You are considering an option to purchase or rent a single residential property. You can rent it for $2,000 per month and the owner would be responsible for maintenance, property insurance, and property taxes. Alternatively, you can purchase this property for $200,000 and finance it with an 80 percent mortgage loan at 6 percent interest that will fully amortize over a 30-year period. The loan can be prepaid at any time with no penalty.

You have done research in the market area and found that

(1) properties have historically appreciated at an annual rate of 3 percent per year, and rents on similar properties have also increased at 3 percent annually;

(2) maintenance and insurance are currently $1,500.00 each per year and they have been increasing at a rate of 3 percent per year;

(3) you are in a 26 percent marginal tax rate and plan to occupy the property as your principal residence for at least four years;

(4) the capital gains exclusion would apply when you sell the property;

(5) selling costs would be 7 percent in the year of sale; and

(6) property taxes have generally been about 2 percent of property value each year.

Based on this information you must decide

a. In order to earn a 10 percent IRR after taxes on your equity, should you buy the property or rent it for a four-year period of ownership?

b. What if your expected period of ownership was to change to five years?Would owning or renting be better if you wanted to earn a10 percent percent IRR after taxes?

c. Approximately, what level of rents would make you indifferent between owning and renting for a four-year period? Assume that a 4.5 percent after-tax IRR would be the minimum you would need to earn on capital invested in the home.

 

Answer:

The purpose of this paper is to analyze the best way to choose between buying the property or renting the house based on the computation of the Internal Rate of Return (IRR). The IRR in this case will be calculated as after-tax IRR after the consideration of tax advantage that is availed by the person considering to buy the property or buying the house (Brueggeman, Fisher 2011). The selling period of the property should be considered in decision making.

Step-by-step explanation

a.       The rent versus owning the property analysis indicates that the property information has the loan and equity calculations annual debt service of $11,511 at 7.19% and equity investment of $40,000. For the 5 years, the loan summary indicates the 1^st year will have a balance of $158,035 with the principal of $1,965 and interest of $9,547. The payment at 5^th year will be $148,887 with the principal of $2,496. The property will increase from the property of $200,000 in the first year to $231,855 in the 5^th year. The net cost of owing will start with cash outflows before taxes recorded at $18,511 with an after-tax cost of $14,989. The net costing of renting will increase rents from $24,000 to $27,012.

Therefore, the cash savings and the IRR indicate the 1^st year the ATIRR will be 6.39% and the 4^th year it will be 31.18% thus the decision to buy the property will be better.

b.      It is indicated that the required IRR is 10% and the ATIRR is established to be 31.61% in the 5^th year. Therefore, owning the property is a better option as compared to the person looking for the property.

c.       The level of rent that will generate the IRR of 4.5% and getting the difference of buying and renting the properties. The indifference between buying and renting the house on annual rent is $12,356 after the rent results in an after-tax IRR of 4.5%.

References;

Adeogun, A. S., & Kuma, S. S. (2020). International Journal of Real Estate Studies INTREST.

Brueggeman, W. B., & Fisher, J. D. (2011). Real estate finance and investments (pp. 5-6). New York: McGraw-Hill Irwin.

Makhija, A. (2020). Managing Real Estate Investments: An analysis of microeconomic and financial metrics and scenarios and their effect on investor-level asset returns.