FIN-2-0047 | October 30th 2020
Caselet
Time and Money: Home Investment
Dilemma
By Dr. Abhinav Kumar Rajverma
This Case was written by Dr. Abhinav Kumar Rajverma, Asst. Professor (Finance), Institute of
Rural Management Anand (IRMA). It is intended to be used as the basis for classroom
discussion rather than to illustrate either effective or ineffective handling of a management
situation. This case is based on secondary research.
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Time and Money: Home Investment Dilemma FIN-2-0047
Time and Money: Home Investment Dilemma
In June 2018, Mr. Rajvarman, a financial consultant, moved to Mumbai to join a
leading investment bank, headquartered at Bandra Kurla Complex (BKC). Soon he
married the love of his life, also an MBA from a premier B-school, and working for the
same organization. Mr. and Mrs. Rajvarman (Rajvarmans) rented a spacious 2BHK
(two-bedroom, hall, and kitchen) flat for ₹200,000 a month in Worli, the popular and
plush localities in South Mumbai. In April 2019, a flat, very similar to the rented one, was
available for sale with an asking price of ₹40 million, including parking facilities. The
newly married couple realized they were tackling a decision dilemma, the classic one
– ‘Rent-versus-Buy.’ They needed to apply the time value of money concepts and
diagnostic tools learned in management school.
Rajvarmans liked the 2BHK flat they were renting. However, they felt that it would be
inadequate for long-term needs. Furthermore, Mr. Rajvarman might get relocated to
the London office in ten years if the job continued to work out well. The couple had
thought around the alternatives of renting versus buying a house. Rajvarmans realized
they had a tough decision to make.
Additionally, they recognized that the decision would not be solely based on
quantitative factors; qualitative aspects should also be considered. Relatives and
friends joined the discussion and suggested various mixed opinions; most were
qualitative. However, they wanted to analyze the decision from the quantitative point
of view, which would ultimately be a major part of their decision. They had two major
concerns if opting to buy: first, arranging the down payment, and second, the long-
term capital gains tax.
HOME OWNERSHIP
The homeownership kindles a range of emotions, including a sense of security and
comforts, a symbol of status and accomplishment. Monetary aspects are important;
still, quantitative and psychological reasons do compel and favors the buy decision.
The rent paid is like money spent forever. However, the installment payment has a
dual benefit, a one-month shelter, and a proportional increase in house ownership.
Rental payments are often like a burden and self-inflicted discomfort. For such people,
the demon of living in a hired house becomes even larger when they meet friends
and relatives owning a house. The emotion becomes severe with time when landlord
acts as the boss, leading some people to buy a house impulsively.
TAXATION AND TAX-SHIELD
Homeownership is coupled with financial gains as well. Apart from the easy financing
options, it is an attractive long-term investment enjoying tax benefits. Mr. and Mrs.
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Time and Money: Home Investment Dilemma FIN-2-0047
Rajvarman enjoy handsome salaries, and income tax applicable for both is thirty1
percent. Under section 24(b) of the Income Tax Act (India), tax deductions of ₹200,000
per annum are applicable on the interest components only. Further, individuals jointly
seeking a home loan can avail tax benefits individually. However, if the house is sold
within the next five financial years of the purchase, the tax benefits claimed on home
loan interest payment under section 24(b) is reversed, and the amount becomes
taxable in the sale year.
After two years of purchase, the sale proceeds from a house attract twenty percent
long-term capital gains (LTCG) tax with indexation. Also, general repairs and
maintenance costs are added to the acquisition cost with indexation. Worth
mentioning is the exemption from LTCG tax payment under section 54. To avail the
exemption, the entire gain from the property sale is to be reinvested to buy another
house within two years or construct a house within three years. If a property is
purchased one year before selling the first one, the exemption is also available.
MUMBAI PROPERTY MARKET
Given the backdrop of rapid economic development and urbanization, high growth
in the middle- and high-income groups, housing prices in India had stellar growth from
2000 to 2010. Mumbai, the financial capital of India, is the most expensive city in terms
of capital value. The prominent factors driving the residential prices include proximity
to premium office complexes, connectivity with important sightseeing locations,
recreational and amusement parks, etc.
According to a brokerage and investment group CLSA, Mumbai’s luxury real estate
market has reached the saturation point, at least in the South Mumbai. According to
the National Housing Bank, during the five years 2011 to 2016, the average Mumbai
property prices increased by approximately two percent quarter-on-quarter. After
that, it softened on the back of sluggish growth to roughly one percent.
FINANCIAL CONSIDERATIONS
If Rajvarmans purchased the new 2BHK, they would pay repairs and general
maintenance, estimated to be around ₹300,000 per year, in addition to monthly
society charge of ₹10,000 and ₹150,000 property tax in a year.
As per the prevailing market conditions, a mortgage loan is extended to a maximum
of 80 percent of residential property purchase value. Rajvarmans decided to go for a
fixed-interest rate mortgage. The mortgage over 30 years, with a lock-in period of
three years and monthly installments, was available at a nominal annual interest rate
of 9 percent, compounded monthly.
Apart from the remaining 20 percent down payment, the initial payments included 5
percent stamp duty, 1 percent registration fee, and rupees ₹500,000 as other
miscellaneous costs that include agency and other closing fees. The employer agreed
1 30 per cent Income tax is not inclusive of surcharge and health & education cess for
simplicity.
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Time and Money: Home Investment Dilemma FIN-2-0047
to extend an interest-free loan of a maximum of ₹3,000,000, recoverable in 30 monthly
installments. They decided to monetize fixed deposits and savings, fetching pre-tax
interest income of 1.5 percent per quarter (average) for the remaining initial amount.
In the case of renting, apart from the monthly rents, society charges were paid by
Rajvarmans. However, the property tax and repairs and general maintenance were
paid by the house owner.
INVESTMENT DECISION
With the above information in hand, the couple conducted a quantitative analysis by
employing the time value of money concept. For house resale value and LTCG tax
estimations, they analyzed the Housing Price Index (HPI) of Mumbai, prepared by the
National Housing Bank (NHB RESIDEX) and Cost Inflation Index (CII), respectively. The
NHB RESIDEX increased by 55 percent (YoY 7.7%) from FY2013 to FY2019, and CII
increased by 40 percent (YoY 5.8%) during the same period (Exhibit I), an annual
spread of 2 percent YoY, on an average.
Exhibit I: House Price Index and Cost Inflation Index
S. No. Financial Year NHB RESIDEX2 Cost Inflation Index3
(Mumbai) (CII)
1 2020 158* 289
2 2019 155 280
3 2018 148 272
4 2017 141 264
5 2016 137 254
6 2015 120 240
7 2014 115 220
8 2013 100 200
*September 2019 data
Compiled by the author from various sources
The base scenario estimated the property value after three, five, and ten years based
on a conservative 6 percent annual growth. For the same period, they assumed 4
percent yearly cost inflation to estimate the LTCG tax. They took an interest rate of 1.5
percent for the opportunity cost, compounded every three months (fixed deposit rate
2 House Price Index (Mumbai); published by the National Housing Bank (Base year FY2013).
3 Cost Inflation Index; notified by the Government of India (Base year FY2002).
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Time and Money: Home Investment Dilemma FIN-2-0047
as proxy). They would pay 2 percent of the selling price to the real-estate broker on
selling the house.
SCENARIO ANALYSIS
To complete the detailed financial analysis of the rent-versus-buy decision,
Rajvarmans are interested in determining the net gain (loss) if the house is sold in three,
five, and ten years under the following additional scenarios:
Over the next three years, the house price reduces by 10 percent, and after that, by
the end of year five, it increases back to the original purchase price. From year five to
year 10, the house price appreciates 8 percent yearly. The annual cost inflation is 1
percent over the first three years, 3 percent over the next two years, and 5 percent
after that.
The house price and cost inflation, over the next ten years, increase quarterly by 1.5
percent and 1 percent, respectively and
The house price and cost inflation increase annually by 8 percent and 5 percent,
respectively, over the next ten years.
The flats were selling quickly, and they needed to act fast to close the financing and
contact a lawyer to assist in the sale deed if they decided to buy.
ASSIGNMENT QUESTION
I. Determine the effective monthly and annual mortgage costs.
II. Estimate the monthly installment and outstanding principal after five years.
III. Explain the capital gains without and with indexation.
IV. Calculate additional payments monthly when opted to buy the house.
V. Discuss and estimate the opportunity costs of initial payments.
VI. Estimate the present value of the interest-free loan and tax-shield benefits.
VII. Estimate the net gain (or loss) after three, five, and ten years under the base
scenario and scenarios as mentioned earlier (refer to scenario analysis)
VIII. Describe the qualitative considerations that could factor into the decision.
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