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Chapter 7
Single Family Housing:
Pricing, Investment, and
Tax Considerations

Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Overview: House Prices and Demand 1

• Growth in population and households is a

necessary condition for housing demand.
• There is a very strong association between house
price appreciation and income/employment
growth.
• Increases in interest rates tend to have a negative
influence on home ownership.
• If renting is more cost-effective than owning, home
ownership may not always be a better investment.

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 Overview: House Prices and Demand 2

Increases In Direction of Impact on Demand

1) Population growth +
2) Household formations +
3) Employment +
4) Household income +
5) Interest rates −
6) Federal income tax benefits +
7) Cost of renting housing +

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 Overview: Renting versus Owning 1

• Assume a property could be rented for $12,000 per year or purchased

for $150,000 with $30,000 down and financed with a fully amortizing
mortgage loan of $120,000 at 4.5 percent interest for 30 years.

1. Property Information Loan Information

Purchase price $150,000 Loan-to-value ratio 80.00%
Initial rent $12,000 Loan amount $120,00
Rental growth rate 2.00% Interest rate 4.50%
Property growth rate 2.00% Loan term 30 years
Insurance $500.00 Payments 12 per year
Maintenance $500.00 Annual debt service (payment) $7,296
Expense growth 2.00% Annual loan constant 6.08%
Marginal tax rate 24.00% Equity Investment/down payment $30,000
Property tax as % of value 1.50% Selling expenses 7.00%

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 Overview: Renting versus Owning 2

2. Annual Loan Schedule

End of year 0 1 2 3 4 5
Mo. Payments.12 $ 7,296 $ 7,296 $ 7,296 $ 7,296 $ 7,296
Balance 118,064 116,039 113,921 111,706 109,390
Interest (year) 5,360 5,271 5,178 5,081 4,979
Amortization (year) 1,936 2,025 2,118 2,215 2,317
3. Property Data
Property value $150,000 $153,000 $156,060 $159,181 $166,365 $165,612
Rents 12,000 12,240 12,485 12,734 12,989

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 Renting versus Owning: Cash Flow
Analysis 1

Year 1 Year 2 Year 3 Year 4 Year 5

A. Before-tax cash flows‒owner:
1) Property taxes $ 2,250 $ 2,295 $ 2,341 $ 2,388 $ 2,435
2) Insurance 500 510 520 531 541
3) Maintenance 500 510 520 531 541
4) Mortgage payments (P&I) 7,296 7,296 7,296 7,296 7,296
5) Cash outlaws before taxes $ 10,546 $ 10,611 $ 10,678 $ 10,745 $ 10,814
B. Tax deductions‒owner:
1) Property taxes $ 2,250 $ 2,295 $ 2,341 $ 2,388 $ 2,345
2) Interest 5,360 5,271 5,178 5,081 4,979
3) Total deductions 7,610 7,566 7,519 7,469 7,415
4) Tax savings @ 24% $ 1,826 $ 1,816 $ 1,805 $ 1,793 $ 1,780
C. Renter Status:
1) Rents $ 12,000 $ 12,240 $ 12,485 $ 12,734 $ 12,989
D. Net cash flows‒owning:
1) Before-tax outlays (A.5) $ (10,546) $ (10,611) $ (10,678) $ (10,745) $ (10,814)
2) Tax savings (B.4) 1,826 1,816 1,805 1,793 1,780
3) After-tax cash flows (8,720) (8,795) (8,873) (8,953) (9,035)
4) Rent saved (C.1) $ 12,000 $ 12,240 $ 12,485 $ 12,734 $ 12,989
5) After-tax cash flows‒owning $ 3,280 $ 3,445 $ 3,612 $ 3,782 $ 3,955

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 Renting versus Owning: Cash Flow
Analysis 2

Year 1 Year 2 Year 3 Year 4 Year 5

E. Before-tax cash flow‒for
sales occurring in years 1‒5:
1) Property value $ 153,000 $ 156,000 $ 159,181 $ 162,365 $ 165,612
2) Less: Selling expenses 10,710 10,920 11,143 11,366 11,593
3) Less: Mortgage payoff 118,064 116,039 113,921 111,706 109,390
4) Before-tax cash flow sale $ 24,226 $ 29,096 $ 34,117 $ 39,293 $ 44,630
F. After-tax cash flow‒for sales
occurring in years 1‒5:
1) Property value $ 153,000 $ 156,060 $ 159,181 $ 162,365 $ 165,612
2) Less: Selling expenses 10,710 10,920 11,143 11,366 11,593
3) Less: Basis 150,000 150,000 150,000 150,000 150,000
4) Gain on sale (7,710) (4,860) (1,962) 999 4,019
5) Less: Exclusion – – – 999 4,019
6) Tax 0 0 0 0 0
7) After-tax cash flow (E.4 − F.6) $ 24,226 $ 29,096 $ 34,117 $ 39,293 $ 44,630
E. After-tax IRR on equity
($30,000) if sold:
1) ATIRR (D.5 + F.7) −8.31% 9.76% 15.37% 17.62% 18.60%

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 Renting versus Owning: Other
Considerations
• In order to justify renting in this example, an
investor would have to earn from 9.8 percent to
18.6 percent on an after-tax basis on other
investments equal in risk with the $30,000 equity
saved to make renting equivalent to owning.
• What should be done with the proceeds from the
sale after year 5?
• Will the investor choose to own or rent from the
end of year 5 into the future?
• What if the owner chooses not to sell after year 5?

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 Renting versus Owning: Other Issues
At what level of rent would one be indifferent
between renting and owning?
• The level of rent that results in an after-tax IRR from
owning that is just sufficient to compensate for the
capital invested as a down payment.

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 Renting versus Owning: Cash Flow
Analysis with a Lower Rent Payment
• Assume that the after-tax IRR from owning that is
just sufficient to compensate for capital invested
as a down payment is 3.5%.
• Recalculate the net cash flows by changing rent
saved to $6,919 for the first year.

Year 1 2 3 4 5
After-tax IRR −25.25% −7.46% −1.16% 1.84% 3.50%

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 Overview: Analyzing Expected House
Prices 1

• Expected rate of appreciation in house prices (EAHP) −

HP1 − HP0
= EAHP %
HP0

• Expected appreciation rate on home equity (EAHE) −

HP1 − HP0
= EAHE %
HP0 1 − L(V )
• “Wealth effect” – the effect that expected appreciation in
assets, including home equity, may have on consumer
spending on other goods and services in the economy.

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 Overview: Analyzing Expected House
Prices 2

• Assume a $100,000 property is financed with an

80 percent loan and house prices fluctuate as
shown.
End of Year House Price Appreciation Rate Equity Calculation Annual EAHE

0 $ 100,000 __ $ 20, 000 __ __

$3, 000
1 103, 000 3% 23, 000 15.0%
$20, 000
$2, 060
2 105, 060 2% 25, 060 9.0%
$23, 000
$4, 202
3 109, 262 4% 29, 262 16.8%
$25, 060

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 Overview: Analyzing Expected House
Prices 3

• What is the • n = 3.
unrealized annual • PV = −20,000.
rate of appreciation
on equity in this • PMT = 0.
example? • FV = 29,262.
• Solve for i = 13.53%.

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 Overview: Analyzing Expected House
Price
• Regional Economic Influences on Property Values –
when analyzing real estate, the regional economic
drivers must be identified and a judgment must be
made about whether these drivers will provide a
source of growth or decline in a region.
• Analogy with the Law of Comparative Advantage –
those markets having industries with the highest
likelihood of future growth will have a positive effect on
house prices.
• Identifying Regional Economic “Drivers” or Base
Industries – identify those businesses producing the
greatest profits or use employment data as a proxy.
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 Overview: Economic Base Analysis –
Location Quotients
 RE j 
 
 TOT   1.0 ?
RE
 USE j 
 
 USE TOT 

where:
RE = regional employment
USE = US employment
j = industry classification
TOT = total

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 Overview: Economic Base Analysis
• Base employment – employment in classifications
with a location quotient > 1.0.
• Supporting employment – employment in
classifications with a location quotient < 1.0.
• Total employment – base employment plus
supporting employment.

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 Housing Supply: Submarkets
Description Measurement/Indicators

1. Quality of school districts SAT scores, percentage of HS graduates that go to college, library facilities

2. Crime rates/police/fire Data relative to various crime categories per 1000 residents, response times

3. Parks/recreation Relative to size of population, quality of programs

Number of listings, time on market prior to sale, percentage of asking price achieved
4. Housing market indicators by submarket

5. Quality of utilities Cost and source of water, electric, gas, sewer. Any assessments related to each

Population, percentage of nearby land area available for future development, and
6. Size of submarket zoning related to such areas

7. Health care facilities Number of physicians and beds per thousand residents

8. Building codes/zoning Restrictions, regulation of construction quality, minimum lot sizes

9. Insurance rates Premiums may vary based on response times by location

10. Noise levels Proximity to, and decibel levels of (airports, freeways, etc.,)

11. Environmental Open spaces, pollution, water, air, and so on

12. Transportation/access Distance and travel time to major employment centers, airports

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 Housing Supply
• Capitalization Effect – the quality of the public
services that individuals receive relative to the
taxes that are paid for these services when they
choose to purchase housing in a particular
neighborhood or municipality.

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 Housing Supply: Pricing Property in
Specific Submarkets/Locations
• The Sales Comparison Approach.
• The Cost Approach.
• The Income Approach.
• Final Estimate of Value.
• Property Appraisal and Actual Sale Price.
• Property Values over Time.

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 Investing in “Distressed Properties”:
Financial Framework
• Distressed properties – properties impacted by various
events or circumstances that present opportunities for
acquisition at below market prices.
A. Acquisition Phase B. Holding Period Phase
Acquisition costs: Interim costs:
Purchase price Renovation costs
Market and legal research costs Insurance, property taxes, and so on
Inspection costs Interest on investor financing
Elimination of liens Other
Other Total costs during holding period

Total acquisition cost

C. Provision Phase D. Profitability
Expected sale price C − (A + B)
Less: Selling expenses
Net cash from sale

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 Investing in Distressed Properties:
Acquisition Phase 1

Sources of Information for Identifying Distressed Properties.

• REO (real estate owned) lists – are maintained by banks and
lenders and are usually made available upon request.
• Individual property owners.

Legal Research.
The Auction Process.
• Lien theory of mortgages – foreclosures generally require a civil
action against the borrower-owner who is in default.
• Title theory of mortgages – title is usually vested in the lender
when the mortgage loan is made and reconveyed to the
borrower when the loan is repaid.
• Modified lien theory – when a loan is made, title is invested in an
independent third party.
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 Investing in Distressed Properties:
Acquisition Phase 2

Lenders at Auctions.
Other Issues – Equitable Rights.
Buying at Auctions Conducted by Public Entities.
Market Research/Costs.
Inspection Costs.
• Land/building.
• Foundation.
• Drainage.
• Building quality and code compliance.
• Environmental issues.

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 Investing in Distressed Properties
Holding Period Phase.
Outlays.
• Renovation costs.
• Interest or other financial carrying costs.
• Property taxes and insurance.

Financing Sources.
• Assumption of outstanding mortgage debt.
• Personal loan or credit lines.
• Personal equity or other equity sources.
• First or second mortgages on other real estate owned.
• Home equity credit line on other real estate owned.
Disposition Phase – Exit Strategies.
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Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.