FIN 142: Real Estate Finance
Professor Nuriddin Ikromov
Rent vs. Own Assignment
Introduction
This assignment is designed to help you compare the buy vs. rent decision. You will first examine the
financial and non-financial costs of homeownership as well as renting. You will then analyze a
hypothetical family’s decision to continue renting or buying a similar. After calculating the rate of
eturn from investing in a house, you will offer a specific, detailed recommendation to the family
under. You will also re-do the calculation and offer an updated recommendation with the benefit of
hindsight (knowing what actually happened to house prices). Finally, you will compare two popular
house price indices and identify the advantages and disadvantages of each.
Part 1: Costs and Benefits of Homeownership vs. Renting
In this part of the assignment, you will explain the benefits and costs of homeownership, as well as
enting. These could include both financial costs and benefits (such as the favorable tax treatment of
homeownership) or non-financial cost and benefits (such as renters not wo
ying about maintenance
and repairs). You are free to explain costs and benefits in paragraph form, or list them in a table.
a. What are the benefits (both financial and non-financial) of homeownership?
. What are the benefits (both financial and non-financial) of renting?
c. What are the costs (both financial and non-financial) of homeownership and renting?
d. What are the costs (both financial and non-financial) of renting?
Part 2: Hypothetical Own vs. Rent Scenario
The Rental
It was December 2014. For the past 15 months, Michael and Celia Wazowski have been renting a
three-bedroom house in the Tahoe Park neighborhood of Sacramento, CA. Their rent for the
duration of their lease had been $1,300 per month, not including utilities. At the beginning of the
month, Mike and Celia received a letter from their landlord stating that their monthly rent would be
going up to $1,500 per month, starting on January 1, 2015. The landlord’s justified the rent hike by
claiming that he had not raised rent on any of her rental properties in the past 3 years, even though
ents in Sacramento had been going up by an average of 10 percent annually over the last few years.
The landlord’s letter further stipulated that if Mike and Celia renewed their lease, she would agree
not to raise their rent by a large amount. Rather, rent would only go up by the rate of inflation,
egardless of how long they continue renting the unit.
Mike and Celia were not happy about this sudden rent hike, since it was a huge 30% jump from
what they had been paying. But after doing a bit of research, they understood where the landlord
was coming from. Both house prices and rents had indeed been going up in the neighborhood and in
the
oader Sacramento region. The Wazowskis liked their house and their neighborhood. Their
house was within walking distance to both the UC Davis Medical center, where Mike was a resident,
and a local elementary school, where Celia taught. They also liked the amenities the neighborhood
offered. Both Mike and Celia strongly prefe
ed to stay in the neighborhood.
The Listing
A few days after the Wazowskis received the letter from their landlord (and while they were still
making up their minds about renewing the lease), a house across the street was listed for sale. On
the weekend it was put on the market, the listing agent had an “open house”, and the Wazowskis
were able to take an extended tour. The house listed for sale was very similar to their cu
ent rental
house: it was built in the same year, had the same layout and the same number of bedrooms and
athrooms, and was equally well-maintained. The new owners likely would not have to do any major
enovation work immediately before or after moving in. As Mike and Celia prefe
ed to stay in the
neighborhood, they realized that buying the house across the street was another viable option, in
addition to renewing their lease on their cu
ent rental.
The day after the Wazowskis visited the open house, Celia called her friend Angela, who was a
licensed agent with a local real estate
okerage. Angela knew the local real estate market well and
had good knowledge of various expenses that came with buying and owning a home. At the end of
the conversation, Celia decided to formally hire Angela as her buying agent. In this role, Angela
would help the Wazowskis to negotiate the purchase price, as well as process all the necessary
paperwork, which would be extensive. The best news was that the Wazowskis would not need to pay
Angela for her services directly – her commission would come from the seller.
After hiring Angela, the Wazowskis toured a number of other properties listed for sale in Tahoe
Park and su
ounding neighborhoods. However, there weren’t a large number of homes listed for
sale at the time, and ultimately the Wazowskis decided to make an offer on the house across the
street from their cu
ent home.
The Price
The house was listed for $410,000, but Angela felt sure that the seller would ultimately agree to sell
it for $400,000. Buying a house would be a huge decision for the Wazowskis – until now their largest
purchase had been Celia’s car, which they had bought used for $12,000. Compared to the high
purchase price, even the increased rent of $1,500 per month sounded reasonable. Was it really worth
uying the house?
Mortgage and Closing Costs
The Wazowskis did not have enough money saved up to buy the house with cash, so they would need
a mortgage. Angela recommended that they make a down payment of at least 20% of the purchase
price. This would ensure that Mike and Celia would receive the lowest interest rate possible and
avoid paying mortgage interest premiums. The lenders required mortgage insurance on loan where
the down payment was less than 20%. The Wazowskis did have enough liquid assets for a 20% down
payment, which would be $80,000. They had $100,000 in treasury bonds and about $5,000 in a
checking account. The treasury bonds were yielding 4% per year on a pre-tax basis. The checking
account did not pay any interest. Therefore, in order to come with the $80,000 down payment, the
Wazowskis would need to liquidate the majority of their holdings of treasury bonds.
Angela recommended that the Wazowskis finance the purchase with a 30-year fixed rate mortgage.
After checking with several local lenders and researching online lenders, Mike and Celia decided to
work with a local mortgage lender. The lender offered to make a $320,000 loan for 30 years at 4.0%
annual interest, with monthly payments. The great thing about this loan was that it did not require
any loan origination fees or “points”. Mike and Celia’s combined annual income was about $160,000,
so they could easily afford the monthly mortgage payments.
The interest portion of the mortgage payments would be deductible for federal income tax purposes.
The mortgage did not have any prepayment penalties, so the Wazowskis could pay off the loan at
any time with no penalty.
Even though the lender did not charge any origination fees or points on the loan, there were still
some fees that the Wazowskis had to pay to purchase the house. Collectively refe
ed to as “closing
costs”, these included things like legal fees, home inspection, title search, transfer taxes, and others.
Overall, the closing costs would add up to $5,000.
Property Taxes
The Wazowskis would have to pay property taxes based on the value of the property. In California,
property taxes were collected by counties and were limited to 1% of the property. Additional, smaller
amounts were paid to local school and community college districts. Altogether, the Wazowskis’
property tax would be about 1.2% of the purchase price in the first year. California law also limited
property tax increases to 2% per year. Therefore, the Wazowskis’ property tax would go up at most
y 2% year-to-year, regardless of the changes in the value of the house.
Like mortgage interest, property taxes were deductible for income tax purposes. Over the past 2
years, the Wazowskis paid approximately 20% of their income in federal income taxes, although
their federal income tax
acket was 28%. They expected to stay in the 28% tax
acket for the
foreseeable future.
Maintenance
One thing that concerned both Mike and Celia about owning a home was maintenance expenses. As
enters, they did not have to wo
y about things like mowing the lawn, the dishwasher
eaking, or
the roof leaking. All maintenance and repairs were the responsibilities of the landlord. Although
they passed maintenance costs on to the tenants in the form of higher rent, the landlords likely took
advantage of economies of scale. Therefore, the maintenance costs for the same would likely be
somewhat higher for an individual homeowner than for a landlord who owns multiple units. Angela
told Mike and Celia that annual maintenance expenses tended to average about 1% of the property
value. Therefore, the Wazowskis expected to spend $4,000 per year on repairs and maintenance per
year. These expenses would likely increase at the rate of inflation in the future.
Homeowner’s Insurance
After checking with an insurance
oker she worked with, Angela said that homeowner’s insurance
would cost the Wazowskis $800 in the first year. Insurance premiums would also increase by the
ate of inflation in the future year.
Expected Tenure
In 5 years, Mike would complete his residency at the UC Davis Medical Center. At that point, the
Wazowskis would return to Colorado, where they were both from. So if they bought the house, they
would most likely sell it in 5 years, in December 2019. Assuming they would be able close and move
in in January 2015, their expected tenure in the house would be 5 years.
Sale Price and Selling Expenses
One important consideration for the Wazowskis’ decision to buy or keep renting would be the
eventual selling price of the house. House prices had risen in Sacramento (and the rest of California)