Real Estate, unlike other investments, is not evaluated on parameters of liquidity, safety, pricing & returns alone. All decision factors for real estate purchase – finance, investment time span & emotional connect – have complexity weaved into it because each of these factors is just too big & overwhelming for an investor. The fact that this investment will have an outsized impact – positive or negative – on overall financial wellbeing of the investor, makes this decision that much harder to take.
A house property could be for self-use or be an investment for capital gains &/or rental income. Either way, one ought to take a holistic view of financial as well as non-financial factors, while choosing between the two options because given the sheer scale of this decision, there may be no turning back.
Long-Term Commitment – House Property is an emotional need for many & buying it satisfies a heart-felt life goal. Buying a house property is akin to growing roots at one place & is, therefore a long-term commitment. It has to be in sync with one’s vision of career, business, children education & social networking. The emotional connect is integral to ‘buy or rent’ decision, as a big, outsized financial commitment is making an investor choose a physical property over many other possible life experiences. One is effectively weighing loss of freedom (to make many life choices) against the satisfaction of owning one’s home. This decision is very personal for every investor & could be beyond financial considerations.
Stability & Freedom – Owning a place provides stability to how life is lived & is free of whims & fancies of landlord. Rent agreements are often drawn in favor of landlord for limited duration & are often not easily enforceable. So, long-term planning with regard to living at one place of choice, cannot be done with too much certainty. Market forces in real estate segment may lead to disruptions on account of fluctuations in rent &/or availability of alternate accommodation in case one is forced to forego rented property. Renting a property could come with restrictions, such as freedom to come & go as one please, food & making alterations to property to suit one’s aesthetics.
Financial Stability – House Property is a big-ticket item & should be considered for purchase only if finances are found capable of bearing any stress caused by such a commitment. Debt financing over long duration brings to fore importance of the fact that earnings do not get disrupted in extended future & there is sufficient flexibility in the expense budget to endure interest rate hike.
A thumb rule suggests EMI (of all long-term debts) under 30% of post-tax income, is at most sustainable debt to carry. With higher dependency on future income comes the loss of freedom to contemplate any change in regard to ongoing service/business.
Running the formula for Affordability & Prudence – The choice between buying & renting involves comparing value of money saved by not purchasing & invested elsewhere with value of property, if purchased.
Buy side of the equation calculates the amount of loan that can be taken or maximum loan that can be raised. The balance has to be paid upfront in the form of down payment. The terms of home loan such as interest rate (flexible or fixed) & the duration are key inputs to arriving at EMI (Equated Monthly Instalment) payable monthly.
- Cash Outflow = Down Payment + EMIs paid over the entire loan duration + Annual Maintenance Charges (increasing over time) + Property Tax (during the entire loan period).
- Value of Buy Option = Total Cost of Property (including Taxes) + Growth in Property Prices (assumed over loan repayment period) + Tax Benefit (of buying House Property over loan repayment period)
Rent side of the equation calculates total rent payable over the entire period of corresponding home loan duration, after taking into account likely increase in rental cost over such period. Money not paid out when choosing rent over buy option reduced by Security Deposit paid to landlord, is assumed to be invested over the entire duration.
- Cash Flow Savings = Cash Outflow in case of ‘Buy’ option (with periodical increase) – Cash Outflow in ‘Rent’ option (including Security Deposit)
- Value of Rent Option = Market Value of Savings (investment compounding at assumed returns) + Tax Benefit (of renting for salaried persons)
Benefit of Renting over Buying = Value of Rent Option – Value of Buy Option
Assumptions as to returns, property appreciation, rent increase, maintenance etc. have a huge role to play in this calculation & need to be conservatively made. Be aware of your biases while making such assumptions.
“Price to Rent” ratio compares the total cost of buying (finances, taxes, tax breaks, insurance, commission etc.) to renting costs, thereby estimating the point at which costs of ownership outstrip the costs of ownership.
House Property as an investment
If house property is bought as an investment, comparison is done between
- post-tax return on alternate investment &
- post-tax rental yield plus increase in value of property.
If decision regarding sale of a property is to be made then rental yield should be calculated as post-tax rent on current market value & not on original purchase price. Anchoring bias i.e., latching onto original purchase price as reference & not taking effect of inflation & taxation are important factors that can distort the judgement.