Working out the returns from a housing project

Mike Maingi writes in to say that his investment club (chama) is considering putting some money in a housing project. But the deal sounds too good to him and so he would like me to see if they are missing something.

The project involves leasing a piece of land for 10 years at a monthly rent of Sh10,000 per month. The club will then build temporary houses using timber and iron sheets for the walls and roofs.

A block with 10 units will cost them about Sh1 million to construct and the market rent in their target area is between Sh2,500 and Sh3,000 per unit.

A quick calculation reveals that they can expect to get an average of Sh27,500 per month in rent. But it is not right to assume that they will get full occupancy all the time. There is also some letting agency commission to be considered. Let us take away Sh2,500 for these two costs.

That leaves Sh25,000, and from this figure, they will pay Sh10,000 to the land owner. So the club’s net income will be about Sh15,000 per month.

At first sight, that amount might seem too little for a one-million shilling project, but we must not forget that once completed, it requires very little additional effort to run.

Sh15,000 per month works out to Sh180,000 in one year. In other words, the rate of return is about 18 per cent... or is it? There are two things we have forgotten.

First, it is not fair to assume that the rent will remain constant through out the 10 year period of the lease. Let us factor in a moderate escalation of 10 per cent every two years.

Thus, in year 1 and 2, the total gross rent will be Sh660,000 (that is, before deducting any expenses); in year 3 and 4 it will be Sh726,000; then Sh800,000 in years 5 and 6; and Sh880,000 in year 7 and 8. Finally, the club will collect Sh965,000 in the last two years of their land lease.

The total gross rent collection over the 10 year period adds up to Sh4,031,000. But, about 10 per cent of this amount will go to the letting agent and also to unoccupied units. That leaves Sh3,627,900.

The biggest cost is the land rent, which is Sh10,000 per month, or Sh1.2 million in 10 years. Deducting this leaves the club with Sh2,427,900.

There is one more major cost that is often forgotten: depreciation. Remember the Sh1,000,000 that went into construction?

It is unlikely that the materials used (timber and iron sheets) will have any meaningful value at the end of 10 years. Therefore, we should treat them as fully consumed.

This means that, at the end of 10 years, the club will have just the Sh2,427,900 and nothing else. So, is it a good investment?

When compounded, it works out to about 9.25 per cent per year; now decide.