1. Real Estate Finance Residential decision making: Buy or lease?

2.  Should you buy or should you rent your home? Incremental cash flows and the return on housing ownership Incremental cash flows Capital appreciation Tax issues Example Overview

3.  The choice between owning and renting is often referred to as tenure choice Tenure choice involves a comparison between two mutually exclusive alternatives: Rent your living space and invest in the broader financial markets, or… Purchase your living space and invest in the local housing market The investment in the location housing market equals the down payment required to finance the acquisition of the house Tenure choice

4.  Incremental cash flow valuation: The incremental cash flows from ownership are the difference between the cash flows paid out as an owner and the cash flows paid out as a renter Periodic: The difference in the annual costs of owning versus renting Capital appreciation: The cash flows from the sale of the property Compare the return received by investing the down payment in the local housing market versus its opportunity cost Tenure choice

5.  The investment in the local housing market, in the form of the down payment, has a residual claim on the cash flows Debt obligations have a senior claim on cash flows due to the secured nature of mortgage lending The investor holding the residual claim is referred to as an equity investor Tenure choice

6.  The annual cost of leasing involves Rental payments Other costs, such as utilities, for example, are included only if they are borne by renters but not owners  The annual cost of ownership involves Mortgage payments Maintenance Property taxes Insurance Tax benefits Tenure choice

7.  Property is typically acquired with mortgage financing which requires that the borrower make a non-trivial down payment at the time of purchase What is the return on the investment made in the local housing market? Future house price appreciation Leverage Tax issues Tenure choice

8.  The tax code in the US applies different tax rates to different sources of financial gain: Income Periodic cash flows generated by the “rental” of human and/or financial capital Wage income Dividend/interest income Rental income Capital gains Discretionary cash flows associated with the sale of an asset Tenure choice and taxes

9.  The US is characterized by a progressive income tax structure; higher tax rates are applied to higher levels of taxable income Taxable income is net income after deductions for particular expenditures identified in the tax code Standardized Itemized Mortgage interest Local tax payments Charitable contributions Non-reimbursed business expenses Tenure choice and taxes

10. 2014 US income tax rates (Married, filing jointly): IncomeTax rate 0 to 18,50010% 18,500 to 73,80015% 73,800 to 148,85025% 148,850 to 226,85028% 226,850 to 405,10033% 405,100 to 457,60035% 457,600 and above39.6% Taxes

12. Why do we care about the marginal tax rate rather than the average tax rate?  Suppose that when you calculated your taxable income, you forgot to include $250 in charitable contributions. If you add this amount to your itemized deductions, what is the adjusted tax liability? Difference is determined by the tax rate for the last dollar earned times the value of the deduction, $62.50 = (.25)250 Taxes

13.  Tax benefits to home ownership: Tax deductibility of interest payments and property tax If a borrower itemizes deductions on their federal income tax forms, their tax liability is reduced by their marginal tax rate times the sum of the interest component of their periodic mortgage payment and their annual property tax payment Capital gains exclusion Individuals: Gains of less than $250,000 are exempt Married couples: Gains of less than $500,000 are exempt Tax may depend on how long the property was owned and how many years the property was occupied by the tax payer Basis used to compute gain can include capital expenditures undertaken by owner Tenure choice and taxes

14.  Tax benefits to home ownership (cont.): An owner/occupier does not have to pay tax on rental income they pay to themselves Consider a house that could be purchased for $100,000 that is currently occupied by a renter in a 25% marginal tax bracket that pays $10,000 a year in rent and receives a 10% return on investment in the financial markets Net change in cash flow if they purchase outright (no mortgage) rather than rent: – 7,500 + 10,000 = 2,500 Loss of investment income (which is taxed) plus gain due to not having to pay rent (which is not taxed) Tenure choice and taxes

15. A two-bedroom apartment in Jersey City that can either be purchased for $965,000 or rented for $3,500/month Buy v lease analysis

18. Should you buy or rent?  Assuming a down payment equal to 20% of the purchase price and equal growth rates for inflation, house prices and rents over a five- year holding period: Own and invest $209,000 in the local housing market which generates an expected after-tax return of 1.17% Rent and invest $209,000 in the broader financial markets What is the opportunity cost of the investment in housing? Buy v lease analysis

19.  Outcomes depend on assumptions: House price appreciation Rent growth Return on investment in the broader financial markets Leverage Tax status Buy v lease analysis

20.  Choice depends centrally on expectations about future growth rates Stable scenario: inflation 2%, house price appreciation 2%, rent growth 2% Expected return 1.17% High P/R scenario: inflation 2%, house price appreciation 5%, rent growth 1% Expected return 11.34% Low P/R scenario: inflation 2%, house price appreciation 1%, rent growth 5% Expected return -1.82% Could also calculate an expected return given subjective likelihoods on future scenarios Buy v lease analysis

21.  Increased proportion of value financed with debt increases variance of returns 90% LTV, other assumptions unchanged 19.19% return associated with High P/R scenario -10.76% return associated with Low P/R scenario  Why does leverage influence returns in this way? Buy v lease analysis

22.  Tax status Standard deduction v itemized deductions Marginal tax rate  Length of tenure  Option value and secured borrowing Prepayment penalties and refinancing decisions Non-recourse debt and default  Non-financial factors Buy v lease analysis