The Buy Versus Rent Decision

TIME VALUE OF MONEY: THE BUY VERSUS RENT DECISION In May 2013, Rebecca Young completed her MBA and moved to Toronto for a new job in" rel="nofollow">in in" rel="nofollow">investment bankin" rel="nofollow">ing. There, she rented a spacious, two-bedroom condomin" rel="nofollow">inium for $3,000 per month, which in" rel="nofollow">included parkin" rel="nofollow">ing but not utilities or cable television. In July 2014, the virtually identical unit next door became available for sale with an askin" rel="nofollow">ing price of $620,000, and Young believed she could purchase it for $600,000. She realized she was facin" rel="nofollow">ing the classic buy-versus-rent decision. It was time for her to apply some of the analytical tools she had acquired in" rel="nofollow">in busin" rel="nofollow">iness school — in" rel="nofollow">includin" rel="nofollow">ing “time value of money” concepts — to her personal life. While Young really liked the condomin" rel="nofollow">inium unit she was rentin" rel="nofollow">ing, as well as the condomin" rel="nofollow">inium buildin" rel="nofollow">ing itself, she felt that it would be in" rel="nofollow">inadequate for her long-term needs, as she planned to move to a house or even to a larger penthouse condomin" rel="nofollow">inium within" rel="nofollow">in five to 10 years — even sooner if her job contin" rel="nofollow">inued to work out well. Friends and family had given Young a variety of mixed opin" rel="nofollow">inions concernin" rel="nofollow">ing the buy-versus-rent debate, rangin" rel="nofollow">ing from “you’re throwin" rel="nofollow">ing your money away on rent” to “it’s better to keep thin" rel="nofollow">ings as cheap and flexible as possible until you are ready to settle in" rel="nofollow">in for good.” She realized that both sides presented good arguments, but she wanted to analyze the buy-versus-rent decision from a quantitative poin" rel="nofollow">int of view in" rel="nofollow">in order to provide some context for the qualitative considerations that would ultimately be a major part of her decision. FINANCIAL DETAILS If Young purchased the new condomin" rel="nofollow">inium, she would pay monthly condo fees of $1,055 per month, plus property taxes of $300 per month on the unit. Unlike when rentin" rel="nofollow">ing, she would also be responsible for repairs and general main" rel="nofollow">intenance, which she estimated would average $600 per year. If she decided to purchase the new unit, Young in" rel="nofollow">intended to provide a cash down payment of 20 per cent of the purchase price. There was also a local deed-transfer tax of approximately 1.5 per cent of the purchase price, and a provin" rel="nofollow">incial deed-transfer tax of 1.5 per cent, both due on the purchase date. (For simplicity, Young planned to in" rel="nofollow">initially ignore any other tax considerations throughout her analysis.) Other closin" rel="nofollow">ing fees were estimated to be around $2,000. In order to fin" rel="nofollow">inance the remain" rel="nofollow">inin" rel="nofollow">ing 80 per cent of the purchase price, Young contacted several lenders and found that she would be able to obtain" rel="nofollow">in a mortgage at a 4 per cent “quoted” annual rate1 that would be locked in" rel="nofollow">in for a 10-year term and that she would amortize the mortgage over 25 years, with monthly payments. The money that Young was plannin" rel="nofollow">ing to use for her down payment and closin" rel="nofollow">ing costs was presently in" rel="nofollow">invested and was earnin" rel="nofollow">ing the same effective monthly rate of return as she would be payin" rel="nofollow">ing on her mortgage. Young assumed that if she were to sell the condomin" rel="nofollow">inium — say, in" rel="nofollow">in the next two to 10 years — she would pay 5 per cent of the sellin" rel="nofollow">ing price to realtor fees plus $2,000 in" rel="nofollow">in other closin" rel="nofollow">ing fees. SCENARIO ANALYSIS In order to complete a fin" rel="nofollow">inancial analysis of the buy-versus-rent decision, Young realized that her first task would be to determin" rel="nofollow">ine the required monthly mortgage payments. Next, she wanted to determin" rel="nofollow">ine the opportunity cost (on a monthly basis) of usin" rel="nofollow">ing the lump-sum required funds for the condomin" rel="nofollow">inium purchase rather than leavin" rel="nofollow">ing those funds in" rel="nofollow">invested and earnin" rel="nofollow">ing the effective monthly rate, assumed to be equivalent to the mortgage rate. She would then be able to determin" rel="nofollow">ine additional monthly payments required to buy the condomin" rel="nofollow">inium compared to rentin" rel="nofollow">ing, in" rel="nofollow">includin" rel="nofollow">ing the opportunity cost. Young wanted to consider what might happen if she chose to sell the condomin" rel="nofollow">inium at a future date. She was confident that any re-sell would not happen for at least two years, but it could certain" rel="nofollow">inly happen in" rel="nofollow">in five or 10 years’ time. She needed to model the amount of the outstandin" rel="nofollow">ing prin" rel="nofollow">incipal at various poin" rel="nofollow">ints in" rel="nofollow">in the future — two, five or 10 years from now. She then wanted to determin" rel="nofollow">ine the net future gain" rel="nofollow">in or loss after two, five and 10 years under the followin" rel="nofollow">ing scenarios, which she had determin" rel="nofollow">ined were possible after some due diligence regardin" rel="nofollow">ing future real-estate prices in" rel="nofollow">in the Toronto condo market: (a) The condo price remain" rel="nofollow">ins unchanged; (b) The condo price drops 10 per cent over the next two years, then in" rel="nofollow">increases back to its purchase price by the end of five years, then in" rel="nofollow">increases by a total of 10 per cent from the origin" rel="nofollow">inal purchase price by the end of 10 years; (c) The condo price in" rel="nofollow">increases annually by the annual rate of in" rel="nofollow">inflation of 2 per cent per year over the next 10 years; and (d) The condo price in" rel="nofollow">increases annually by an annual rate of 5 per cent per year over the next 10 years. FINAL CONSIDERATIONS Young realized she had a tough decision ahead of her, but she was well train" rel="nofollow">ined to make these types of decisions. She also recognized that her decision would not be based on quantitative factors alone; it would need to be based on any qualitative considerations as well. She knew she needed to act soon because condomin" rel="nofollow">iniums were sellin" rel="nofollow">ing fairly quickly, and she would need to arrange fin" rel="nofollow">inancin" rel="nofollow">ing and contact a lawyer to assist in" rel="nofollow">in any paperwork if she decided to buy. Read the HBR case study Time Value of Money: The Buy Versus Rent Decision and calculate the best route for the graduate’s housin" rel="nofollow">ing situation, developin" rel="nofollow">ing your understandin" rel="nofollow">ing of time value of money (TVM) concepts and calculations. Describe your assumptions, methodology, and results in" rel="nofollow">in your discussion narrative, and attach a simple spreadsheet supportin" rel="nofollow">ing your analysis. This case study can be located in" rel="nofollow">in your custom textbook/case study bundle.