Buying vs. Renting a Home: A Financial Analysis

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Buying vs. Renting a Home: A Financial Analysis

Andrew Fraser Markus Linke

Russ Reilly Justin Rosales Daniel Rossman Abbey Staffnik Mohammed Tarin Berman Tijerino Robert Wellman

Prepared in partial fulfillment requirements in CEE 300 ? Engineering Business Practices Dr. Thomas Seager, Instructor Arizona State University 13 August, 2012

Executive Summary

Salman Khan said, "The single most important video [series] anyone can watch" is his presentation on renting vs. buying a home. Khan explains that, for a given year, it may be better to rent than it is to buy, assuming the houses are similar. However, Khan further explains how the decision to buy or rent could be dominated by the appreciation and depreciation in the value of a house. The housing market is unpredictable without making a few assumptions. The methods used to analyze buying vs. renting were to study a few key data sources. The US Census Bureau publishes median home asking prices for four regions of the US at . The S&P/Case-Shiller Home Price Index presents data on twenty different metro home areas, including Phoenix, AZ. Lastly, publishes sales data and market estimates for individual houses. This study compares house prices in four different areas in metropolitan Phoenix: central Phoenix, Tempe, Scottsdale, and West Phoenix/Glendale. Using a spreadsheet downloadable from to reduce expected cash flow forecasts to net present value, this analysis recommends buying rather than renting, given an assumed forecast of little to no price appreciation expected in the Phoenix housing market.

Table of Contents

Introduction......................................................................................................1 Problem Statement..............................................................................................2 Assumptions...............................................................................................................................3 Methods..........................................................................................................6 Discussion and Analysis.....................................................................................14 Recommendation.............................................................................................18 References....................................................................................................19 Appendix......................................................................................................20

List of figures Figure 1.0 ? Cash flow diagram for buying a home.......................................................2 Figure 1.1 ? Cash flow diagram for renting a home .......................................................3 Figure 2.0 ? Median asking rents and sales prices.........................................................5 Figure 3.0 ? Trend of US home prices.......................................................................6 Figure 4.0 ? Median sales price of new US homes.........................................................7 Figure 5.0 ? Phoenix S&P/Case-Shiller Home Price Index...............................................7 Figure 6.0 ? Average home value. .....................................................................................8 Figure 6.1 ? Average area of homes in studied areas.........................................................9 Figure 6.2 ? Average payments..........................................................................................9 Figure 7.0 ? Khan's modified Excel spreadsheet..........................................................13 Figure 8.0 ? Buy vs. Rent in central Phoenix, 30 year mortgage........................................15 Figure 8.1 ? Buy vs. Rent in Scottsdale, 5/1 ARM........................................................16 Figure 9.0 ? Decision chart...........................................................................................17

List of tables

Table 1.0 ? Average mortgage rates........................................................................4 Table 2.0 ? Home types and amount of homes studied...................................................8 Table 3.0 ? Variable list for sample calculations.........................................................11 Table A.CP ? Central Phoenix homes.....................................................................20 Table A.T ? Tempe homes..................................................................................20 Table A.S ? Scottsdale homes..............................................................................21 Table A.WP ? West Phoenix/Glendale homes...........................................................21

Introduction

The question asked for this report was "Which is cheaper--renting or buying?" Taking into account the current market conditions of real estate in 2012 an in depth analysis was made comparing rental properties to homes for sale in four metropolitan areas of Phoenix, Arizona. The areas were as follows: central Phoenix, Tempe, Scottsdale and West Phoenix/Glendale.

Renters have landlords who charge a monthly fee for staying in their home. The rental agreement is a binding contract between the renter and the landlord, so renters must make periodic payments under the agreement to occupy the home. When renting, the landlord usually carries the cost of maintenance and repair to the building and property, which can be substantial when considering how much it would cost to replace an air conditioner. This is a great benefit to the renter since it is unnecessary to set money aside for maintenance and repair. It is advisable to carry renters insurance on the valuables in the home. Price of rent can fluctuate over time--they can go up and down. Renters have no control over the rent or how much it can change over time. Often times, rental agreements limit on how many changes or improvements are allowed to the home. Usually a security deposit is required to rent a home to protect the landlord from having to make improvements or repairs from damages the renter caused. This security deposit will be returned to the renter upon leaving the home in acceptable shape. An advantage of renting vs. buying is the flexibility of movement. If for whatever reason renters have to move, then renters can simply pack up their belongings and move out without having to sell the home. Another advantage is that renters do not have to worry about depreciation of the house.

If homeowners cannot buy the house outright, then they will most likely have a mortgage. The mortgage is a loan secured by property that requires the borrower to make payments to whoever holds the title of the home. This payment is most likely made up of four parts: the interest on the outstanding loan, principal to pay down the balance of the loan, property taxes, and homeowners insurance. Property taxes are what the responsible municipality charges based on the assessed value of the property and dwelling. Homeowners insurance is required as part of the loan agreement to ensure there is money to pay for replacement or repair in the case of loss. The mortgage can be in the form of a fixed interest rate with payments spread over 15 to 40 years, depending on the signed agreement. Fixed rate loans are also known as conventional loans. Another option is the Adjustable-Rate Mortgage (ARM), which was very popular during the last housing boom. An ARM will start homeowners out with a lower initial interest rate than a conventional loan but can be adjusted periodically depending if it is tied to the London Interbank offered Rate, or LIBOR ("Definitions"). A Federal Housing Administration (FHA) loan does not require as stringent credit qualification or as a large as a down payment when compared to a conventional loan. As a homeowner with a fixed mortgage, the payments of principal and interest will remain the same for the term of the loan; however the portion

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consisting of property taxes and homeowners insurance can fluctuate with time ("What's in a Mortgage Payment?").

A benefit of having a mortgage payment is that the paid interest is tax deductible ("Renting vs. Buying a home"). This should only be small factor when deciding to buy a home. The biggest benefit of homeownership is the possibility of the home's appreciation, which means the home is most likely worth more than the original purchase when homeowners decide to sell. With the appreciation and the paying down of the principal, there should be a net gain over the purchase price. The downfall is when the home's value depreciates, which means the home is worth less than what the original purchase. Homeowners are responsible for maintaining and repairing the building and property, so important to have money in savings for unexpected repairs.

Problem Statement: Is it more economical to buy or rent a house during the 2012 Third Quarter?

The following figures show cash flow diagrams for buying and renting a home.

Figure 1.0 ? Simple cash flow diagram for buying a home. Figure 1.0 reflects a one year ownership of a house with a purchase price of $131,500, 20% down payment, 15 year fixed mortgage rate at 3.09%, 0% appreciation, and assumes the home is sold at the end of the year with a 6% of the sale going to the realtor.

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Figure 1.1 ? Simple cash flow diagram for renting a home.

Figure 1.1 reflects a one year rental agreement with a monthly rent cost, which includes renters insurance, of $949, a security deposit of $949, and assumes a full refund of the security deposit at the end of the rental agreement.

Assumptions

In order to compare buying vs. renting a home a few assumptions must first be made about the prospective buyer/renter. First and foremost, the client is looking for a place to live and intends to live there for at least 5 years. This excludes any client looking at buying a house as an investment rental property. Secondly, it is assumed that the client is in a position to buy a home. That is to say, they have enough cash on hand for a 20% down payment and have a credit score and debt situation that guarantees them a home loan. This client also has a steady stream of income that would qualify them for a first mortgage. This analysis considers a client with secure income, rather than a client that has reason to expect they may lost their job and face home foreclosure due to an inability to make regular mortgage payments..

The report will only look at single-family detached homes. Apartments, duplexes, condominiums, mobile homes, and loft spaces have all been excluded. The analysis will only compare homes that are in move-in ready condition. For the sake of this report, move-in ready is defined as a home that does not require any additional work for prospective buyer/renter. The house does not have any structural deficiencies, does not require painting inside or out, the floors and/or carpet are in good shape and do not need replacement, the appliances and plumbing are in good working order, and the yard has been maintained. There are a number of homes on the

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market that are available at a substantial discount but require additional improvements to make the house livable. These have excluded because it is difficult to find rental equivalence and/or estimate the cost of future renovations on these houses.

The report is specific to the greater Phoenix area, focusing on four areas: central Phoenix, West Phoenix and Glendale, Scottsdale, and Tempe. In order to get a representation of each of each of these areas, sale and rental properties have been analyzed using two, three and four bedroom homes as the base categories provided they meet the move-in ready criteria listed above.

There are additional costs associated with buying a home and those will be defined using the following rates. Mortgage interest rate, maintenance, closing costs, property tax, homeowners insurance, security deposits, renters insurance, appreciation, and depreciation.

While mortgage rates vary from place to place, however this report will use the average rates posted by the Mortgage Bankers Association for August 2012, which is shown in Table 1.0. Maintenance costs range from 1-2% of the home's value, and this report will use an average maintenance cost of 1.5% of the home's value ("Budgeting for Home Maintenance and Repair Costs").

Table 1.0 ? Average mortgage rates for August 2012 ()

30 Year Fixed 15 Year Fixed

5/1 ARM

3.75% 3.09% 2.73%

Closing costs also represent additional expenses typically paid by the purchaser. These costs include "loan origination fees, discount points, appraisal fees, title searches, title insurance, surveys, taxes, deed-recording fees, and credit report charges" among others ("Closing Costs").

Based on research conducted in 2010, closing costs in Arizona average 1.5% of the homes selling price. This number will be used for all calculations in this report and is paid at the same time as the purchase of the home ("Closing costs averages comparison: Arizona").

Property tax rates vary greatly depending on location. The tax rate used in this report is based on the average rate for Maricopa County for a home's estimated fair market value, which is 0.55%. For this report, property taxes are paid at the end of the year ("Maricopa County Average Property Tax").

As of March 2012, the average Arizona homeowners insurance is $617.00 per year, or $51.42 per month ("Arizona Homeowners Insurance Quotes"). The main components of homeowners insurance are the dwelling, contents or personal property, and loss of use. Some

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