When investing in property, don’t confuse break-even with payback

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

22 September 2019

Some one forwarded this seemingly simple question to me on Twitter: what is the break-even period for rental property in Kenya? My immediate response was: what do you mean by “break-even”?

 Many people confuse break-even with payback. Break-even is point at which the costs of running a business is equal to the revenue (sales) generated. Payback, on the hand is when the accumulated profit from the business is equal to the amount of money invested in starting it.

Both these quantities depend largely on the amount of loan borrowed to finance the property. If you buy a house with your own saved money, then it will break even as soon as you get your first tenant!

The reason is that a new house has virtually no expenses, so, the entire rent will be your profit. But the payback period is a different matter.

My casual observation is that, in the middle-class areas of Nairobi, the market value of a house is about 200 times its monthly rent. Thus, if you buy a house for, say, Sh10 million, you will probably collect rent if about Sh50,000 per month.

In other words, if you buy this house with your saved money, it will take you 200 months to earn back your investment of Sh10 million. That is, about 16 or 17 years.

But if you build the house instead of buying, there is a good chance that it will cost you Sh5 million or less. In that case, the payback period comes down to about 8 years.

If you are using borrowed money, the situation changes dramatically. Suppose you get 80 per cent finance (Sh8 million) at, say 14 per cent interest for 15 years, your installment will be Sh106,500 per month. But the house can only raise Sh50,000 so you have to look for Sh56,000 from other sources.

Now, one part of the Sh106,500 is interest and the other is principal payment. The principal is not a cost but an investment thus it cannot be subtracted as an expense. The interest is a finance cost.

As time passes, the interest amount in the loan instalment decreases as the principal payment increases. In the first month, the interest is Sh93,000. It crosses the Sh50,000 mark in the tenth year. This is the break-even period.

Thus, your house be making losses during the first ten years. Of course, I have assumed that you will not have increased the rent in that period.

According to the Hass Rental Index, rents in Nairobi have been increasing at about 6 per cent per annum over the past decade. When this is factored in the calculation, the break-even period comes down slightly to about seven years.

However, even though the house is making a profit, the escalated rent of about Sh70,000 in the seventh year is still smaller than the loan installment of Sh106,500. Indeed, you will only be able to get enough money to pay the loan in the 14th year!

So, what’s the payback period for such a house bought with borrowed money? That is a question for another day.