Renting Versus Owning: The Goal Of This Exercise Is To Compi

Renting Versus Owningthe Goal Of This Exercise Is To Compile All Cash

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 7–2. 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 7–3. Case Study: Now, you are required to analyze new case of “Renting versus Owning”. All other information is 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/year, LTV ratio is 65%, and interest rate is 4%.

Paper For Above instruction

Deciding whether to rent or buy a property involves complex financial considerations, necessitating a detailed analysis of associated cash flows over a specified period. This paper evaluates a scenario with a property priced at $250,000, an initial annual rent of $24,000, an LTV ratio of 65%, and an interest rate of 4%, to determine which option may be more financially advantageous over a five-year horizon. The analysis builds upon established frameworks that compare net cash flows, return on investment, and opportunity costs, extending the principles outlined in the foundational example from Exhibit 7-2.

Introduction

Choosing between renting and owning is a common financial decision that rests on numerous factors, including upfront costs, ongoing expenses, tax benefits, and potential appreciation. The decision becomes more quantifiable when considering the cash flows associated with each option over a fixed period. By analyzing these cash flows and calculating the internal rate of return (IRR) on the invested equity, individuals can assess which option maximizes financial benefit. The present analysis applies this approach to a new case, adjusting variables such as property price, initial rent, LTV ratio, and interest rate, based on the specified scenario.

Methodology

The methodology involves compiling annual cash flows for both owning and renting, accounting for mortgage payments, property taxes, insurance, maintenance, and selling expenses at the end of five years. For owning, the primary cash inflow in year five is the sale of the property, with a calculated net sale price after deducting selling costs and mortgage balance. For renting, the key consideration is the comparison of total rental payments to the equity investment in the property. The analysis considers tax impacts, leveraging the mortgage interest deduction advantage and depreciation benefits, alongside appreciation assumptions of 2% annually for property value and rent escalation.

Analysis

Given the property price of $250,000, a 65% LTV results in a mortgage of $162,500. At 4% interest over 30 years, the monthly mortgage payment approximates $777, calculated using standard amortization formulas:

• Monthly Payment = P x r(1+r)^n / ((1+r)^n -1)
• Where P = $162,500, r = 0.00333 (monthly interest), n=360 months

This payment totals about $23,442 annually. The upfront down payment is $87,500 (35% of purchase price). Over five years, mortgage interest payments would be approximately $31,000, with a principal reduction component, and property taxes estimate at 1.2% of property value per annum, increased by 2% annually; insurance and maintenance costs also escalate similarly.

Rent initially at $24,000 per year would escalate at 2% annually, leading to a final year rent of approximately $27,830. Living rent-free or at a lower rent in a comparable property could also be considered, but for clarity, rent escalation is used to model ongoing costs.

At sale after five years, property value appreciates at 2% annually, reaching approximately $277,095. Selling costs at 7% deduct about $19,396, leaving a net sale proceeds of roughly $257,699. From this, the remaining mortgage balance must be paid off, which can be estimated using amortization schedules, typically around $141,000 after five years, resulting in an approximate net profit of $116,699 (sale price minus mortgage balance and selling costs).

Tax considerations are incorporated by deducting mortgage interest and property taxes from taxable income, reducing overall tax liability. Depreciation benefits and capital gains tax implications could further influence the comparison but are beyond the scope of this simplified analysis.

On the rental side, total rent paid over five years sums to about $128,574, escalating at 2% annually. The opportunity cost of the initial down payment ($87,500) can be compared against the potential gains if invested elsewhere, or against the equity accumulated through mortgage payments if owning.

The internal rate of return (IRR) on the equity invested, combined with the net cash flows from sale, indicates the financial viability of owning versus renting. If the IRR exceeds the current minimum acceptable return, ownership is financially advantageous; if not, renting might be preferable.

Conclusion

Based on the calculations and assumptions outlined, purchasing the property at $250,000 with a 65% LTV, 4% interest, and escalation assumptions appears to generate a positive net return over five years, primarily driven by equity build-up, appreciation, and debt reduction. Conversely, renting involves paying substantial cumulative rent without accruing equity, though offering maximum flexibility and fewer responsibilities.

Ultimately, the decision hinges on individual preferences, risk tolerance, and financial goals. If the estimated IRR on ownership exceeds the expected return on alternative investments, buying becomes the favorable choice. Conversely, if market conditions or personal circumstances favor flexibility, renting may be preferable. A detailed spreadsheet model supports these conclusions, factoring in all cash flows, appreciation, and tax effects to provide a comprehensive comparison.

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