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.

EXHIBIT 7-2 Rent versus Own Analysis of a Personal Residence $150,000 $12,000 2.00% 2.00% $500.00 $500.00 2.00% 28.00% 1.50% 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% 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 o 1 4 5 $ 9,580 118,781 8,361 1,219 2 $ 9,580 117,474 8,273 1,307 3 $ 9,580 116,072 8,179 1,402 $ 9,580 114,569 8,077 1,503 $ 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 Year 4 Year 5 $ 2,388 530 530 9,580 $ 13,028 $ 2,435 540 540 9,580 $ 13,095 8,179 $ 2,388 8,077 10,465 $ 2,930 $ 2,435 7,969 10,404 $ 2,913 $ 12,734 $ 12,989 EXHIBIT 7-3 Cash Flow Analysis-Rent versus Own Analysis of a Personal Residence Year 1 Year 2 Year 3 A. Before-tax cash flows-owner: (1) Property taxes $ 2,250 $ 2,295 $ 2,341 (2) Insurance 500 510 520 (3) Maintenance 500 510 520 (4) Mortgage payments (P&I) 9,580 9,580 9,580 (5) Cash outflows before taxes $ 12,830 $ 12,895 $ 12,961 B. Tax deductions-owner: (1) Property taxes $ 2,250 $ 2,295 $ 2,341 (2) Interest 8,361 8,273 (3) Total deductions 10,611 10,568 10,520 (4) Tax savings @ 28% $ 2,971 $ 2,959 $ 2,945 C. Renter status: (1) Rents $ 12,000 $ 12,240 $ 12,485 D. Net cash flows owning: (1) Before-tax outlays (A.5) $(12,830) $(12,895) $(12,961) (2) Tax savings (1.4) 2,971 2,959 2,945 (3) After-tax cash flows (9,859) (9,936) (10,016) (4) Rent saved (C.1) $ 12,000 $ 12,240 $ 12,485 (5) After-tax cash flows-owning $ 2,141 $ 2,304 $2,469 E. Before-tax cash flow-for sales occurring in years 1-5: (1) Property value $153,000 $156,060 $159,181 (2) Less: Selling expenses 10,710 10,920 11,143 (3) Less: Mortgage payoff 118,781 117,474 116,072 (4) Before-tax cash flow sale $ 23,509 $ 27,666 $ 31,966 F. After-tax cash flow-for sales occurring in years 1-5: (1) Property value $153,000 $156,060 $159,181 (2) Less: Selling expenses 10,710 10,920 11,143 (3) Less: Basis 150,000 150,000 150,000 (4) Gain on sale (7,710) (4,860) (1,962) (5) Less: Exclusion (6) Tax 0 0 0 (7) After-tax cash flow (E.4 - F.6) $ 23,509 $ 27,666 $ 31,966 G. After-tax IRR on equity ($30,000) if sold: (1) ATIRR (0.5 + F.7) -14.50% 3.57% 9.63% $(13,028) 2,930 (10,190) $ 12,734 $ 2,635 $(13,095) 2,913 (10,182) $ 12,989 $ 2,807 $162,365 11,366 114,569 $ 36,430 $165,612 11,593 112,958 $ 41,061 $162,365 11,366 150,000 999 999 0 $ 36,430 $165,612 11,593 150,000 4,019 4,019 0 $ 41,061 12.34% 13.71%