Renting versus Owning The goal of this exercise is to compile all cash flows associated with each form of occupancy, and then calculate the rate of return that will be earned on the funds used to make an equity investment (down payment) if the property is purchased. Alternatively, it is this rate of return that an investor would have to earn on the down payment saved if renting is chosen, to make renting the financial equivalent of owning. The framework for making a comparison between renting and owning is presented in the example summarized in Exhibit 72. In this example, we have a property that could be rented for $12,000 per year ($1,000 per month) or purchased for $150,000 with $30,000 down and financed with a fully amortizing mortgage loan of $120,000 at 7 percent interest for 30 years. Other costs associated with owning include maintenance, insurance, and property taxes. In our example, these expenses would not have to be paid if renting is chosen. All other expenses would have to be paid regardless of whether the property is owned or rented, such as utilities, and so on. Because they offset, they do not have to be included in our analysis. Other assumptions include (1) a federal income tax rate of 28 percent, (2) escalation in expenses, rents, and property value at 2 percent per year, and (3) a five-year period of analysis, at the end of which, the property would be sold (if owned). Selling expenses of 7 percent would have to be paid at that time. Cash flows associated with our analysis are summarized annually for convenience and presented in Exhibit 73. Case Study: Now, you are required to analyze new case of Renting versus Owning. All other informations are same as in Exhibit 7-2 besides property price, initial rent, LTV(loan to value) ratio and interest rate. Suppose the purchase price of property is $250,000, the initial rent is $24,000(yr), LTV(Loan to Value) ratio is 65% and interest rate is 4%. 1) Discuss whether you support the purchasing a property or renting a property based on your computation as in Exhibit 7-3. 2) Attach a spreadsheet that can support your conclusion.

excel EXHIBIT 7-2 Rent versus Own Analysis of a Personal Residence www.mhhe.com/bf14e $150,000 $12.000 2.00% 2.00% $500.00 $500.00 2.00% 28.00% 1.50% 1. Property Information Purchase price Initial rent Rental growth rate Property growth rate Insurance Maintenance Expense growth Marginal tax rate Property tax as % of value 2. Annual Loan Schedule End of year Mo. Payments. 12 Balance Interest (year) Amortization (year) 3. Property Data Property value Rents Loan Information Loan-to-value ratio Loan amount Interest rate Loan term Payments Annual debt service (payment) Annual loan constant Equity investment/down payment Selling expenses 80.00% $120,000 7.00% 30 years 12 per year $9,580 7.98% $30,000 7.00% 0 1 2 4 $ 9,580 $ 9,580 118,781 8,361 1,219 $ 9,580 117,474 8,273 1,307 116,072 8,179 1,402 $ 9,580 114,569 8,077 1,503 5 $ 9,580 112,958 7,969 1,612 $150,000 $153,000 12,000 $156,060 12,240 $159,181 12,485 $166,365 12,734 $165,612 12,989 our analysis. Cash rented for $12,000 per year ($1,000 per month) or purchased for $150,000 with $30,000 down and financed with a fully amortizing mortgage loan of $120,000 at 7 percent interest for 30 years. Other costs associated with owning include maintenance, insurance, and property taxes. In our example, these expenses would not have to be paid if renting chosen. All other expenses would have to be paid regardless of whether the property is owned or rented, such as utilities, and so on. Because they offset, they do not have to be included in Other assumptions include (1) a federal income tax rate of 28 percent, (2) escalation in expenses, rents, and property value at 2 percent per year, and (3) a five-year period of analysis, at the end of which, the property would be sold (if owned). Selling expenses of 7 percent would have to be paid at that time. flows associated our analysis are summarized annually for convenience and presented in Exhibit 7-3. Note that for the ownership alternative, cash flows must be developed both before and after taxes because, as indicated owners of residential property are provided with federal income tax treatment (see summary of tax provisions in Exhibit 7-4). This treatment is not available to renters; therefore, cash outflows for renters are the same on a before and after-tax basis (see part C). Looking to Exhibit 73, note that in panel A, we have summarized before-tax cash outflows associated with owning. These total $12,8300 O during year 1. Included in these cash outflows are constant monthly mortgage payments of $798.33 - (12), or $9,580 each year. The tax treatment shown in part B includes allowable deductions for property taxes and mortgage interest. These deductions reduce the owner's federal income tax payments and therefore reduce net outflows associated with homeownership. These deductions reduce taxes at a rate of 28 percent, or by a total of $2,971 in year 1. Interest deductions decline to $7,969 in year 5 because This assumes that the homeowner itemizes for tax purposes. Chapter 7 Single Family Housing: Pricing, Investment, and lax Considerations 187 EXHIBIT 7-3 Cash Flow Analysis-Rent versus Own Analysis of a Personal Residence Year 1 Year 2 Year 3 Year 4 Year 5 $ 2,250 500 500 9,580 $ 12,830 $ 2,295 510 510 9,580 $ 12,899 $ 2,341 520 520 9,580 $ 12.961 $ 2,388 530 530 9,580 $ 13,028 $ 2,435 540 540 9,580 $ 13,095 $ 2,250 8,361 10,611 $ 2,971 $ 2,295 8,273 10,568 $ 2,959 $ 2,341 8,179 10,520 $ 2.945 2,388 8,077 10,465 2,930 $ 2,435 7,969 10,404 $ 2,913 $ 12,000 $ 12,240 $ 12,485 $ 12,734 $ 12,989 A. Before-tax cash flows-owner: (1) Property taxes (2) Insurance (3) Maintenance (4) Mortgage payments (P&l) (5) Cash outflows before taxes B. Tax deductions-owner: (1) Property taxes (2) Interest (3) Total deductions (4) Tax savings @ 28% C. Renter status: (1) Rents D. Net cash flows-owning: (1) Before-tax outlays (A.5) (2) Tax savings (B.4) (3) After-tax cash flows (4) Rent saved (C.1) (5) After-tax cash flows-owning E. Before-tax cash flow-for sales occurring in years 1-5: (1) Property value (2) Less: Selling expenses (3) Less: Mortgage payoff (4) Before-tax cash flow sale F. After-tax cash flow-for sales occurring in years 1-5: (1) Property value (2) Less: Selling expenses (3) Less: Basis (4) Gain on sale (5) Less: Exclusion (6) Tax (7) After-tax cash flow (E.4 - F.6) G. After-tax IRR on equity ($30,000) if sold: (1) ATIRR (D.5 + F.7) $ (12,830) 2,971 (9,859) $ 12,000 $ 2,141 $ (12,895) 2,959 (9,936) $ 12,240 $ 2,304 $(12,961) 2,945 (10,016) $ 12,485 $ 2,469 $(13,028) 2,930 (10,190) $ 12,734 $ 2,635 $(13,095) 2,913 (10,182) $ 12,989 $ 2,807 $153,000 10,710 118,781 $ 23,509 $156,060 10,920 117,474 $ 27,666 $159,181 11,143 116,072 $ 31,966 $162,365 11,366 114,569 $ 36,430 $165,612 11,593 112,958 $ 41,061 $153,000 10,710 150,000 (7,710) $156,060 10,920 150,000 (4,860) $159,181 11,143 150,000 (1,962) $162,365 11,366 150,000 999 999 0 $ 36,430 $165,612 11,593 150,000 4,019 4,019 0 $ 41,061 0 $ 27,666 $ 23,509 0 $ 31,966 -14.50% 3.57% 9.63% 12.34% 13.71% interest on the loan declines over time. The net annual after-tax cash outflows if owning is chosen are summarized in part D and are $12,830 (from part A) less $2,971 in tax savings (from part B), resulting in a net outflow of $9,859. If the property is owned, this also means that rent of $12,000 does not have to be paid. To complete the annual outflow in our analysis, we must consider rent savings if owning is chosen. This amounts to $12,000 the excel EXHIBIT 7-2 Rent versus Own Analysis of a Personal Residence www.mhhe.com/bf14e $150,000 $12.000 2.00% 2.00% $500.00 $500.00 2.00% 28.00% 1.50% 1. Property Information Purchase price Initial rent Rental growth rate Property growth rate Insurance Maintenance Expense growth Marginal tax rate Property tax as % of value 2. Annual Loan Schedule End of year Mo. Payments. 12 Balance Interest (year) Amortization (year) 3. Property Data Property value Rents Loan Information Loan-to-value ratio Loan amount Interest rate Loan term Payments Annual debt service (payment) Annual loan constant Equity investment/down payment Selling expenses 80.00% $120,000 7.00% 30 years 12 per year $9,580 7.98% $30,000 7.00% 0 1 2 4 $ 9,580 $ 9,580 118,781 8,361 1,219 $ 9,580 117,474 8,273 1,307 116,072 8,179 1,402 $ 9,580 114,569 8,077 1,503 5 $ 9,580 112,958 7,969 1,612 $150,000 $153,000 12,000 $156,060 12,240 $159,181 12,485 $166,365 12,734 $165,612 12,989 our analysis. Cash rented for $12,000 per year ($1,000 per month) or purchased for $150,000 with $30,000 down and financed with a fully amortizing mortgage loan of $120,000 at 7 percent interest for 30 years. Other costs associated with owning include maintenance, insurance, and property taxes. In our example, these expenses would not have to be paid if renting chosen. All other expenses would have to be paid regardless of whether the property is owned or rented, such as utilities, and so on. Because they offset, they do not have to be included in Other assumptions include (1) a federal income tax rate of 28 percent, (2) escalation in expenses, rents, and property value at 2 percent per year, and (3) a five-year period of analysis, at the end of which, the property would be sold (if owned). Selling expenses of 7 percent would have to be paid at that time. flows associated our analysis are summarized annually for convenience and presented in Exhibit 7-3. Note that for the ownership alternative, cash flows must be developed both before and after taxes because, as indicated owners of residential property are provided with federal income tax treatment (see summary of tax provisions in Exhibit 7-4). This treatment is not available to renters; therefore, cash outflows for renters are the same on a before and after-tax basis (see part C). Looking to Exhibit 73, note that in panel A, we have summarized before-tax cash outflows associated with owning. These total $12,8300 O during year 1. Included in these cash outflows are constant monthly mortgage payments of $798.33 - (12), or $9,580 each year. The tax treatment shown in part B includes allowable deductions for property taxes and mortgage interest. These deductions reduce the owner's federal income tax payments and therefore reduce net outflows associated with homeownership. These deductions reduce taxes at a rate of 28 percent, or by a total of $2,971 in year 1. Interest deductions decline to $7,969 in year 5 because This assumes that the homeowner itemizes for tax purposes. Chapter 7 Single Family Housing: Pricing, Investment, and lax Considerations 187 EXHIBIT 7-3 Cash Flow Analysis-Rent versus Own Analysis of a Personal Residence Year 1 Year 2 Year 3 Year 4 Year 5 $ 2,250 500 500 9,580 $ 12,830 $ 2,295 510 510 9,580 $ 12,899 $ 2,341 520 520 9,580 $ 12.961 $ 2,388 530 530 9,580 $ 13,028 $ 2,435 540 540 9,580 $ 13,095 $ 2,250 8,361 10,611 $ 2,971 $ 2,295 8,273 10,568 $ 2,959 $ 2,341 8,179 10,520 $ 2.945 2,388 8,077 10,465 2,930 $ 2,435 7,969 10,404 $ 2,913 $ 12,000 $ 12,240 $ 12,485 $ 12,734 $ 12,989 A. Before-tax cash flows-owner: (1) Property taxes (2) Insurance (3) Maintenance (4) Mortgage payments (P&l) (5) Cash outflows before taxes B. Tax deductions-owner: (1) Property taxes (2) Interest (3) Total deductions (4) Tax savings @ 28% C. Renter status: (1) Rents D. Net cash flows-owning: (1) Before-tax outlays (A.5) (2) Tax savings (B.4) (3) After-tax cash flows (4) Rent saved (C.1) (5) After-tax cash flows-owning E. Before-tax cash flow-for sales occurring in years 1-5: (1) Property value (2) Less: Selling expenses (3) Less: Mortgage payoff (4) Before-tax cash flow sale F. After-tax cash flow-for sales occurring in years 1-5: (1) Property value (2) Less: Selling expenses (3) Less: Basis (4) Gain on sale (5) Less: Exclusion (6) Tax (7) After-tax cash flow (E.4 - F.6) G. After-tax IRR on equity ($30,000) if sold: (1) ATIRR (D.5 + F.7) $ (12,830) 2,971 (9,859) $ 12,000 $ 2,141 $ (12,895) 2,959 (9,936) $ 12,240 $ 2,304 $(12,961) 2,945 (10,016) $ 12,485 $ 2,469 $(13,028) 2,930 (10,190) $ 12,734 $ 2,635 $(13,095) 2,913 (10,182) $ 12,989 $ 2,807 $153,000 10,710 118,781 $ 23,509 $156,060 10,920 117,474 $ 27,666 $159,181 11,143 116,072 $ 31,966 $162,365 11,366 114,569 $ 36,430 $165,612 11,593 112,958 $ 41,061 $153,000 10,710 150,000 (7,710) $156,060 10,920 150,000 (4,860) $159,181 11,143 150,000 (1,962) $162,365 11,366 150,000 999 999 0 $ 36,430 $165,612 11,593 150,000 4,019 4,019 0 $ 41,061 0 $ 27,666 $ 23,509 0 $ 31,966 -14.50% 3.57% 9.63% 12.34% 13.71% interest on the loan declines over time. The net annual after-tax cash outflows if owning is chosen are summarized in part D and are $12,830 (from part A) less $2,971 in tax savings (from part B), resulting in a net outflow of $9,859. If the property is owned, this also means that rent of $12,000 does not have to be paid. To complete the annual outflow in our analysis, we must consider rent savings if owning is chosen. This amounts to $12,000 the