Wednesday, April 27, 2005

Real Estate - A Strategy for Apartment Purchase?

For some months now, I’ve been in the market to purchase a good apartment. Unfortunately, I find I’m not alone! Thousands of others have had the same thought – apparently at the same time – and, armed with cheap home loans, they’re driving up prices way beyond control.

Unfortunately, not only is a flat a major investment, it is illiquid and the price at any point is quite subjective. There are few, if any, guidelines to determine the value of a property accurately.

A Strategy for Purchase

Now, if you’re like me, you’d have taken a loan for the purchase, probably up to 90% of the value of the apartment. The remainder plus the registration amount would be financed through available cash and perhaps a personal loan as well.

In this scenario, there are two components to the investment we’re making – principal repayment (which is basically installment payments against the value of the apartment) and interest (which is the amount we are spending in addition to the value of the apartment). Since the principal is merely a payment for the property, we don’t have an issue with it – we got a flat and we’re paying off against it. The problem is with the interest, which is an additional, fairly substantial, amount that we will have to fork out over time. This is the part we need to take care of.

The plan I have is to ensure that the rent for the apartment takes care of the interest component (home loan + personal loan if any) at least. This way, I’m merely paying for the value of the property, which is not an issue.

The other problem is the down payment that we’ve made from our own cash resources. Given a choice we would like the cash to earn interest. Let’s assume that for a low-risk investment similar to property, we would want returns of 10-12%. The expectation would then be that the apartment being purchased must has enough scope to appreciate by an amount that would make such returns possible.

Thus, in summary:

  • Principal payment (home loan + personal loan) gets set off against value of the house
  • Interest component (home loan + personal loan) should be matched by the rent
  • Capital appreciation in the value of the property should be at least enough to translate into 10-12% returns from the down payment made with our own cash

An an example, let's take an apartment of value 50 lakhs, of which the home loan is for 45 lakhs. Let's assume registration amount is 5 lakhs. The down payment required is therefore 10 lakhs, of which the buyer intends to take a personal loan of 5 lakhs and fund the rest himself. The interest component of all the loans works out to about Rs. 25,000-27,000, which needs to be covered by the rent. Further, the apartment must appreciate by at least Rs. 50,000 per annum to generate returns of 10% on the 5 lakhs paid by the buyer. This implies that the apartment should show capital appreciation of 1% per annum at a minimum.

If the buyer had been able to fund the entire down payment himself, the rent requirement would have been lower at about Rs. 18,000 and the capital appreciation required would have been 1 lakh per annum, or about 2%.