The Rental

It was December 2014. For the past 15 months, Michael and Celia Wazowski have been renting a three-bedroom house in the Tahoe Park neighborhood of Sacramento, CA. Their rent for the duration of their lease had been $1,200 per month, not including utilities. At the beginning of the month, Mike and Celia received a letter from their landlord stating that their monthly rent would be going up to $1,500 per month, starting on January 1, 2015. The landlord's justified the rent hike by claiming that he had not raised rent on any of her rental properties in the past 3 years, even though rents in Sacramento had been going up by an average of 10 percent annually over the last few years. The landlord's letter further stipulated that if Mike and Celia renewed their lease, she would agree not to raise their rent by a large amount. Rather, rent would only go up by the rate of inflation, regardless of how long they continue renting the unit.

Mike and Celia were not happy about this sudden rent hike, since it was a huge 25% jump from what they had been paying. But after doing a bit of research, they understood where the landlord was coming from. Both house prices and rents had indeed been going up in the neighborhood and in the broader Sacramento region. The Wazowskis liked their house and their neighborhood. Their house was within walking distance to both the UC Davis Medical center, where Mike was a resident, and a local elementary school, where Celia taught. They also liked the amenities the neighborhood offered. Both Mike and Celia strongly preferred to stay in the neighborhood.

The Listing

A few days after the Wazowskis received the letter from their landlord (and while they were still making up their minds about renewing the lease), a house across the street was listed for sale. On the weekend it was put on the market, the listing agent had an "open house", and the Wazowskis were able to take an extended tour. The house listed for sale was very similar to their current rental house: it was built in the same year, had the same layout and the same number of bedrooms and bathrooms, and was equally well-maintained. The new owners likely would not have to do any major renovation work immediately before or after moving in. As Mike and Celia preferred to stay in the neighborhood, they realized that buying the house across the street was another viable option, in addition to renewing their lease on their current rental.

The day after the Wazowskis visited the open house, Celia called her friend Angela, who was a licensed agent with a local real estate brokerage. Angela knew the local real estate market well and had good knowledge of various expenses that came with buying and owning a home. At the end of the conversation, Celia decided to formally hire Angela as her buying agent. In this role, Angela would help the Wazowskis to negotiate the purchase price, as well as process all the necessary paperwork, which would be extensive. The best news was that the Wazowskis would not need to pay Angela for her services directly - her commission would come from the seller.

After hiring Angela, the Wazowskis toured a number of other properties listed for sale in Tahoe Park and surrounding neighborhoods. However, there weren't a large number of homes listed for sale at the time, and ultimately the Wazowskis decided to make an offer on the house across the street from their current home.

The Price

The house was listed for $410,000, but Angela felt sure that the seller would ultimately agree to sell it for $400,000. Buying a house would be a huge decision for the Wazowskis - until now their largest purchase had been Celia's car, which they had bought used for $12,000. Compared to the high purchase price, even the increased rent of $1,500 per month sounded reasonable. Was it really worth buying the house?

Mortgage and Closing Costs

The Wazowskis did not have enough money saved up to buy the house with cash, so they would need a mortgage. Angela recommended that they make a down payment of at least 20% of the purchase price. This would ensure that Mike and Celia would receive the lowest interest rate possible and avoid paying mortgage interest premiums. The lenders required mortgage insurance on loan where the down payment was less than 20%. The Wazowskis did have enough liquid assets for a 20% down payment, which would be $80,000. They had $100,000 in treasury bonds and about $5,000 in a checking account. The treasury bonds were yielding 4% per year on a pre-tax basis. The checking account did not pay any interest. Therefore, in order to come with the $80,000 down payment, the Wazowskis would need to liquidate the majority of their holdings of treasury bonds.

Angela recommended that the Wazowskis finance the purchase with a 30-year fixed rate mortgage. After checking with several local lenders and researching online lenders, Mike and Celia decided to work with a local mortgage lender. The lender offered to make a $320,000 loan for 30 years at 4.0% annual interest, with monthly payments. The great thing about this loan was that it did not require any loan origination fees or "points". Mike and Celia's combined annual income was about $160,000, so they could easily afford the monthly mortgage payments.

The interest portion of the mortgage payments would be deductible for federal income tax purposes. The mortgage did not have any prepayment penalties, so the Wazowskis could pay off the loan at any time with no penalty.

Even though the lender did not charge any origination fees or points on the loan, there were still some fees that the Wazowskis had to pay to purchase the house. Collectively referred to as "closing costs", these included things like legal fees, home inspection, title search, transfer taxes, and others. Overall, the closing costs would add up to $5,000.

Property Taxes

The Wazowskis would have to pay property taxes based on the value of the property. In California, property taxes were collected by counties and were limited to 1% of the property. Additional, smaller amounts were paid to local school and community college districts. Altogether, the Wazowskis' property tax would be about 1.2% of the purchase price in the first year. California law also limited property tax increases to 2% per year. Therefore, the Wazowskis' property tax would go up at most by 2% year-to-year, regardless of the changes in the value of the house.

Like mortgage interest, property taxes were deductible for income tax purposes. Over the past 2 years, the Wazowskis paid approximately 20% of their income in federal income taxes, although their federal income tax bracket was 28%. They expected to stay in the 28% tax bracket for the foreseeable future.

Maintenance

One thing that concerned both Mike and Celia about owning a home was maintenance expenses. As renters, they did not have to worry about things like mowing the lawn, the dishwasher breaking, or the roof leaking. All maintenance and repairs were the responsibilities of the landlord. Although they passed maintenance costs on to the tenants in the form of higher rent, the landlords likely took advantage of economies of scale. Therefore, the maintenance costs for the same would likely be somewhat higher for an individual homeowner than for a landlord who owns multiple units. Angela told Mike and Celia that annual maintenance expenses tended to average about 1% of the property value. Therefore, the Wazowskis expected to spend $4,000 per year on repairs and maintenance per year. These expenses would likely increase at the rate of inflation in the future.

Homeowner's Insurance

After checking with an insurance broker she worked with, Angela said that homeowner's insurance would cost the Wazowskis $800 in the first year. Insurance premiums would also increase by the rate of inflation in the future year. Expected Tenure

In 5 years, Mike would complete his residency at the UC Davis Medical Center. At that point, the Wazowskis would return to Colorado, where they were both from. So if they bought the house, they would most likely sell it in 5 years, in January 2020. Assuming they would be able close and move in in January 2015, their expected tenure in the house would be 5 years.

Sale Price and Selling Expenses

One important consideration for the Wazowskis' decision to buy or keep renting would be the eventual selling price of the house. House prices had risen in Sacramento (and the rest of California) at unprecedented rates between the years 2000 - 2006. According to the Freddie Mac House Price Index, house prices in Sacramento increased by 130% between June 2000 and May 2005 - an annual price appreciation rate of 15%. However, after peaking in the summer of 2006, house price crashed and entered a period of precipitous decline, not reaching a bottom for another 6 years. By April 2012, Sacramento house prices had declined by 49% from their 2006 peaks - an 11% per year decline. House prices in Sacramento had actually appreciated by an average of 12% per year in 2013 and 2014. However, there was a sense that house prices had stabilized. Therefore, Angela suggested that the Wazowskis should not count on a high appreciation rate. Rather, they should be conservative and assume that the value of the house would go up by a modest 2% per year. Furthermore, they should account for a brokerage commission of 6% of the selling price when they sold the house. Theoretically, their capital gains would also be taxed at the rate of 15%. However, the first $500,000 in capital gains were exempt from taxes, so it was very unlikely that the Wazowskis would have to pay any capital gains taxes.

1. Put yourselves in the Wazowskis' shoes in December 2014. Consider what they know or expect regarding the costs of continuing to rent their current unit and the costs of buying the house listed across the street. If the scenario is ambiguous about a variable. What is the after-tax IRR from homeownership for the January 2015 - January 2020 period

2. what is minimum rate of return from ownership that would be sufficient to induce the Wazowskis to buy the house?

Answer rating: 100% (QA)

To calculate the aftertax Internal Rate of Return IRR from homeownership for the January 2015 Januar... View the full answer