INCOME PROPERTY ANALYSIS Simulation Analysis

INCOME PROPERTY ANALYSIS Simulation Analysis

Tenure Choice: Buy or Rent? Is homeownership a good investment? What are the expected (after tax) cash flows? 1) 2) 3) Acquisition Holding Period Reversion What does the alternative (e.g. renting) cost? Tenure Choice: Buy or Rent? Homeownership Acquisition Costs: 1) Down Payment = Purchase Price - Loan Amount 2) Loan Origination Fee 3) Discount Points (tax deductible for purchases)

4) Closing Costs (title search, title insurance, title examination appraisal fee, credit report, lenders inspection fee, document preparation, recording fees, lawyers fees, survey, pest inspection, escrow fees, etc.) Tenure Choice: Buy or Rent? Homeownership Holding Period Costs Tax Deductible Operating Costs: 1) Interest on mortgage debt 2) Property taxes (city, schools, county, community colleges, Parkland Hospital) Non-deductible Operating Costs: 1) Principal repayment 2) Maintenance and repair expenditures 3) Hazard Insurance

Tenure Choice: Buy or Rent? Homeownership Selling Costs 1) Selling Costs: brokers commission, ususally 6% 2) Outstanding Mortage Balance (usually without penalty) 3) Other Closing Costs (attorneys fees, transfer taxes, etc.) 4) Avoid capital gains tax (if there are any gains) provided: a) purchase more expensive house within 2 years; OR b) elect one time capital gains exclusion of up to $125,000 for sellers 55 years of age or older Tenure Choice: Buy or Rent? P re s e n t V a lu e o f th e A fte r T a x C o s t o f H o m e o w n e rs h ip P V o f O w n in g C o s ts = - A fte r T a x E q u ity

T t1 ( In t. T a x e s ) (1 t ) (P r in . M a in . In s.) t (1 d ) S e llin g P r ic e C o m m . C lo s in g M B (1 d ) T Tenure Choice: Buy or Rent? The (After Tax) Discount Rate (Opportunity Cost) What discount rate should you use to discount expected after tax cash flows associated with homeownership?

Rate on tax free municipal bonds + risk premium for additional risk associated with homeownership. Sources of additional risk: 1) Future selling price uncertainty 2) Liquidity risk -- time on the market Tenure Choice: Buy or Rent? Example Compare the present value of the after tax cost of owning to the after tax cost of renting the following property. The house is a single family detached house located at 10111 Ivy Gate Circle in Lake Highlands, Dallas, TX. The property has 2,220 square feet of living space (4 bedrooms, 2.5 bathrooms) and was built in 1966. The market price of comparable properties is $60/foot and the market rent is $1,300 per month. Eighty percent of the purchase price will be financed with a 7.5% annual interest rate, 30 year, fixed rate mortgage. The loan requires a 1% fee and one discount point.

Tenure Choice: Buy or Rent? Example Additional assumptions: 1) the property will be owner-occupied for 5 years 2) house prices will remain constant over the period 3) the selling commission is 6% 4) market rents will increase 4% per year 5) additional closing costs: a) $1,500 at the time of purchase b) $2,000 at the time of sale 5) other homeownership operating costs: 4%/year a) property taxes are $3,200/year, b) annual maintenance $1,500/year, 4%/year c) annual hazard insurance $750/year, 4%/year

Tenure Choice: Buy or Rent? Example Additional assumptions: The homeowner: 6) is in the 28% tax bracket 7) discounts expected (after tax) cash flows at 7% annually Tenure Choice: Buy or Rent? Example: (after tax) cash flows Acquisition Purchase Price Loan Amount $ 133,200 106,560 Down Payment (Price - Loan)

Loan Fee (1% of loan) After Tax Discount Points (0.72 x 1,066) Closing Costs $ 26,640 1,066 767 1,500 After tax equity $ 29,973 Tenure Choice: Buy or Rent? Example: (after tax) cash flows Holding Period: Deductible Costs Year: 1 2

3 4 5 Interest 7,959 7,882 Property Tax 3,200 3,328 Total Before Tax Cost 11,159 11,210 Subtotal After Tax Cost 8,034 8,071 7,800 3,461 11,261 8,108 7,712

3,600 11,311 8,144 7,616 3,744 11,360 8,179 Tenure Choice: Buy or Rent? Example: (after tax) cash flows Holding Period: Non-deductible and Total After Tax Costs Year: Principal Maintenance Insurance Sub total Total after tax cost: 1

2 3 4 5 982 1,500 750 3,232 1,059 1,560 780 3,399 1,141 1,622

811 3,574 1,229 1,687 844 3,760 1,325 1,755 877 3,957 11,267 11,470 11,683 11,904 12,136 Tenure Choice: Buy or Rent? Example: (after tax) cash flows Reversion Selling Price in 5 Years (= Purchase Price) $ 133,200 less Selling Costs (@ 6%) 7,992

less Closing Costs 2,000 less Outstanding Loan Balance 100,824 (After Tax) Cash Flow from Reversion $ 22,384 Tenure Choice: Buy or Rent? Example: PV of Homeownership Costs PV $29,973 $11,267 $11,470 $11,683 107 . 107

. 2 107 . 3 $11,904 $12,136 $22,384 107 . 4 107 . 5 107 . 5 = - $61,832 (Is this a good investment?) (5th years cash flow = + $10,248)

= - $ 61,832 Tenure Choice: Buy or Rent? E x a m p le : P V o f (A fte r T a x ) R e n tin g C o s ts $ 1 5 ,6 0 0 $ 1 6 ,2 2 4 $ 1 6 ,8 7 3 PV 2 1 .0 7 1 .0 7 1 .0 7 3 $ 1 7 ,5 4 8 $ 1 8 ,2 5 0 1 .0 7 4

1 .0 7 5 = - $ 6 8 ,9 2 3 W h ic h a lte r n a tiv e is c h e a p e r ? O w n in g is $ 7 ,0 9 1 ( = - $ 6 1 ,6 3 2 - [ - $ 6 8 ,9 2 3 ] ) le s s e x p e n s iv e . Tenure Choice: Buy or Rent? Insert Tenure Choice Spreadsheet

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