Impact of Exchange Rates and Interest Rates Variations on Mortgages

Cash Purchase versus Credit Purchase.

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With 100,000 KD in hand, one wonders which alternative is the most profitable when deciding in favor of a real estate investment.

The immediate choices, available for the buyer/investor are:

Choice No.1: Cash Purchase of the property without the benefit of rental income.

Choice No. 2: Credit Purchase of the property without the benefit of rental income.

Choice No. 3: Cash Purchase of the property with the benefit of generating rental income.

Choice No. 4: Credit Purchase of the property with the benefit of generating rental income.

Now, let’s see each choice in detail.

Choice No.1: Cash Purchase of the property without the benefit of rental income.

The buyer/investor purchases a property valued at 100,000 KD with cash in hand.

The property is not offered for rent, thus it will not generate rental income.

The benefit for this type of purchase lies exclusively on Capital Growth. The property will increase in value with the passing of time and this increment will represent the only profit from this investment.

Assuming an inflation rate of 5% PA, in 15 years time the property would have increased by 107,893 KD to a total of 207,893 or a total increment of 107.8%. Compounded ROI will stand then at 5% PA.

Choice No. 2: Credit Purchase of the property without the benefit of rental income.

The buyer/investor is having this 100,000 KD in a savings account, generating interests at 2.5% PA, and decides to buy the property thru a mortgage for 15 years at 5% PA.

With mortgage interest standing at 5% PA and savings A/C at only 2.5% there will definitely be a negative cash flow to cover the difference between interest earned and owed.

In 15 years time, the mortgage will generate an interest liability of 29,640 KD but only 9,923 KD will be earned in the savings A/C producing a negative cash position of 19,716 KD.

Buyer/investor will still benefit here from Capital Growth which will stand at 107,893 KD in total gain, but Net Investment will not be just 100,000 KD but 119,716 KD thus additional cash will be needed to cover the negative cash position.

This additional cash contribution/investment will decrease total ROI by setting it at just 3.75% PA (compounded rate).

The Point of Equilibrium, where Interest Earned in Savings A/C will be equal to Mortgage interest will lie in the coordinate where Interest in Savings A/C = 5.7236%

In other words, any investment vehicle which returns 14.472% more than mortgage interest, will be at point of equilibrium.

If investor prefers a credit purchase and needs assurances that his/her actual mortgage interest will be fully covered by whatever investment vehicle is available, one must make sure that this investment vehicle returns at least 14.472% more than actual mortgage interests.

Choice No. 3: Cash Purchase of the property with the benefit of generating rental income.

Although the buyer/investor makes a cash purchase, it decides to grant a management company the right to rent the property to third parties, in exchange for a secured rental income.

In a 15 years period, the property would have generated a NET rental income – after payment of all expenses and interests- of 78,542 KD, or a total return of 78.5% which represents 5.23% PA.

If capital growth is included, total ROI after 15 years will stand at :

107,893 KD (Capital Growth) + 78,542 (Net Rental Income) = 186,435

which represents an annual compounded ROI of 7.26%.

Choice No. 4: Credit Purchase of the property with the benefit of generating rental income.

The buyer/investor makes the clever decision to take advantage of the leverage that real estate investment can offer, by buying a property which doubles in value his/her down payment. In other words, these 100,000 KD is used as a down payment to purchase a property with a total value of 200,000 KD.

After 15 years, the property would have generated a NET rental income of 103,220 KD which is a total rental return on investment of 103.2% or 6.88% PA.

If Capital Growth is included, total ROI after 15 years will stand at:

215,786 KD (Capital Growth) + 103,220 KD (Net Rental Income) = 319,006 KD.

Meaning that Return on Investment (100,000 KD) will stand at 11.6% PA.

Summary:

As a Percentage of Investment:

Compounded ROI in Choice No. 1.:-5% PA

Compounded ROI in Choice No. 2.:-3.75% PA

Compounded ROI in Choice No. 3.:-7.26% PA

Compounded ROI in Choice No. 4.:-11.6% PA