Rent/Buy

RM/FIN 460: Real Estate Financial Analysis with Jiro Yoshida

Overview

  • This study guide provides detailed notes on the key concepts covered in the Real Estate Financial Analysis course led by Jiro Yoshida.

  • The course focuses on both financial and non-financial aspects of real estate decisions, particularly the analysis of whether to buy or rent a property.

Key Themes

1. Non-Financial vs. Financial Factors

  • Non-Financial Factors:

    • Pride

    • Status

    • Stability

    • Preferences

  • Financial Factors:

    • Central focus of the course is on financial analysis to compute the gap between the cost of owning and the cost of renting.

    • The comparison allows individuals to consider if non-financial factors justify the cost difference.

2. Renting vs. Buying

  • No single answer:

    • Decision to buy or rent is not straightforward; various monetary and non-monetary costs need to be accounted for.

  • Monetary Costs of Buying:

    • Interest on the mortgage.

    • Property taxes.

    • Upkeep costs or maintenance expenses.

  • Non-Monetary Items to Consider:

    • Personal taste for home and location.

    • Need for stability versus flexibility in living arrangement.

  • Missing Factors to Consider:

    • Price depreciation/appreciation trends.

    • Impact of expected rent inflation on price appreciation.

    • Opportunity cost associated with the down payment spent on buying a house.

Common Arguments for Buying vs. Renting

Argument 1: Cost Comparison

  • Buy if: Monthly mortgage payments significantly less than monthly rental payments. Example:

    • Monthly rent = $7,250

    • Monthly mortgage payment is to be explored based on interest rates.

Argument 2: Asset Accumulation

  • Renters: Do not accumulate any tangible asset after years of paying rent.

  • Buyers: Build home equity over time as mortgage payments are made, which creates a financial asset.

Argument 3: Government Subsidies

  • Homeowners can benefit from implicit mortgage subsidies, which are not available to renters.

User Cost Analysis

3. User Cost

  • User Cost Definition: The annual cost associated with owning a property.

    • Includes various components that will be elaborated below.

User Cost Equation

  • The formula for calculating user cost includes multifactorial components such as capital cost, property taxes, and maintenance costs. It can be expressed generally as:
    User Cost=Capital Cost+Property Tax+Maintenance Cost+Net Depreciation\text{User Cost} = \text{Capital Cost} + \text{Property Tax} + \text{Maintenance Cost} + \text{Net Depreciation}

Components of User Cost

  • Capital Cost: Includes:

    • Loan interest.

    • Opportunity cost of down payment. Considerations for:

    • Inclusion of principal payments and their effect

    • Whether to use after-tax interest rates.

  • Property Tax:

    • Includes real estate taxes paid to different local entities (county, city, school district).

    • Considerations on using after-tax property tax for calculations.

  • Maintenance Cost:

    • Defined broadly to include regular upkeep, property insurance, property management expenses, and repair costs.

  • Net Depreciation: Shown as:
    Net Depreciation=Price Depreciation due to aging−Market-wide Price Appreciation\text{Net Depreciation} = \text{Price Depreciation due to aging} - \text{Market-wide Price Appreciation}

Example Calculation

  • Given numbers for a quiz scenario:

    • Capital Cost (After-Tax) = $15,000/year

    • Property Tax (After-Tax) = $3,000/year

    • Maintenance Cost = $3,000/year

    • Net Depreciation = -$12,000/year (which indicates appreciation)

User Cost Calculation:

  • To find the user cost of housing, sum the components based on the provided values.

User Cost Equation Detailed

  • A more detailed user cost equation is presented:
    User Cost=Home Price×[1−(LTV+Mortgage Interest Rate+Opportunity Cost of Home Equity+Property Tax Rate+Maintenance Cost Rate+Depreciation Rate+Market-wide Appreciation Rate)]\text{User Cost} = \text{Home Price} \times \left[ 1 - ( \text{LTV} + \text{Mortgage Interest Rate} + \text{Opportunity Cost of Home Equity} + \text{Property Tax Rate} + \text{Maintenance Cost Rate} + \text{Depreciation Rate} + \text{Market-wide Appreciation Rate}) \right]

Parameters in User Cost Calculation

  • E.g.,

    • Home Price = $200,000

    • Loan-To-Value Ratio (LTV) = 0.8

    • Mortgage Interest Rate = 0.04

    • Opportunity Cost of Home Equity = 0.15

    • Property Tax Rate = 0.01

    • Rate of Maintenance Costs = 0.01

    • Depreciation Rate = 0.02

    • Expected Market-wide appreciation rate = 0.03

Decision Criteria

Individual Decision Rule

  • Rent if: Annual Rental Cost < Annual User Cost;

  • Buy otherwise.

  • Incorporates expected future rent inflation and benefits of accumulating home equity into price appreciation.

  • Evaluates the viability of options considering personal financial circumstances like down payment and credit score.

Property Tax as a Share of Home Prices

  • Graphical representation of property tax collection trends and its relationship with market prices for homeownership.

Maintenance Cost and Depreciation Metrics

  • Regular recording of property management quality and further relationships to net operating income (NOI).

Capitalization Rate (Cap Rate)

Definition and Significance

  • Cap Rate: Definition: Cap Rate=PriceNOI\text{Cap Rate} = \frac{\text{Price}}{\text{NOI}}

    • E.g., if Price = $100M and NOI = $10M, then Cap Rate = 10%.

    • Used in direct capitalization valuation for property analysis:
      Capitalization Rate=PGI (Rent*SF)−Vacancy+Other Income−Operating ExpensesPrice\text{Capitalization Rate} = \frac{\text{PGI (Rent*SF)} - \text{Vacancy} + \text{Other Income} - \text{Operating Expenses}}{\text{Price}}

Cap Rate Relation to User Cost

  • The user cost equation can be re-arranged to show the relationship with the cap rate, emphasizing rent-price ratios and various contributing financial factors.

Conclusion and Applications

Comparison between Renting and Owning

  • Establishes frameworks for computing investment values between ownership and renting.

  • Analytical comparisons lead to decisions based on user cost, rental cost, and appreciation trends over time.