Are you planning to purchase a house for your family? You probably heard that some of your relatives purchased a house in 90's and today their house is worth millions of rupees? Well, great to know, but let's do some math and see if purchasing a house is really a great investment...
Before we move, forward, however, some facts in place. Decade of 90's was the time when Indian economy was beginning to grow. Group housing and apartments were beginning to grow, and the rate at which India's annual growth was increasing was very good. Today, however, we're surrounded with uncertainties about global economy. Emerging economies like India are already in the spotlight for global investors, and the tough fact is, that Indian economy is not growing any faster! Yes, we're growing at 7-9% on an average for last few years, but the fact is, we're not growing faster any more, we're just maintaining the growth rate.
Another fact that's very important. Big metro cities like Delhi / NCR and Mumbai and Bangalore are already over-populated, and not at all affordable to live by any means unless you're earning at least a lac of rupees every month. So, probably, we're also around the time when the rate at which people migrate from sub-urban regions of the country to big cities may be peaking. Even psychologically, big cities tend to be noisy, traffic problems, large distances, etc, and this can be motivation for at least middle aged people to move out and settle in sub-urbs, if not the young generation. All of this can be a good reason why we'd not see phenomenal real estate growth rates as we've witnessed in last 15 years.
It's a well known fact that rate of growth of house rent and house prices tend to closely track each other, over long periods such as 10 years. Also, due to illiquid nature of real estate assets, their prices will always grow slower than more liquid investments such as equity. If you consider numbers, the long term average annual growth rate of good quality equity investments such as mutual funds, when invested in a systematic manner, have yielded over 25%, even 40% in some cases. On the other hand, the long term average growth rate of house rents in big cities has been 10-15%. As mentioned above, we'll not consider the growth rate history of housing prices, since they reflect an era that's gone, reasons to count being housing bubble burst in US, housing prices being closer to all time highs for a while in India, and psychological reasons cited above.
Ok, enough of facts, let's come back to maths now. Let's take an example of a salaried family, who plans to purchase a 3BHK house in Noida (NCR), which is nearing its completion of construction. We must keep in mind that, prices tend to increase significantly when people start living in the apartments, and to simplify calculations, we assume that the family will stop paying house rent as soon as they purchase the house, since they can start living in their newly purchased house. Here's the various numbers we take for calculations, based on market study at the time of writing:
Cost of a 3BHK house, nearing completion in Noida: Rs. 50,00,000
Rent of a 3BHK house in Noida: Rs 20,000
Average interest rate of home loan: 10% compounded, annually
Let's assume the following growth rates:
Compounded annual growth rate (CAGR) of house prices: 12%
CAGR of house rent: 10%
A lower rate of growth of house rent indicates that housing prices will keep increasing, which is a worst case assumption for our study.
The maximum loan that you can get on housing is capped to 80% of the total cost, so the family can obtain a loan of Rs. 40,00,000. This means that the family needs to make a down payment of Rs. 1,00,000 using their own sources. Let's assume that the family can pay off the entire loan, including interest, in 10 years. At this rate, their monthly EMI will turn out to be Rs. 52,860.
If you do the calculations, we find that total cost of purchase of flat, including the interest paid in 10 years, is Rs. 73,43,235, and at assumed rate of growth, the price of house after 10 years will be Rs. 1,65,01,934. Good, the family is in a decent profit of about 1 crore rupees.
However, we need a comparison to see how good this profit really is. Let us now consider another family which decides, for their own reason, to instead live in a rented house, and save the extra money in mutual funds, in a systematic manner, i.e., small amounts every month. This family also saves aside a total of Rs. 52,860 for 10 years, same as the first family. However, a part of this saving goes to pay house rent, and remaining is invested in mutual funds. Since house rent will increase with time, their monthly saving decrease over time. Still, let's see how much their "mutual fund assets" grow in 10 years.
Let's first assume the same growth rate of their alternate investment as that of housing prices, i.e. 12%. At this rate, they end up at Rs. 82,83,339 after 10 years, which is certainly lesser than what the first family has. This is a meager profit compared to that of first family.
However, let's see what growth rate of alternate investment can take the profits of second family beyond that of the first. If you play with the Excel calculator (contact me and I'll share this with you) I built, you easily find that if their mutual funds earn them 21% CAGR, their asset worth becomes Rs. 1,75,37,065, more than the worth of first family's house. Most importantly, 21% is still lesser than the historical growth rates you can achieve in mutual funds, and since equity markets tend to move up and down in cycles of roughly 3 years, it's easier to achieve such growth rates in systematic investments than compared to the growth of real estate assets.
If you study carefully, there's a relation between the house rent and home loan EMI amounts, that'll decide which of the two approaches will earn you better returns. Roughly speaking, the moment you start paying more than 2.4 times your monthly rent as home load EMI, at rates assumed above, you'll end up in poorer profits with your house purchase, or on the other hand, your alternate, systematic investments will give you better returns. However, if you want to live in the same kind of house, it's very difficult that your home loan EMI will be anywhere less than this multiple of your house rent.
Hmm, a long post, well, I'd quickly summarize. Stop being emotional, and better invest in good quality mutual funds, in a systematic manner, and live in a rented apartment. In fact, if you like big house in good localities, you can afford higher rent without becoming less profitable, at the current, highly over priced real estate in big Indian cities.
Be Happy, be a smart investor!
