Do You Really Know the True Gains from Your Real Estate Investment?

Do you know your true gains from real estate investment

We all at some point in our lives think about buying a house, either for end use or as an investment. It is correct that real estate has acted as a hedge against inflation and in some cases has created large amount of wealth. In fact for most of the middle income families, it is the single largest asset when they call it a day and retire. Therefore, it is important to understand how real estate actually creates wealth.

Disclaimer: These are rough, back of the envelope calculations to create awareness. The actual numbers can be quite different, but I am sure you will get the gist.

Basis

Before we start, let us make a few assumptions: Prem is buying a house for 1.5 crores in Mumbai, taking a 20 year housing loan of 1.2 crores. He contributes the rest of the 30 lakhs from his own pocket. The same house if taken for rent would have cost him a rental of INR 38000 per month.

We also assume that the house is going to compound at a rate of 12% per annum, which is in line with Indian real estate returns nowadays. The EMI per month that Prem would need to pay every month would be a whopping INR 1,15,000. Prem would also be required to pay annual maintenance, property tax etc for his house. We club this over a 20 year period as 25 lakhs.

We are assuming the following for simplicity:

  1. Rent of the same house increases by 10% annually
  2. Housing Loan interest is at 10% throughout

Scenario 1: Sale after 10 years

If Prem decides to sell the house after 10 years, the number crunching is as follows for Prem to calculate his true gains:

  1. Sale Price of the house (A) :   4.65 crores
  2. Maintenance and taxes (B) :  0.12 crores
  3. Difference between EMI – Rent (C), This is the calculation of the additional cost Prem is paying instead of renting: 0.65 crores
  4. Repayment of Principal (D) : 0.88 crores. As the loan is closed prematurely after 10 years.
  5. Net Gain = A-B-C-D = 3 crores

Prem”s real estate investment has made a neat 3 crores after selling his house in 10 years. He goes on to buy a bigger house by taking another loan, sigh!

What if Prem had held on to his house for the next 10 years? The numbers are startling!

Scenario 2: Sale after 20 years

If Prem decides to sell the house after 20 years, the number crunching is as follows for Prem to calculate his true gains:

  1. Sale Price of the house (A) :  14.5 crores
  2. Maintenance and taxes (B) :  0.25 crores
  3. Difference between EMI – Rent (C), This is the calculation of the additional cost Prem is paying instead of renting: 0.15 crores
  4. Repayment of Principal (D) : 0 crores. As the loan is fully paid.
  5. Net Gain = A-B-C-D = 14 crores

Prem would have taken home 14 crores! Yes, you read it right 14 crores! He would earn 11 crores more than scenario 1. How did this happen? What are the factors contributing to the massive gain in scenario 2 and modest gains in scenario 1?

Factor-1 Home Loan repayment structure

Did you realize in scenario 1 after 10 years, Prem still had to repay 88 lakhs of the 1.2 crores borrowing? The banks are clever. They first take all the interest from you and then the Principal. Therefore Prem repaid 32 lakhs in the first 10 years and would pay 88 lakhs in the next 10 years.

Factor-2 EMI – Rent

If you do a simple excel calculation, you will realize that the difference between EMI and rent turns negative from the year 13. That would mean the rent exceeds INR 1,15,000 from year 13. In fact the rent in year 20 is INR 2,32,000 per month.

Factor 3 Compounding

Most importantly the magic of compounding makes the sale price of the house after 20 years 14.5 crores compared to 4.65 crores in year 10. It is correct that in scenario 1, Prem would have reinvested the 3 crores in a bigger house. Still he would be taking another loan, and the same story would continue.

Conclusion

The key takeaway points are:

  1. Time: Wait adequately for your real estate to give you phenomenal returns, especially if you borrow to invest. Compounding is the 8th wonder of the world.
  2. Loan: Remember, your home loan is structured to benefit banks. Try repaying Principal frequently; else wait for the entire loan period.
  3. Calculate: Try quantifying your gains every time you decide to sell. You may change your decision once you know the numbers.

A home is an emotional investment, overriding financial gains. Even though emotions shall come first, it is important to be conscious of the numbers and to create wealth with your real-estate investment!

Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.