Thursday, June 23, 2011

Estimating Real Estate Investment Returns

This ad was posted in Facebook by one of my students a couple of months back. I was interested in the ad not because I was looking to rent the place, but because I wanted to know if condos make good investments.

Real property, and condominiums in particular, have become investments of choice among Filipinos in the past several years. In various areas around the metro, we see a lot of activity from the condominium development industry; for example, along the 1.6 km stretch of Katipunan in the vicinity of Ateneo and Miriam College, there are at least three on going projects, with a couple more underway. This rapid expansion of supply is a reaction to the surge in demand from an increasing population of young professionals and OFWs who are looking for better returns than what bank deposits offer and who, for one reason or another, have a deep-seated aversion for financial investment vehicles like stocks and bonds. Just to illustrate, two of my colleagues at the Ateneo bought units at SM Development's Berkeley Place in Katipunan and at least three of my friends here in Hong Kong--Filipino professionals, all--purchased units at SMDC's other developments in Quezon City. 

So is real estate as good an investment choice as many of us believe? And given the available financing alternatives in the Philippines and prevailing interest rates, does it make sense to borrow to buy a condo for investment, even if you could easily afford future mortgage payments?

The approach in answering these questions is the same as the one we use for any investment or purchase decision: compare the cost of the investment or asset to its projected future benefits while accounting for the time value of money. To get some information that I'll need for the analysis, I asked my student a few questions about the unit that she was trying to let. The primary fruits of a real estate investment is rental income: my student's asking rent for her 36 square meter unit was 18,000 pesos per month, or down to 14,000 if the unit was bare. Her parents had just recently bought the unit for around 3 million pesos; this amount would be the initial cost of the investment.

Since we don't have actual values for the other information that are needed in the analysis, we would have to make some assumptions.
  • The maximum life of a condominium project as defined by law is 50 years. In our analysis, we assume that the condo will be fully depreciated by this time so that the terminal value of the investment is zero.
  • We assume an annual rent increase of 2%, for conservatism.
Our analysis recognizes two financing alternatives for the purchase: your own money and debt. For the debt scenario, we would have to estimate some parameters.
  • Downpayment as a percentage of the loan amount (or purchase price)
  • Mortgage rate, or the interest rate of the debt. Rates offered by Pag-Ibig and banks are based on the term of the loan (years to pay). Ranges from 5% to 11.5% per year.
  • Years to pay, the loan term. Typically ranges from 5 to 15 years for bank loans to as long as 30 years for Pag-Ibig.
  • The monthly amortization or payment is computed automatically from the three inputs above.
Real property owners are taxed on two levels: the real property tax and the tax on rental income. Real property tax is easy to compute: residential property in Metro Manila is taxed at 2% of 20% of the assessed value of the property, which we'll assume to be just equal to the purchase price, for simplicity (you can take a look at this World Bank primer for more details). Rental income tax is a bit more complicated to compute; since the income tax schedule looks at the total income of an individual, we have to assume a figure for annual income from other sources (such as employment), compute for the income tax without and with rental income, and treat the difference as the tax amount that's attributable to the investment. We may also specify the rate at which non-rent income is assumed to grow per year to make our model more realistic. 

Using the assumptions found on the "Main" worksheet above, we see that we will earn around 6% on our investment per year if we are to use our own money, and just 4.53% if we finance our investment with debt. Given that the assumption that we will be able to rent out our unit continuously every month for 50 years is on the optimistic side, I find the resulting rates of return to be not so attractive. At least based on our assumptions, this particular investment does not seem to be extraordinarily profitable. (You can click on the "Cash Flows" tab to see the annual cash flows).

Of course, we can always improve the attractiveness of our investment is by getting a less expensive condo at a given rental level, or by asking for higher rent for a given investment amount (or by increasing the annual rent growth rate). However, we should keep in mind that pricing, more often than not, could not be easily adjusted since it is primarily dictated by market supply and demand.

In analyzing the potential returns of your own real estate investment, feel free to modify the inputs of the analysis (cells with the light-green highlight) according to your specific circumstances (here's a copy of the spreadsheet above in Excel format). How does your own investment fare against the example above? Using the template, you can also try to modify the terms of the housing loan option; you'll find that in situations where the mortgage interest rate is lower than the "own money" investment return, the borrow option becomes more attractive. 

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