Buying a Condo: Cash or Installment?

DEAR INVESTOR JUAN

Dear Investor Juan,

My husband and I decided to buy a condo unit for use by my 2 college students.  Instead of paying rent which is an outright "loss", we will be paying for a property which is "gain".  We have enough cash in our emergency fund (which are in 5-yr tax free time deposits at 4-6%interest p.a.) to buy the condo unit in cash and earn the benefit of 12% discount. Or pay 45% downpayment without interest in 27 months and then pay the remaining 55% lump sum (thus avoiding bank financing) and still enjoy 3% discount.

The dilemma is this: husband says we do the former--12% is way bigger than the 5-6 % the money will earn in the banks. But I choose the latter--at our age (43 and 45), we'll never know when we will have medical emergencies.  I don't want to let go of our savings, we're still earning and we'll just pay for the condo unit on a monthly basis from the money we still have to earn.

The property costs 2.6M. If we withdraw from out time deposits, we get charged 10-50% of earnings depending on the bank, the number of years still remaining, plus documentary stamps costs.

What do you think?

Weng


Dear Weng,

From a purely economic standpoint, the reasoning of your husband makes sense since the additional 9% discount (12% vs. 3%) that your get by paying for the property with cash outright is greater than the 5 to 6% you earn from your time deposits. If you want a more systematic analysis, however, there are a couple of things that you can do: (1), determine how much more it would cost you in terms of interest per year to pay in installments, or (2) compare the present values of cash flows of both options.



The table above shows the different discounts applied to the two payment options (I assumed that the 3% discount for the installment option would be applied to the gross cost). Then, we see the payments that you would have to make under each option; to simplify matters, I just assumed that the balance for the installment plan would be due in 24 months instead of 27.

Obviously, the installment option would cost you more in peso terms, but how much more would it cost you per year in percentage terms, considering the time value of money? To do this, we first get the "incremental cash flows" of choosing the installment plan over cash payment, then compute for the internal rate of return (IRR) of the cash flows. Using the IRR function of Excel, we get 9.68% per year. This means that by choosing to pay in installments rather than cash, you will pay an implied interest or cost of 9.68% per year. And since this is higher than what you earn from your time deposits, you are better off choosing the cash payment option.

Or, taking the 5% from your time deposits as your "cost of money," you can just get the present value of the cash flows from the two options. Since paying cash has a lower present value of payments than the installment plan, then you should choose the former.

Of course, there are other non-economic and subjective factors that you might want to consider in choosing a payment plan. If paying the entire amount in cash would leave your emergency fund empty, you might be forced to resort to more expensive debt in case of emergencies. However, I assume that both you and your husband are still working and would have ample insurance coverage as part of your work compensation and are capable of saving a significant amount on a monthly basis to rebuild your emergency fund fairly quickly. So maybe you can afford to spend your entire savings this one time.

If you really want to be on the safe side, however, I propose this "middle-ground" solution: get a housing loan for 1 million with an interest rate of less than 9.68% (which I think you can get from Pag Ibig), use this and a portion of your savings to pay cash and avail of the 12% discount, and still have a 1 million peso emergency fund.

PSE Targets 2013 for REITs in the Philippines

IN THE NEWS

A real estate investment trust or REIT is a modern innovation in finance which allows small investors to participate in future and existing real estate development projects. While the issuance of REITs in the Philippines has already been covered by the REIT Act of 2009, property developers have found requirements too steep to actually push through with an issue. Concerns center on a 40% public-ownership requirement, which needs to be raised to 67% in three years, and the imposition of value-added tax on the transfer of property assets into the REIT. The PSE now proposes changes to these regulations to ease the burden on potential issuers and lead to the first REIT offerings in 2013.

REITs have generated considerable interest from both property developers and investors; the eventual issuance of REITs is seen to further the development of local financial markets. As such, the SEC and the Department of Finance have expressed openness to review the proposals of the PSE.

via Business Mirror

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. 

4 Questions About REITs Answered

INVESTMENT SPOTLIGHT

In a previous post, we caught a brief glimpse of Real Estate Investment Trusts or REITs and how it gives "small" investors a more affordable way of investing in real estate. Recently, the Philippine Stock Exchange released a primer about this new investment vehicle that's about to enter our market. Here are some of the more important things you need to know about REITs.

1. What exactly is it?

A Real Estate Investment Trust (REIT, pronounced as “reet”)  is a stock corporation created for the purpose of owning and managing income-generating real estate such as office buildings, residential condominiums, shopping centers, hotels, warehouses, hospitals, airports, and tollways. The Philippine REIT, under Republic Act No. 9856, otherwise known as the REIT Act of 2009, requires REITs to list its shares of stock on the Philippine Stock Exchange or PSE. The REIT distributes 90% of its distributable income to investors in the form of regular dividends and receives special tax considerations as an incentive.

REITs allow investors--especially small or retail investors--to participate in the ownership of one or more income-generating real estate. For property developers, REITs provide to ready capital which may be immediately used to finance new projects and investments.

2. What are the allowed activities and investments of REITs?

REITs are allowed to make investments in the following:

• Real estate;
• Real estate-related assets;
• Managed funds, debt, securities, and listed share issued by local or foreign non-property corporations;
• Government securities (issued in the Philippines and others);
• Cash and its equivalent; and
• Similar investments (see REIT Act IRR).

3. How do investors earn from owning REIT shares?

Owning REIT shares is like owning a hybrid fixed income and equity security. Since REITs have access only to a limited number and specific types of investments, earnings distribution in the form of dividends should be more reliable and stable than dividends paid by stock companies. Also, since REIT shares are freely traded in the market, investors can also benefit from capital appreciation when there is high demand for the shares.

4. What are the other advantages of investing in REITs?

Through REITs, investments in real estate become more affordable to small or retail investors. And since there is (presumably) a ready market for REIT shares, investments in REITs are more liquid than direct investments in real property.

Finally, because REITs offer features that are distinct from traditional investments like bonds and stocks, they can enhance an investor's portfolio through more effective diversification.

10 Exercises: A Fitness Manual for Random Walkers (Part 2)

STUFF I LEARNED FROM Burton G. Malkiel's "A Random Walk Down Wall Street"

6. Begin Your Walk at Your Own Home; Renting Leads to Flabby Investment Muscles

"A good house on good land keeps its value no matter what happens to money. As long as the world's population continues to grow, the demand for real estate will be among the most dependable inflation hedges available."

Land is a scarce resource whose supply is limited; demand for land goes up as the population grows. We all know from Economics 101 that this interplay between supply and demand could only lead to higher prices in the future; it's hard to argue with the soundness of this reasoning.

But as they say, the devil is in the details. Important issues continuously face the would-be real estate investor. For example, we all know that investing in real estate entails significant capital, usually upwards of 1 million pesos for any decent piece of property. As most investors don't have that kind of investable cash at hand, the only available recourse is debt. But borrowing at, say, 7% per year (roughly Pag-ibig's interest rate per annum for a 1 million peso housing loan) will only make sense if you anticipate that the value of your property will grow at least 7% per year, or if you think investments of comparable risk (like say, stocks) will yield higher annual returns in the long run. The point is that investing in real estate is not an automatic investment win, and is not always the best alternative under particular circumstances.

Second, as in all investment situations, the investor makes financial decisions in an uncertain environment. The housing bubble in the US which led to the financial crisis in 2008, and the devastating blow dealt by typhoon Ondoy on the Marikina and Pasig real estate markets last year, will make any investor think twice before making any real estate purhcase. But we have to remember that these things are part and parcel of investment dynamics, and that instead of ineffectively trying to preempt what can happen, maybe the best thing to do is protect ourselves with things like insurance and diversification.

7. Beef Up with Real Estate Investment Trusts

"If you want to move your portfolio toward terra firma, I strongly suggest you invest some of your assets in REITs."

A real estate trust fund or REIT (pronounced as reet) is a corporation that invests in real estate, and whose earnings are distributed to investors at a lower tax rate. Basically, a REIT is to real estate as mutual funds or UITFs are to stocks and other financial assets.

REITs may be public or private; shares of public REITs may be traded on public exchanges, like the Philippine Stock Exchange. REITs make investing in real estate easier for individual investors as real estate portfolios are divided into a number of shares, resulting in more affordable minimum required participation.

In July 2007, Senate Bill number 63 or the Real Estate Investment Trust Act was passed in congress. Big players in the real estate market are just starting to capitalize on this new way to attract investor funds, with Ayala Land recently setting up a REIT that will be offered to the public in the near future.

8. Tiptoe through the Investment Fields of Gold and Collectibles

"The Honda Accord in your backyard can rust, and the three-year-old TV dinner in your freezer may not taste very good. I tend to prefer the kinds of assets that produce a return while they are giving inflation protection."

Some people mistakenly believe that the best way to fight inflation is to buy stuff now, while prices are presumably lower, rather than later. The problem with this "strategy" is that not everything can be consumed all at once, and most "stuff" that remain lose a portion, and eventually all, of their value over time.

Investing, by definition, involves buying something that can either provide a stream of future income, or whose price can appreciate in the future, or both. Unfortunately, just buying any kind of good does not meet either of these criteria. One might argue that a valuable commodity like gold is not like other "stuff": while it does not generate periodic income, its price can definitely appreciate considerably at any given time. But because the price of gold is mostly determined by investor speculation, and thus can be very volatile, Malkiel recommends holding just a small portion (around 5%) in your portfolio by buying shares of funds that invest in gold.

9. Remember that Commission Costs Are Not Random; Some Are Cheaper than Others

"With the advent of competitive commission rates, it has now become possible to buy your brokerage services at wholesale prices."

As we've seen with UITFs in the Philippines, the fees fund managers charge can vary greatly and can even result in considerable differences in annual returns. Unfortunately, the same can also be said of mutual funds, stock brokers, and other entities that provide financial services for a fee. In availing of these services, then, be sure to do your homework and shop around for the lowest rates to maximize the fruits of your investment.

10. Diversify Your Investment Steps

"A biblical proverb states that 'in the multitude of counselors there is safety.' The same can be said of investments. Diversification reduces risk and makes it far more likely that you will achieve the kind of good average long-run return that meets your investment objective."

Diversification remains to be one of the most effective ways of managing investment risk. By investing in different asset classes -- stocks, bonds, real estate, etc. -- you lessen the chance of being wiped out in case something catastrophic happens. While this strategy may provide lower potential returns compared to, say, picking individual stocks, theoretical and empirical evidence continue to show that the trade off is well worth it.

Is it Better to Buy or Rent?

I found myself asking this question often ever since I started earning my own money. For many of us, the holy grail of independence is to own our own home (which is also one of the most important reasons why most Chinese save a significant portion of their income); if you’re on the wrong side of thirty and you’re still renting your apartment, you’re not yet “made.”

We all know that buying your own place provides several important intangible benefits like a sense of accomplishment and security that renting cannot provide, but is it really the best economic option? In making a financial decision as important and expensive as buying real estate, you’ll have to consider all relevant factors and perform due diligence analysis, which can easily overwhelm you with details and data. It’s a good thing the New York Times recently released an online, interactive tool that helps you decide which is the better option for you.

Basic Inputs

The graphic comes pre-loaded with default values that you’ll have to change to reflect your own specific circumstances. The first thing you have to realize is that while some of the input boxes are labeled with the US dollar sign ($), you can actually use any currency unit (like our beloved Philippine peso) as long as you’re thoroughly consistent.

On the left-hand side of the main page, you’ll have to enter basic information about the property and your finances:

1. Monthly rent – of the property you’re thinking of buying, or another property that’s comparable to it; the typical monthly rent for a 40-square meter condominium unit along Katipunan Avenue is around 20,000 pesos

2. Home price – current market value of the property if paid up front; note that this is not the same as the sum of your monthly payments if you get a mortgage (housing loan) to pay for the house; the market value of the condominium unit I’m using in this example is around 2.5 million pesos

3. Mortgage rate – the annual interest rate of the housing loan that’s available to you; for most banks, this is at around 10%; for Pag-Ibig, interest rates for lower loan amounts are substantially lower; a 2.5 million peso loan from Pag-Ibig goes at an annual interest rate of 10.5%

4. Annual property taxes – there’s no one percentage rate applied for property tax in the Philippines, and the computation is really quite convoluted, so I think leaving the default value as is should suffice.

On the top portion of the graph, you’ll find two slider bars for the following inputs:

5. Annual home price change – this should be the long-term annual percent change of the price of the property; for the sake of conservatism, I set this one to zero

6. Annual rent increase or decrease – in my experience, apartment rents increase at an average of 5% per year

Advanced Inputs

If you want a more customized analysis, click the “advanced settings” button at the upper right corner of the graph. The more relevant advanced settings include,

1. Condo fee/common charge (buying) – condo fees are around 40 pesos per square meter per month, so that’s 1,600 for my property

2. Rent deposit (renting) – rent deposit is anywhere from 2 to 3 times the monthly rent

3. Rate of return on investments (other) – this is your opportunity cost of capital, the answer to the question “how much annual interest would you earn from an available investment with similar risk?”; a good figure would be 8%, which is the typical yield of medium-term retail corporate bonds nowadays (more on that in a future post)

4. Marginal tax rate (other) – or income tax rate, anywhere from 20% to 35%, depending on your gross monthly income

5. Inflation rate (other) – the average annual percent increase in the price of basic goods and services; 5% should be a good enough estimate

I decided to leave other details as is.

The Output

After entering all the required information, the tool coughs up its recommendation. Based on the details I’ve entered, “Buying is better than renting after 11 years.” Well, that’s pretty clear, straightforward and useful. That means if I plan to stay and live in the Katipunan area for less than 11 years (an eternity in my book), I would be better off if I rented a condo for 20,000 pesos per month that if I buy the same property now for 2.5 million pesos (and sell it when I’m ready to move).

The tool also presents an organized summary of the annual and total costs of both alternatives, and a year-by-year analysis of the better decision based on how long you plan to live in your chosen place of residence (for example, renting the condo for ten years will save me a total of 60,617 pesos compared to buying).

GIGO

I always ask my classes what they think this acronym means; the most common answer is “Go In, Go Out,” which up to now does not make sense to me. I guess IT professionals would be more familiar to the phrase “Garbage In, Garbage Out,” which just means the reliability of the any process’ output depends on the soundness of the inputs. So in using the NY Times’ Buy or Rent tool, you should remember that the usefulness of its recommendation is only as good as your input estimates and assumptions. Finally, while making important purchasing and financial decisions is best done objectively and quantitatively, sometimes intangible, intuitive factors are equally important.