Question

Rent vs Own

You are considering an option to purchase or rent a single residential property. You can rent it for $4,000 per month and the owner would be responsible for maintenance, property insurance, and property taxes.

Alternatively, you can purchase this property for $300,000 and finance it with an 80% mortgage at 7% interest, 25 year - fixed. The loan can be prepaid at any time with no penalty.

You have done research in the market and found that properties have historically appreciated at an annual rate of 4% per year. Rents on similar properties have also increased at the same rate. Maintenance and insurance are currently $2,500 each per year and they have been increasing at a rate of 4% per year. Property taxes have generally been about 3% of the property value each year. If you purchase, the plan is to occupy the property for at least four years. Selling costs would be 7% in the year of sale.

Based on this information you must decide:

 In order to earn a 10% internal rate of return, should you buy the property or rent it for a four-year period of ownership?

Please show work in excel and show the formulas you use in excel

Answer 1

Loan amount = Value x LTV = 300,000 x 80% = 240,000

Payment per month = PMT (Rate, Nper, PV, FV) = PMT (7%/12, 12 x 25, -240000, 0) = $ 1,696.27

Annual payment = 12 x PMT = 12 x 1,696.27 = 20,355.24

Loan outstanding at the end of 4 years = -PV (Rate, Nper, PMT, FV) = -PV (7%/12, 12 x (25 - 4), 1696.27, 0)

= 223,643.16

Equity consideration at the time of purchase = Value - loan = 300,000 - 240,000 = 60,000

Please see the table below. All financials are in $. Please see the second column to understand the mathematics. The cells colored in yellow contain your answer. Adjacent cell in blue shows the excel formula used to get the answer.

Hence, you should buy the property, as the IRR of buy vs. rent is 52.26% > desired return of 10%