Majority of us know the right answer. Borrowing money for real estate investment purchase should be minimised as much as possible.

But knowing the right answer, and understanding it are two different things.

So in this article we will try to understand the **math** behind the borrowed money.

Ever since I started taking my investment decisions myself, I was repeatedly reminded of this fact…

Home loan substantially lowers the investment yield.

This article will quantify how much of it is true.

The calculation will try to quantify **how ugly** is borrowing money for real estate investment purchase.

If one wants to borrow money for real estate investment purchase, the math use here will eliminate few apprehensions.

After all “not investing the borrowed money” is something which was not written in Gita or Bible. 🙂

Jokes apart, I always wanted to arrive at a mathematical conclusion proving whether loan is good or bad for real estate investment purchase.

## What is the need to dig deeper…?

On one side, I live with this prehistoric **belief** that home loan lowers the investment yield.

On the other side, I also see that few *best of minds* do not mind taking home loan for purchasing real estate properties.

After all, the whole financial business revolving around *home loans *cannot be built only on fake propositions.

So which is real, my belief or otherwise?

To arrive at some sort of conclusion, it was necessary to dig deeper into the mathematics side of it.

So, keep an open mind and read this blog post till its end.

If you agree/disagree with my point of view, do add in your opinion in the comment section below.

## Lets ask, why we invest money?

Borrowing money for Real Estate Investment lowers the yield, ok.

But I am asking, show me the numbers…

This is a common *belief*. One must not use the borrowed money for buying investments.

But we still do it, right?

When we take home loan and buy a residential property, we make this alleged mistake.

Financial Gurus ask as to first save money, and when we have * enough* savings, then buy a home.

Their idea is to protect us from getting fully dependent on home loan, and in turn purchase an overvalued property.

But they also never say that,

loan will substantially lower the investment yield.

Why they do not utter these words? May be it is not true.

To know this, we have to see the calculations…

But before that, lets look at another aspect of home loan. May be there lies the hidden answer.

How much savings (self contribution) is **enough** to buy a real estate property?

As per rules, if you can pay 20% from your savings, banks will finance you the balance 80% as home loan.

So does it mean that financing 20% from self is good enough?

No. Ideally the self contribution should be 100%.

But without being too harsh on oneself, I have made my own rule here.

To buy a real estate property, self contribution must be more than 50%. If it is * above 65%*, nothing like it.

But why these rules?

To answer this question, we must first realize why we invest money.

Money is invested mainly for earning higher returns.

We earn a meager 3.5% (net of inflation is **-2.5%**) from our savings account. We invest money to earn higher returns than what’s provided by our savings account.

What happens if our investment is not able to yield enough returns?

A no brainer investment is bank’s fixed deposit. Without any thought we can invest our money in FD and earn a net of inflation return of close to **+0.5%**.

Suppose you decided not to invest in FD; and invested in real estate. But the net yield from this investment is close to 0.5%.

Will it still be considered a good investment? No.

You could have bough a FD, sitting from the comfort of your home. No questions asked, upon click of a button the money is invested.

Similarly, upon maturity the invested money automatically gets credited to your bank account.

But you instead took that **extra (BIG) effort** to invest your money in Real Estate, and its return is like FD? Useless investment, right?

Why on earth you did all that hard work for?

What people fear is this. Net yield of real estate investment, considering home loan factor, becomes as low as returns from FD.

If this is true, home loan is surely bad.

But where are the numbers which confirms this apprehension?

Less people know how to calculate the numbers. Hence people like me has inflicted tough rules on self (self contribution between 50%-65%).

Less loan means less extra cost, resulting is higher yield.

But again where are the numbers?

Let’s try to do some number crunching now….

## #1. Investment Yield – with home loan.

- Suppose you desire to buy a residential property for investment.
- Total Cost of property – Rs.62.5 Lakhs.
- Self contribution (20%) – Rs.12,50,000.
- Home Loan portion (80%) – Rs.50,00,000 (Interest 9% per annum).
- This property will be able to fetch you a rental income of Rs.15,000 in the first year. The rental income also grows subsequently @8% per annum for next 20 years.

Lets try to value this real estate investment which is heavily loaded with home loan.

##### #1.1 Total Cost of Investment

So what we can understand from the above information?

You will have to pay a loan EMI of Rs.39,670 (cash-outflow, hence depicted in negative) for next 20 years.

[**P.Note**: In India, home loan rate in on a falling trend. Hence instead of considering the present interest rate, I have assumed an average interest rate of 7.3% for next 20 years]

Using the **present value** concept, what will be the present value of all cash-out flows happening for next 20 years?

Present value of all future cash-outflows can be calculated using a excel formula:

**Present Value = PV(rate, nper, pmt, pv, type)**

[rate = discount rate = average inflation for next 20 years = 6%]

**Rate**– 6%/12 per month.**Nper**– 20*12 months.**Pmt**– Rs.-39,670/month.**Pv**– Zero (0).**Type**– Zero (0).

= PV(6%/12, 20*12, -39,670, 0, 0)

**= Rs.55,37,227**

It means, though you took a loan of only Rs.50Lakhs, but as you will pay an EMI of Rs.39,670/month for next 20 years, present value of total loan payment will be Rs.55.37 Lakhs (instead of 50 lakhs).

So in terms of present value, what is the actual cost of the real estate property?

= Self Contribution + Present Value of all Future Cash Flows

= 12,50,000 + 55,37,227

= Rs.67,87,227

Adding another 2.5% for Property tax and maintenance etc

**Total Cost of Property = 67,87,227 * (1 + 2.5%) = Rs.69,56,900**

##### #1.2 Total Return of Investment

In a real estate investment, total returns will be rental income plus capital appreciation.

**#1.2.1 Capital Appreciation**:

- Present value of property: Rs.62,50,000
- Average Valuation growth in next 20 years: 12.0% per annum
- Value of property in next 20 years = Rs.6.03 Crore [=PV(12%,20,0,6250000,0)]

**#1.2.2 Rental Income**:

- Suppose your property will generate a rental income of Rs.15,000/month in first year.
- Henceforth, the rental income will increase @8% average for next 20 years.
- Hence, average rental income for next 20 years will be Rs.34,321 per month

The real estate property generating rental income of **Rs.34,321 per month**.

**#1.2.3 Present Value of Property**

Lets value this property in terms of its:

- Rental income generating capability, plus
- Its capital appreciation capability.

What will be the Present Value of all cash-inflows generated by the property in next 20 years?

[we will discount all future cash-inflows (rent) by 6% per annum]

**Present Value = PV(rate, nper, pmt, pv, type)**

- rate = discount rate = average inflation for next 20 years = 6%/12.
- nper = 20*12.
- pmt = Rs.34,321/month
- pv = value of property in 20th year = Rs.6.03 Crore
- type = 0

= PV(6%/12, 20*12, 34321, 60289332, 0)

**= Rs.2,30,03,792**

##### #1.2 What is the investment yield?

- Total Cost = Rs.69,56,900
- Value Appreciation (after discounting for inflation) = Rs.2,30,02,792

Value of property appreciated from Rs.69.56 Laks to Rs.2.30 Crore.

Lets see if this value appreciation is good enough or not…

Investment Yield = [(23002792/6956900)^(1/20)]-1 = **6.16% per annum**

Net of inflation yield of real estate property, which is being held for 20 years is 6.16%.

*Is this yield good enough?*

Lets compare it with *net of inflation (6%) yield* of following investments (just a rough estimate):

- Saving A/c : -2.5% per annum
- Fixed Deposit : +0.5% per annum
- Gold : +1.0% per annum
- Company Deposits : +1.5% per annum
- Debt based Mutual Funds : +3.0% per annum
- Balanced Mutual Funds : +6.5% per annum
- Equity based Mutual Funds : +8.0% per annum
- Value Stocks : +10.0% per annum

Looking at above, how would you rate your real estate investment yield?

All your hard work that went into paying the EMI’s, though sweat and blood, looks worth?

I assume, the return in not bad at all.

## #2. Investment yield – without home loan

**Total Cost of Property = 62,50,000 * (1 + 2.5%) = Rs.64,06,250**

- Total Cost = Rs.64,06,250
- Value Appreciation (after discounting for inflation) =Rs.2,30,02,792

Value of property appreciated from Rs.64.06 Lakhs to Rs.2.03 Crore.

Investment Yield = [(23002792/6406250)^(1/20)]-1 = **6.6% per annum**

## Conclusion…

It is important to buy property at price where it can give future growth of 12% per annum.

If the property valuation grows at 12% per annum, only then the following condition will be valid:

- Investment yield (with home loan) – 6.16%
- Investment yield (w/o home loan) – 6.60%

It means, home loan reduces the yield from 6.6% to 6.16% (**0.44%**).

It doesn’t look to so ugly, right?

So we can conclude that borrowing money for real estate investment is not so bad.

In fact, the net of inflation yield of real estate investment (with home loan) is close to the long term returns of balanced mutual funds.

Considering other tangible benefits of obtaining a real estate property, investment yield of 6.16% (net of inflation) is fantastic.

**Disclaimer**: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyse all securities before investing in one.

The interest portion of the home loan is tax deductible. If you take this also into consideration, the ‘with home loan’ option would be more attractive.

You are right. Income tax benefit improves the benefit

thanks explained very well

Great post mani. Have experienced this first hand. While I agree on the idea to check on investments less frequently, however do share on when should an investor think about changing funds.