Ever Wondered… Buying Vs. Renting?

Ever Wondered… Buying Vs. Renting?

"Human behaviour flows from three main sources – desire, emotion, and knowledge." – Plato

"A house is made of walls and beams; a home is made of love and dreams"! Our homes are a very emotional and integral part of our lives. The one that we grow up in, the one where we start our family and watch our children grow, and the one where we want to grow old. From the time that we get our first pay check, we start saving for the day we can buy our own home. That's how important it is for most of us!

The desire to own a home is fuelled by our strong emotions more than knowledge or reason. But to use the same emotions to make financial decisions can land us in a world of trouble. According to some estimates, more than 70% of Indian household savings are invested in physical assets such as real estate! Despite the tremendous drawbacks of investing in real estate, it is the single most preferred asset class by a huge margin. And the primary reason behind it is that, when it comes to our homes, our rationality gets clouded by our overwhelming emotions.

The Mathematics of Buying a House

Let's first consider the idea of buying property purely as an investment. For majority of us, a property investment will be the single largest asset in our portfolio. Hence, it is crucial to understand the full financial impact of doing so. Stamp duty, registration fees, service tax, VAT, maintenance deposits, brokerage fees, parking space and interior decoration are just some of the costs involved in buying a house. Typically, a residential property worth 1 crore can incur well over 15-18 lakhs in added costs. That's a 15% upfront cost of investment at the very least!

Besides the high "entry load", and subsequently an "exit load" at the time of selling, the risk of value appreciation also has a lot of risks. Given the high capital requirement for investing, it is difficult to create a diversified portfolio where localized risks can be mitigated. Each investment is prone to a high degree of risk from unsystematic factors such as geographical location, local infrastructure development, delayed or delinquent projects, valuation risk due to lack of transparency, litigation and political risk, etc. To make things worse, there are significant systemic risks in the Indian real estate sector that have made it one of the worst performing sectors in the country. Large unsold inventories, artificially inflated prices, valuations driven by investors rather than genuine home owners and poor regulatory oversight have resulted in one of worst 10-year periods for real estate in India.

Let's do some simple math. Assume that property prices are going to increase ~10% each year for the next decade. That's a very optimistic assumption, given that according to a recent Knight Frank report, real estate prices have gone up by a maximum of 5-7% in most major cities in the last 10 years. But the real question is, that even if they went up 10%, what would be the return on investment after taking into account the entry and exit costs of investment?

For buying a property worth 87 lakhs, the initial investment required would be roughly 1 crore. The price of this property would increase to 2.25 crores in 10 years. After accounting for selling costs, you would make a net profit of just under 1.21 crores on the initial 1 crore capital. That implies a realized investment return of 8.25%. If we include an optimistic 3% rental yield and long-term capital gains tax of 20%, the return will be less than 9.66% annualized!

That's right, a 9.66% return every year on a 1 crore investment after assuming an optimistic 10% annual appreciation in property prices and 3% rental yield. Sounds unreasonable? It surely is, and the reason why most people don't realize this simple fact is that they get disillusioned by the large absolute gains. It feels great to think about a profit of 1.21 crores, without realizing that the profit is so high only because the initial investment was of the same magnitude!

"Without Mathematics, there is nothing you can do. Everything around you is mathematics. Everything around you is numbers." – Shakuntala Devi, Indian writer, popularly known as the 'human computer'.

The Financials of Buying vs. Renting

Next, let's consider the two alternatives of buying a home vs. renting it purely from a financial aspect. For the sake of simplicity, let's assume that you already have 1 crore in savings to buy a house worth 87 lakhs and don't need to take a home loan. The first scenario where you buy the house is straightforward. Since you are going to occupy the house, there will be no rental income and the price appreciation will be the only financial consideration. The other scenario where you choose to rent is a bit more complex.

For starters, you would have to pay the rent which is typically 1-3% of the value of the house in most Indian Metros and Tier1 cities. So, your annual rental cost would be roughly 2.5 lakhs for renting that same house instead of buying it. But now you also have the option to invest your 1 crore savings somewhere else. Let's assume that you invest the money in mutual funds or stocks which give you an average return of 15% each year – the historical long-term average returns. You will also have to withdraw each year's rent at the beginning of the year and invest whatever's left. Let's also assume that your annual rent will increase by 10% every year.

So, what happens after 10 years? In Scenario 1, you will end up owning a house worth 2.25 crores which you might be able to sell for a profit of less than 1 crore after tax if you are able to get fair market value for it. Scenario 2 would result in an investment corpus of 3.17 crores and a net profit of 2.14 crores. Since long-term capital gains on stock market investments are tax-free and the cost of selling is less than 1%, all of this is your net profit.

Scenario 1: 97 lakhs

Scenario 2: 2.14 crore

The Psychology of Buying a Home

"Humans were eventually irrational creatures gifted with the power of rationality." – L. E. Modesitt Jr., science fiction author.

The above calculation paints a simplified illustration of the debate between buying vs. renting a house. In real life, things are rarely that simple!

For starters, we haven't considered the non-financial aspects of these two scenarios. Despite the obvious financial disadvantage, why do so many people choose to buy their own home? Our compulsive drive towards owning a house stems from our natural instincts for safety and security. The psychology of "settling down" and "creating a stable environment for the family" fuels our desire to own a piece of property that we can call home. Even in the worst of times, we feel safe and secure in our homes. When we rent a house, there is always uncertainty about our residential status. The house might become unavailable due to various reasons, forcing us to shift to a new place. That alone can be a cumbersome ordeal for most people. It is also tough to alter a rented house based on our needs and choices.

On the other hand, buying a home also has a few drawbacks. It typically means that we are stuck in one location. We lose the freedom to move closer to our workplace or change cities frequently. Buying a house on loan is a long-term financial obligation that becomes a major factor in all our future life decisions.

In Conclusion

"I always like to look on the optimistic side of life, but I am realistic enough to know that life is a complex matter." – Walt Disney, American entrepreneur, animator, producer.

Investing in real estate is not a suitable recourse for most people. Unless you can boast of a large financial investment portfolio and are looking to diversify into different asset classes, real estate should be the last option for you to consider. These investments have high transaction costs, are highly risky, and are very illiquid, which means they are difficult to sell on short notice.

Buying a house or renting it instead… that's a more complex matter indeed. So, it is wrong to give generic advice to choose the best course of action for each specific case. But what is important is that we make these decisions on the basis of accurate information and sound reasoning. Some of the more crucial decisions that we make, such as buying a house, can drastically alter the course of our lives. As long as we weigh the pros and cons of all available options rationally, we are bound to make good decisions that will benefit us in the long run!