Physical Capital - Tangible goods purchased by the household that are used up over time. Such durable goods may serve as an investment or means of storing wealth.

Largest Physical Capital Investment Made by a Family is a HOUSE. Home Ownership rates 2006: – US = 68.8% – Utah = 73.5% Since 1900, home ownership has been in excess of 40% in the U.S. Source:

The Percentage of Families Owning Homes Over Time %

Housing appreciation

Housing Prices are determined by Supply & Demand Demand – Average household size down – Average income up – Availability of substitutes down – Life cycle stage of housing Childhood home, apartment, starter home, family home, empty nest home, retirement home, institutionalization or back to family, burial vault Supply – Business cycle

Benefits associated with purchasing a home... tax benefits - deduction of mortgage interest payments and property taxes from income for federal tax purposes. appreciation - during the past 40+ years because demand has grown at a faster rate than supply. – vary considerably across time (near zero in 1965, 18% in 1980, 4% in 1988, 11% in 2004) – vary by geographic location forced saving - portion of mortgage payment that goes towards building up equity. reduction in risk of future housing costs. (PITI)

Costs associated with purchasing a home... depreciation - the wearing out (or using up) of the home. – Can be off-set with regular maintenance -- but this is also costly. opportunity costs of having money tied up in the purchase of the home. property taxes and insurance costs risk that market value of the home may decline in the future fixed costs of the purchase - i.e., one time closing costs.

A Cost-Benefit Approach (CBA) to the home ownership decision Is it better to own a home or to rent? The CBA of home ownership answers the question: – how much will I have to sell my house for at the end of the time period, in order to get back the dollars I spent (e.g., to break even)? – What money do you need to get back?

1. What is the time period over which the household plans to own/rent? 2. What are the one-time fixed costs associated with purchasing the home? – down payment – closing costs (e.g., points, fees) – Do you pay these costs if you are renting?

3. What are the recurring (i.e., monthly) NET costs associated with owning compared to renting? How much more does it cost you to own than to rent every single month? You want to get that money back at the end… – Sum of owning costs (mortgage payment, property taxes, hazard insurance, operating and maintenance expenses) minus tax savings – Sum of renting costs (rent, operating expenses) 4. What will the outstanding loan balance be at the end of the time period? You have to pay off your loan when you sell 5. What will the estimated selling costs be at the end of the time period? You need to pay a realtor, and you want to get those dollars back

6. Place all of these costs into future value dollars using 3% real interest rate Remember, all of our dollars have to be at one point in time – we are putting all of our dollars in to the future – One-time costs (because these costs are one-time costs): FV=PV(1+r) n – Recurring costs (because these costs happen every single month): – Loan balance (already in future dollars; do not need to use a formula): – Selling costs: Add up the one-time costs, recurring costs, loan balance, and selling costs, for the total costs expressed in future value terms – This equals the minimum required future value of the home, or the break even price – This is how much you have to sell your home for in the future in order to get back all of the dollars that you have spent

7. Compute the interest rate – This interest rate is the annual rate of appreciation that will have to occur if you are to break even on purchasing a house rather than renting for n years. This converts the dollar amount into an interest rate, so that you can compare your housing investment with other types of investments

DECISION RULE - If the forecasted rate of housing appreciation is greater than the calculated interest rate, then economic benefits of home ownership outweigh the economic costs. – So, buy the house If the forecasted housing appreciation rate is less than the calculated interest rate, then the economic costs of home ownership outweigh the economic benefits. – So, rent

Example – write on the same page of notes (pg. 239) Original Purchase Price = $100, Time period = 8 years 2. One-time fixed costs: – Down Payment = $10,000 – Closing Costs = $3,000 – Total = __________ 3. Recurring Net costs – Sum of owning costs – tax savings = $1200 – Sum of renting costs = $900 – Net Costs = $ $900 = _______ 4. Loan balance: $81,900 (get from amortization table) 5. Selling Costs: $6,000

6. FV of one-time costs = FV=13000(1+.03) 8 FVA of recurring costs (with monthly compounding) = =$16,468 = $32,504

6. Now, add up all of the future costs: – FV – FVA – Loan Balance – Selling Costs = $136,872

7. = 0.04 or 4%

Decision = if forecasted housing appreciation rates are higher than 4%, you should buy this house