Do not confuse profit with profitability

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

07 August 2016

There is a serious misconception about profit. A number of readers have written in to challenge the statement I made two weeks ago that, if you buy a house in cash, then the rent you collect is profit – beginning from the first month. Their position is that you will only start making a profit once you have accumulated enough rent to cover the purchase price; that is, the Sh10 million.

According to this line of thought, if we assume a 10 per cent rent increment every two years, you will start making a profit after about nine and a half years. Now let me be very clear: This argument is wrong – dead wrong!

Suppose that, instead of buying a house, you deposited the money in an account paying you, say, 10 per cent per annum interest. Each month, you would get about Sh83,000. Would you call this your profit? Of course you would!

After ten years, the accumulated interest would be Sh10 million. But your initial Sh10m-deposit would still be in the bank account. It is the same with the house. The act of buying it is simply converting the nature your money from a meaningless number on a piece of paper held at the bank (otherwise known as a bank statement) into a physical object. It is still the same Sh10m.

Before the purchase, you own an asset known as “cash balance in the bank”, valued at Sh10m. Upon conclusion of the deal, you have another asset known as “house” valued at Sh10m. Nothing has changed: you still own Sh10m.

Since the Sh10 million (whether as a bank balance or as a house) is not incurring any expenses, then, any income it generates (whether interest or rent) is your profit. The question of recovering the money invested falls under the realm of profitability; not profit.

Profitability is a measure of the efficiency with which your investment is generating profit. There are many ways of assessing profitability; one of them is finding out how long it takes to buy itself. Accountants call this the pay-back period.

The Sh10m-house in our illustration takes about nine and a half years to pay back. Keeping the money in the bank at 10 per cent per annum takes 10 years. The house pays back faster and so, it has a higher profitability.

But of course, the house appreciates in value. Using data from the Kenya Bankers Association Property Price Index, I estimate that it will be worth about Sh13m in nine years. So the question arises: where does that gain in value go? The answer is: nowhere!

Unless you sell the house, you will not see that value appreciation. Accountants call it unrealized gain. So, as far as you are concerned, the house is still worth Sh10m because that is what you paid for it. If you do sell the house at the prevailing market price of Sh13m, then a different tax kicks in – the capital gains tax. But that’s a story for another day.