Have you ever wondered what the net return from a real estate investment is? I bet you did at some point like I did at multiple junctures. Armed with google, I searched the net but in vain. The closest analysis I could find is that for lumpsum investment, like this article. But we are not HNIs and hence have to opt for loan. What is the net return when you purchase a real estate through EMIs is the unanswered question and here is my attempt to find an answer for this.
There were quite a few startling discoveries en-route my quest for this answer. Read on to experience it! All my analysis are based on few reasonable assumptions to simplify the math. (eh! those dreaded formulas..)
The Assumptions..
Based on widely accepted fact (courtesy various online articles) I assumed that real-estate fetches a CAGR (compounded annualized growth rate) of 15% for lump-sum investment. My second realistic assumption was a bank loan interest rate of 10%. Most banks provide loan for just 80% of the total cost; remaining 20% has to be a down-payment. Since down-payment is the same as lump-sum investment it would fetch a return of about 15%. The mystery is about the remaining 80% which you pay(correction, invest) through EMIs!
Now let us refresh some of our old unused memory. Return from compounded interest is “F = P(1+i)n –> Eq-1″, where F is the final amount when a principal P is invested for a return of i% (i is in fraction. i.e 0.3 for 30%) compounded annually for n years.
To calculate the return from EMIs, let’s take yearly investment from EMIs to be Pe for simplicity.
Let Pe1 be the EMI investment in 1st year Pe2 in 2nd year and so on.
Then “F = Pe1(1+i)n + Pe2(1+i)(n-1) +…. Pen(n-n)“. Since Pe1, Pe2 etc are all equal, let us represent it as Pe. Hence “F = Pe[(1+i)n +(1+i)(n-1) + … (1+i)0]”. On simplification this will reduce to “F = Pe[{(1+i)(n+1) – 1}/i] –> Eq-2″
With the above 2 formulas in place, we are half way through our journey. Next step is to find out “i” in Eq-2 for various values of “n”, assuming “i” in Eq-1 is 15%.
I have calculated the values of “i” in Eq-2 for n = 10, 15, 20 and 25 yrs. The curious among you can try the calculations in your rough pad, given that you have all the formulas in hand. To keep the article as less boring as possible, I have sidelined these calculations.
For n= 10 yrs, “i” is approximately equal to 15.50%;
For n= 15 yrs, “i” is approximately equal to 16.39%;
For n= 20 yrs, “i” is approximately equal to 16.37%;
For n= 25 yrs, “i” is approximately equal to 16.24%;
Did you notice it! The return is not linear; rather it peaks out at a certain loan tenure(n) with tapering before and after. These returns are the net return, accounting for the loan interest rate of 10%.
Thus in summary, following are the take away conclusions.
1) It is profitable to invest through loan even if you have surplus cash. However, we need to understand that this is because of the leverage we get from loan and any leverage acts on both rise and fall.
2) It is unwise to go for a loan tenure less than 20 yrs. (Although 15yrs has the highest return, 20yrs too has very similar return. You may rather choose 20yrs and reduce EMI burden)
Note: Tax benefits on the loan interest paid is not considered in any of the above calculations. That might add another percent to your return.
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