A rental house can make profits but have no cash
The Sunday Nation
Nairobi,
12 August 2012
Last week’s article ended on a rather curious note: that a house bought on mortgage is a loss maker and consequently, the owner deserves refunds from the taxman.
However, as pointed out in the article, that loss making situation does not last for ever. The reason being that the amount of interest paid for the mortgage reduces every subsequent month and also that the rent collected increases gradually with time.
We looked at the case of house bought with a Sh5 million mortgage repayable over a period of 15 years at 18 per cent per annum. The monthly instalment comes to Sh80,521. That amount has an interest and a principal component.
In the first month, the interest is Sh75,000 and the principal is only Sh5,521. At the end of the one year, the monthly instalment still remains Sh80,521 but now the distribution is Sh74,019 and Sh6,502.
It is possible to tabulate this progression on a year-by-year basis and to get the total interest paid each year for the entire duration of the mortgage. The banks call it an amortisation table.
If we assumed that the rent remains fixed at Sh30,000 per month during the 15-year period, then we only need to look for the year when the interest paid goes below Sh360,000. This will be the year when the house begins to make a profit – of course there is the implied assumption that there are no other costs incurred.
It turns out that this will only happen in the 13th year of the mortgage! The interest component of the repayments will be about Sh331,000. This is Sh29,000 higher than the rent. But chances are that the surplus will be eaten away by other costs; thus the house will just break-even!
But of course the assumption that the rent remains constant is not reasonable. Generally, rents increase by between 15 and 20 per cent every two years. Thus we can reasonably expect that in the third and fourth year, it will be Sh35,000; this will then rise to about Sh42,000 in the fifth and sixth years; and so on. The corresponding annual amounts will then be Sh420,000, Sh504,000 and so on, respectively.
Extrapolating this trend into the future, it turns out that the house will begin to make a profit in the ninth year of the mortgage. By this time, the rent is likely to have increased to Sh60,000 per month – double the amount collected at the beginning!
In that year, the total rent will be Sh720,000 while the interest paid on the mortgage will be Sh655,000. This leaves about Sh65,000 which is more than enough to take care of other expenses. Thus the house might make a small profit.
However, it is important to note that even though the house is making a profit, the Sh60,000 rent collected will still not be enough to cover the Sh80,521 mortgage instalment. Thus we are now in an interesting position where it making profits but its cash flow is negative!
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