Building for Rent

Recently I was at a housewarming ceremony of a friend of mine. The said friend of mine had been holding the plot for sometime now and decided that the best way forward was to build a few houses and let it out for rent. This he said gave him the best possible return for his money compared to investing in a fixed deposit or stocks with his assets providing him a regular income which keeps raising year on year.

While in theory, that sounded perfectly fine, I wondered (as I do when people make statements with too many assumptions and without any data to back them up) as to whether that is really true.

The cost of construction came to 7 Million and the friend of mine was anticipating a rent of around 40,000 per month which comes to a rental yield of around 6.85% (pre-tax) on his investment excluding the amount that was spent on acquiring the said site. This seems like a very good number indeed, but how would this compare to investing the same amount of money in the market.

While I come across persons who are happy to invest big money onto properties at one go (after all, you cannot acquire a plot by way of Investing Systematically month on month, can you 🙂 ), when it comes to the market, they find themselves scared enough to risk only a small amount, something even if invested in a very good stock can become meaningless over time.

While its true that risk in markets are high, the same is the case for any other investment save for investing in a fixed deposit. But then again, with fixed deposits not even beating inflation, its not exactly a wealth generator, especially for the younger generation who are and should take more risks in an attempt to build a better nest egg.

First off, here is the matrix of Capital growth using only Rent (which rises 5% year on year). Tax has been assumed to be 15% . While there will be other costs (Taxes, Repairs, Broker Fee, etc), all those have been excluded to make the assumptions simple. Also I have added Interest (on previous years Rent + Accured) at 6% p.a  All in all, the end amount is the minimum (not the maximum) one will definitely be able to save / gain from the house.

Our final number comes to a impressive 12.20 Million at the end of 15 years. Definitely not a number to be scoffed at though if we were to apply a higher tax percentage, it can drop quite a bit. If tax percentage is 25%, the final number comes to just above the 10 Million mark.

Now, lets move to the other way of investing those funds – the stock market.

Theoretically there are two ways – One invest in a few bluechip stocks and hold on to them or to invest in a set of mutual funds and hope they either meet or beat the market indices. And then there is the third way, investing into a Exchange traded fund that tracks the Primary Index – in our case Nifty or the Sensex.

Direct investing in stocks can be pretty risky or a pretty awesome move with the final result being dependent on what we bought in the first place. Blue chip  companies of the 1970 & 1980’s are not the blue chip companies of today (though a few do remain). Also, its generally scary to plough all the life savings into a few stocks and hope they shall click, and click big.

While its more simple in the world of Mutual funds, even there the risk remains that the fund you chose may actually turn out to be a bad choice. In 1996, you could have invested in funds like Kothari Templeton Prima / Prima Plus as also invested into funds like CRB Mutual Fund. Its only in hindsight that we know which fund delivered and which did not.

While its true that some mutual funds have delivered better results than the Sensex, I doubt if any one can tell the fund that shall BEAT market returns over the next 15 years. The easier option is to just invest into the ETF’s that track the Index and hope that the India growth story shall ensure that we garner a substantial return over time.

If I was looking at a investment period of 15 years (same as the Rent accumulation), what would be the returns provided by the ETF?

To get a answer, lets look at the historical CAGR returns that Sensex has generated over the last 15 years.

The average CAGR return over 15 years has been 14.52% with a maximum of 21.43% and a minimum of 7.31% (the 7.31% being the returns one would have got if one got in Dec 1993 and exited in Dec 2008.

If we were to assume, a CAGR growth of 12%, what would our investment today of 7 Million look like 15 years from now?

If 12 Million was awesome, how about 38 Million 🙂

But, there is a caveat you would say. While it cost 7 Million to build a house today, it would cost a lot more after 15 years and that is a true question indeed. Hence lets look at what would be the cost of construction assuming that construction prices keep moving higher. Assuming that construction costs move by around 6% per Annum, here is the table on what it may cost 15 years from now

A house that costs 7 Million to construct may cost 16 Million 15 years from now. But even accounting for that, the gap between the returns of the Sensex and Rental Income comes to around 28 Million, definitely not small change.

While one may argue that market returns are not smooth, one also needs to understand the various hassles that come with renting a property. And the above returns assume that one had the property for rent for the whole 15 years. What if one did not find a suitable tenant for a few years? How much of a impact it will have on final returns?

While FAR ratio in Indian Cities are pretty low, its bound to go up in the future. Mumbai is already working on a plan where FAR ratio may be anywhere between 0.5 to 8. The FAR ratio for properties around Metro is being increased in cities such as Bangalore and Pune and this additional supply can and would lead to softening of rental returns as we move into the suburbs.

While there can be no Apples to Apples comparison, above analysis does seem to suggest that building a house to rent it out is not exactly the best way to create wealth for ourselves and our future generation.