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Revisiting an age-old question: Should you buy or rent a house?

Whether to buy or rent a house is an important question. One that merits modelling multiple variables and their corresponding cash flows in Excel at leisure! In this article, I compare the IRR from purchasing a house with a 20 year home loan versus the IRR from renting the same house and investing the down-payment and the difference between EMIs and rents through-out the home loan term. I have considered the tax implications of both the alternatives – tax exemptions u/s 24 and 80C for the Home loan and the deductions as per HRA in case of living on rent.

For easier reading, I have denoted IRR for house purchase as IRR-P and IRR for renting the house as IRR-R. Setting assumptions like long term house price appreciation and rent escalation based on actual historic movements and rent capitalization rate, interest rate, yield on investment etc. at levels that to my mind seem reasonable, the IRR-P trumps IRR-R hands-down. Assumptions on net salary, basic, HRA, and DA are required for computing tax benefit on HRA exemption. I have attached the model with this post, so you can tweak all the assumptions to your heart’s content!

Key observations:

  • Rent capitalization rate (Cap rate) is the most sensitive variable in determining whether one should buy or rent a house. Put simply, the price that you are willing to pay for a house should necessarily take into account the market rent that is being asked on the same or similar apartments. As a corollary, the rent you are willing to pay for a house should necessarily take into the account the price that is being asked for the same or similar apartments.
  • The higher your income, the more you benefit from purchasing a house than renting it.
  • Higher house price drags down IRR-P as the tax exemption on interest payments is capped at Rs 150,000 per annum irrespective of how much interest you actually pay.
  • If long term property price appreciation rate is same or only slightly more than long term rent escalation rate, IRR-P is lower than IRR-R.
  • The higher the leverage on the home loan, the higher the IRR-P.

Snapshot of the assumptions and the resultant IRRs:

buy or rent

Sensitivity of the IRRs to the variables:

buy or rent

Excel File: HomeLoanVsRentCalc

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Vinay Upponi

Vinay Upponi works with a national departmental store chain where he is responsible for assessing real estate and market potential for the company's formats. Prior work experience includes a 4-year stint at CRISIL Research. Vinay was a part of the Customized Research division which provides consultancy services in market sizing and entry formulation, portfolio credit quality assessment, and feasibility studies for capacity expansions. Earlier, Vinay tracked the coal mining and power industries while at CRISIL and shared sector opinions with some of the largest domestic and multinational banks including State Bank of India, ICICI Bank, Australia and New Zealand Bank, etc. Vinay graduated from the University of Mumbai in 2002 with a Bachelors in Commerce and has passed two levels of the international Chartered Financial Analyst program.
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15 comments

  1. You missed maintenance costs. As the house gets older, maintenance costs increase significantly (faster than inflation infact). To get your terminal value of 3cr (!!), you will have to spend a huge amount to renovate the house.

    Assume a building has a life of 50 years. After which it is unlivable (structurally unsafe) and has to be torn down. The only terminal value you will get here is the value of the land minus costs of tearing down building. If you are living in an a 20 storey apartment, then each apartment owner will essentially have a claim to 1/20th of the land. This should be your terminal value then.

    For individual homes, structural renovation can cost about 50-70% of the cost of building a new house. Load bearing columns are kept,but everything else is replaced. Roof, floor tiles, bathrooms, electrical wiring, etc etc.
    For apartments, the cost is probably more.

    Another fact that you missed is that home preferences change over time. 50 years from now, people will be living in very different types of homes. Would you like to live in a 50 year old apartment today (without attached bathrooms, exposed electrical wires, etc) ?

    • Thanks for pointing out the discrepancies. I am working on a
      version 2 and would include periodic renovation expenditure in the
      model. The preference change consideration however may not be very
      pertinent in a 20 year scenario. At any rate, I am assuming that
      apartments would continue to be inhabited and valued for the kind
      of housing they provide.

  2. Dear Vinay, This is a very good calculator and you have simplified
    a difficult decision in terms of IRR. I disagree with rts about
    including the kind of maintenance cost referred to. This is not an
    usual expenditure. Monthly maintenance could be included but since
    it will much less than EMI it should not matter much. Rent vs. Buy
    necessarily assumes the buyer is going to life out his life in the
    new building. Even for someone getting a loan at 25 a house is good
    enough to live in up to age 75. If he/she wants to move they will
    have to reuse the calculator! There is some element of speculation
    in such calculators. Factoring a second home purchase is taking it
    a bit too far! A comparison bet EMI and Rent paid will be helpful.
    I am paying rent X. Suppose I pay EMI X or (X+25%) what will the be
    apartment cost and then which will be better. Tenure can be
    variable. Sure you thought about this. Tougher to implement when
    you are calculating IRR. Excel 2010 works best for this. Typically
    a 15 year home loan is more beneficial than a 20 year one. All rent
    vs buy calculators depend on one crucial aspect: property price
    appreciation. Correct me if I am wrong: Am I right in assuming this
    represents the appreciation in cost if I consider postponing the
    home purchase? The heading may give the wrong impression to users.
    Many incl the present cost of their house in their networth which
    is nonsense. I have had several requests to make this kind of
    calculator. I haven’t done much about it because this is more an
    emotional issue than a financial one. When I got the enthusiasm to
    start work on one (still learning about it) I realized retirement
    must be factored in: What will be my retirement corpus if I buy
    (now or later) and what will it be if I rent. In my view this is
    THE crucial factor in deciding when to buy a house. Thanks again
    for the nice calculator.

  3. Dear Pattabhiraman, Thank you for taking the time to go through the model. I completely agree that major life decisions like retirement corpus are important drivers of the rent vs. buy decision. In real life a higher IRR alone may not be a guiding factor for someone to elect to buy or rent a house. Rather, the liquid funds available for meeting other life goals – kid’s education, marriage, or luxurious retirement may also play a big role in his decision. A major stumbling block for me is the complete non availability of historic rental data in the country. I will be following this up with more improvements in the days and weeks to come. Have also yet to fully explore the many other calculators that you have so masterfully created. Thanks again and best regards.

  4. Pattabhiram,
    Yes, monthly maintenance costs are low. But renovation of a 50 or a 60 year old house is an enormous cost. Also at that stage without renovation it will be unusable.

    A house is no different from any other man-made object. It depreciates with time and at some time the value is zero. What we should do is value its returns over the lifetime. When people buy 40-50year old houses today, the building itself is virtually valued at zero. Its only the land that is paid for.

    Strictly speaking we should value a house just as a stock is valued, i.e. the discounted sum of all future dividends. In case of a house this is the rent. Terminal value is zero.

    • I fully agree with what you are saying. However my point is there are aspects that cannot and should not be build into a buy vs rent calculator.

      Mathematical reasons aside there is no guarantee that one would be alive to see his or her property get that old. So I would plan for that when it is about 15 years away and not 50 years away.

      The cost of self owned property is important only when
      1. you want to buy it and
      2. when you to renovate extensively.
      Rest of the time its value is zero from the point of view of an individuals net worth.

      • You say that ‘there is no guarantee that one would be alive to see his or her property get that old’.

        Agreed. But you miss the fact that the buyer at stage will factor in the remaining life of the house into his buying decision.

        For example, I mentioned in my previous post that for 50year building, price of building is valued at zero.
        Now, work backwards. Lets say you sell when the house is 30 years old. The prospective buyers at that stage will factor in the fact the house will only be usable say for another 20 years and he will quote accordingly.

        Work backwards further. For a new house then, you should factor in the life of the house of say 50 years and pay the right price accordingly.

        This is quite easy to do in excel. Start with the rent that you can get initially (dont include monthly maintenance costs that you for elevator, water, etc).
        For the first 20-30 years, assume rent increases at the rate of inflation. Lets also assume that after 30 years, the rent starts to decrease and finally at 50 years, building is dead and rent is zero.
        Use the NPV function for this. Assume a cost of capital of around 15%. You will then get what the house is worth today.

  5. Continuing from my previous post.

    If you do the above, you will see that a new house should be valued at between 150 to 250 times the monthly rent that it can get. (The variation is because the calculation can change based on your assumptions about rental growth and cost of capital).

    This equates to a price/annual_rent ratio of about 15 to 20 . Not surprisingly if you look at stock markets, long term P/E ratio there is also around the same. In India, long term P/E average for sensex is about 17 .

    In the USA, long term reliable housing data is available. There too, price/rent ratio ranges from around 12 to 25. The average P/E ratio for the Dow Index has been around 15 over the last 100 or so years.

    • It is good way of viewing house value. What you suggest to be done in Excel is easy enough to do. My problem is I fail to see the relevance of this analysis to the present context.

      All I can compare is the rent I pay vs the EMI I will pay. These are completely independent quantities in real life. Just realised that the calculator compares the value vs rent it would fetch. Pretty uncomfortable about that in the first place.

      Assuming I fix the value of the property I want to buy with the rent I currently pay then

      value = (annual rent)/3% seems to be closer to reality

      value = 250X (monthly rent) (as a crude rule of thumb using your argument[I understand it is meant to be used on the same property])

      does not seem to reflect reality (no reason that it should!)

      My point is I completely fail to understand why the rent that a potential property would fetch is even relevant to the buy vs. rent question.

      @ rts, @ vinay, when you reply kindly keep in mind that I am a novice wrt real estate. I had a hard time understanding some of your responses!

  6. Hi Rts, If I understand correctly, valuation based on DDM or rental yields lies at the core of your argument. This is without doubt a rock-solid way to assess investments. However, in developing countries like India, assets like equities, for example, if valued by the DDM alone throw values which in many cases are significantly lower than their market prices. This is because the market implicitly assumes that the growth factor (or capital appreciation component) will make up for the low yields. For example, there are few localities in Indian metros today where you’ll find a house valued at 150-200 times monthly rent.

    There are times when the markets take the future growth argument just way to far, such as during the heady days of 2007 when cheap credit was pretty much available on tap!

    Correctly valuing a house would therefore require having to predict the rental yields, which as a country develops will move towards the 5-7% range as you have rightly pointed out. But forecasting rental yields for 50 year periods would be essentially an academic exercise. Rather, it would make sense to estimate the terminal value after a 5-7 year period for which one can have at least some visibility.

    Just my 2 cents!

  7. @Pattabihram – “My point is I completely fail to understand why the rent that a potential property would fetch is even relevant to the buy vs. rent question.”
    Short answer – https://en.wikipedia.org/wiki/Opportunity_cost .
    Essentially, you have to see what the money invested elsewhere would have got.

    @Vinay – “For example, there are few localities in Indian metros today where you’ll find a house valued at 150-200 times monthly rent. ”
    To me that is a measure of the exuberance which still exists in our RE market. We had a similar exuberance in our equity markets in 2007 as you point out. That thankfully has ended. The RE bubble will end too. Whether that is through an outright price correction, or through a stagnation in prices till inflation and rent catches up remains to be seen.
    I had posted a link to an academic paper which documented how prices fell 60% in Mumbai in 1990s after a similar meteoric rise. In such cases, a terminal value 7 years down the line can also be misleading, because the assumption then becomes that price rises seen in recent years will continue for 5-7 years. This then becomes essentially a momentum play, rather than a valuation based one. Riding momentum maybe fine if one is a big investor and is ok getting blind-sided by the market. But for the average person for whom RE is a gigantic investment (note SIP not possible here), I would argue that one is better off using long term data and then computing accordingly. Mean reversion is guaranteed in all asset classes. Fundamental value always reasserts itself. Better that we
    factor that into our calculations.

    I for one hope that we have REITs introduced to the Indian market soon. That will give a good chance to get some RE exposure without having to pony up a big amount at one go.

    • I under what an opportunity cost means and I also understand the ones involved here. My point is the rent I currently pay should be involved rather than the rent my potential own house would fetch. if it is an investment property I can understand. Not for a house to be occupied.

  8. @Vinay – “This is because the market implicitly assumes that the growth factor (or capital appreciation component) will make up for the low yields”

    If yields continue to be low, then price will correct accordingly. After all, the price is simply the discounted sum of all future dividends/rents.

    Over the last ten or so years, rents have largely tracked inflation. Prices have gone up at 15-20%pa. The difference is due to banking credit and expectations. Now credit is expensive, and expectations are muted.

  9. The size and scope of the scams & cash market have grown massively over the past 10 years and the real estate market will continue to grow proportionately. The rental market will never witness the same volume of cash transactions , and hence it will always appear cheaper. Then , can we really compare buy vs rent ? Renting will always be cheaper , but you will miss out on owning the most important and expensive asset that an individual typically buys in his lifetime – a house .

  10. @jvats – “but you will miss out on owning the most important and expensive asset that an individual typically buys in his lifetime – a house .”
    Expensive asset – I agree.
    Important – I disagree. I would argue that good educational qualifications is a far better asset to own.

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