At what point does profit from house start counting?

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

01 August 2021

Teachers know this: if your explanation elicits further questions, then it was understood! For that reason, I am convinced that the explanation I gave here last week on how to work out the payback period of a rental house factoring inflation was understood well: several readers asked further questions.

Francis Wamwangi wants to know ho to calculate the interest earned: “Is it after the pay back period or is it straight up 420,000/5,000,000?”, he asks. This question illustrates the common misconception that the profit from an investment only starts to count after the property has paid back itself.

However; from the moment the property is purchased, it belongs to the investor. In this example of the house, the Leonard converted the Sh5 million from a number written on a piece of paper [a bank statement] into a tangible object made of stones, concrete and steel. But it is still the same Sh5 million!

For that reason, the profit begins to count immediately. Hence, at the end of the first month, the investor will have a total of Sh5,035,000 – the Sh5 million house and the Sh35,000 rent collected – and at the end of the year, he will have Sh5,420,000. Therefore, the annual rate of return on the investment is Sh420,000 divided by Sh5 million = 8.4 per cent.

Another way of thinking about it is to imagine that the money had been placed in a fixed deposit account in a bank earning 8.4 per cent per annum. At the end of one year, the investor gets Sh420,000. The Sh5 million is still in his account…just like the title deed for the house is in his name.

William Chege and Joseph Ngure introduced a new dimension to the calculation: the monetary value of the house does not remain constant. If the investor was to sell the house after the 18-year payback period, he would get a lot more than the Sh5 million that he had paid for it.

If we estimate a modest average rate of 10 per cent per year, then, it turns out that, after 18 years, the value of the house will have climbed to over Sh25 million. After factoring 5 per cent inflation this will be equivalent to over one million pencils. In other words, the “pencil-value” of the house will double! Should the investor keep it or sell it?