Calculating the opportunity cost of a property investment

Calculating the opportunity cost of a property investmentAmit Mitbawkar

I was sitting with a client recently, a sales director of a multinational company, to help him set his financial goals. Like many others before him, he asked: ''Should I buy property in Dubai today?'' He was paying a large sum for rent and was wondering if it is better to invest the amount in property.

There are a number of factors to consider before making what could be the single-largest purchasing decision in your life.

- Buying for investment vs. buying for occupancy

When buying property to live in, the timing of the purchase may not matter, since there is no real reason to sell it at a profit or a loss. Most people who intend to stay in the UAE for a long period of time buy property through mortgage and it makes sense to do so. However, when buying property as an investment, a mortgage may not be the right choice depending on the borrowing costs and rental returns as a percentage of the property value.

There are two ways property can earn money: rent and capital appreciation.

When buying property as an investment, timing is important. Dubai saw a major drop in rents around 2000. Rental rates then peaked in 2007, but dropped by half in 2008. Seven years since the downturn, the question now is, will history repeat itself?

The general opinion in the market is that now is a good time to sell property that was bought as investment. End users are still continuing to buy and rightly so.

- Can you afford it?

Affordability of the mortgage premium is not the only consideration. You have to look at other issues as well. Most properties in the UAE have maintenance charges that are to be paid over and above the mortgage premium. This actually comes as a surprise to most property buyers. There are also the brokerage and the transfer fees, which can be quite expensive.

In certain instances, you need to pay insurance charges and before you know it a large chunk of your savings is gone. Many expats I meet tend to use their six-month emergency fund to make a down payment and this puts their family at risk.

What if there is an emergency just after the property is bought? Can you afford to buy property in this scenario? Perhaps not. Consider buying property without using your emergency fund.

- Opportunity cost

When investing in property, the opportunity cost needs to be considered. The opportunity cost is simply the returns generated from an investment that you could have made.

For example, let us examine the costs and returns when you rent out for 15 years and then sell a Dh1.5-million one-bedroom apartment in Dubai Marina.

The buying costs are 20 per cent down payment (Dh300,000), 2 per cent brokerage cost (Dh30,000) and 4 per cent transfer fee (Dh60,000). The total initial cost would be Dh390,000. For a finance amount of Dh1.2 million at an interest rate of 4 per cent for 15 years, the mortgage cost (using HSBC's Dubai mortgage calculator) would total around Dh1.59 million
(for a monthly premium of Dh8,876 for 15 years).

The maintenance charges would be around Dh375,000 (Dh25,000 per year for 15 years). The total cost of ownership would be around Dh2.36 million.

The rental income would be Dh1.35 million (Dh90,000 per year over 15 years), while the sale value after 15 years would be around Dh3.23 million, assuming 5 per cent appreciation per year. The net profit after 15 years would, therefore, be Dh2.22 million.

Now imagine investing the same amount as a lump sum and left it there for 15 years. Let's also assume that you invested the monthly mortgage and maintenance charges for the property, i.e. Dh10,960, in a regular savings plan with a diversified portfolio over 15 years.

In that time frame your Dh390,000 initial investment would have grown to Dh608,400 at an assumed growth rate of 5 per cent per year. On the other hand, your regular savings plan of Dh10,690 per month would have grown to around Dh2.97 million over 15 years at an assumed growth rate of 5 per cent per year. The net profit after 15 years would be around Dh3.58 million.

The opportunity cost for buying property would then be around Dh1.36 million — the difference between the net profit from the lump sum investment and regular savings plan (Dh3.58 million) and the net profit from the property investment (Dh2.22 million).

In summary, property should be an integral part of a balanced investment portfolio, but the decision to buy property is not one to be taken lightly. You should take expert financial advice to ensure the decision is right.

A decision taken in haste could cost you dearly.

Find out how to build up a property portfolio from scratch

Source: Amit Mitbawkar, Special to Property Weekly

The writer is a senior financial planner with Acuma Independent Financial Advice. Based in the UAE since 1997, Mitbawkar specialises in education and retirement planning, with a focus on safe investments that maximise returns on a quarterly basis. He earned an MBA at the University of Wollongong. Mitbawkar is the author of Creating, Preserving and Distributing Wealth


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