|Interest Payment @ 12%
|Less: Tax Benefit
||@30% of Rs. 150,000
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
||@30,000 per month
|Less: Interest on Fixed deposit
||@7.5% on Rs. 2 m
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.
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