How about some fun for your money brain? Here’s a modified version of an actual financial decision faced by an individual. Let’s assume you are the one faced with the challenge.
You have a commercial real estate with 2 floors, which are rented out already. Your tenant on the 2nd floor, Rajesh Kumar, runs an IT company and his business has been expanding.
Rajesh has approached you with an offer. If you provide another 25 seats on the 3rd floor, then he is happy to pay you Rs 1 lakh per month additional for this extra space.
You are not sure if you should accept this offer. There are municipal permissions involved, an architect has to build the design, construction contractor to be hired, etc. Building real estate is never easy.
Finally, you are wondering, if the cost of this addition is justified by the additional rent.
In any case, you decide to evaluate this.
You find out that the initial total cost of building the 3rd floor as per the tenant’s requirements will be about Rs. 35 lakhs. In the 4th year, you will need to spend another 5 lakhs for one time major maintenance and repairs. This should repeat after every 3 years.
As discussed with Rajesh, the tenant, the initial rent will be Rs. 1 lakh per month (gross). There will be an increment of 5% every year in the rent.
Maintenance costs and local taxes will total to about Rs. 2 lakhs per year. You expect this to grow at 5% every year.
Finally, you are in the 30% income tax bracket.
The big question is whether you should you go ahead with building the floor? Does it make for a sound financial decision? What is the expected return? How soon can you have the payback from this investment?
I await your responses in the comments section. Please feel free to add detailed notes. Have a great weekend!
If you have taken the Investing 101 series or read this blog regularly, you should be able to work out this decision easily. 🙂
Money Master is an educational series to help you develop capacity to make various financial decisions and become a smart investor. See more from the series here.
This’ll depend till how long you get the rental income, if the agreement is for 10 years, then he should invest. He’ll break even in 7th year, and assuming he gets rents as per expected increase for 10 years, the XIRR will be about 15%.
Even if he runs it for 8 years, the XIRR will be 11%, which is a good return.
Thanks for sharing. Is it possible to see your calculations?
Thanks Rishi. Quick comment. The income tax is paid on (Rent – Expenses) and not the gross rent. Also, taxes are paid end of year.
That should reduce the payback period.