Objective: To construct a realistic financial model of a home-purchase-to-rent deal similar to that presented below
Objective: To construct a realistic financial model of a home-purchase-to-rent deal similar to that presented below
Format: Include your Excel model along with a cover sheet justifying your assumptions and answering the questionsasked below.
Assumptions: Develop realistic assumptions for this hypothetical real estate deal and describe how you arrived at those assumptions in your cover sheet:
Purchase Price. Using Zillow or a similar listings website select a representative home to purchase in your chosen metro area (it can be in the central city of your metro or in the suburbs). Select a property close to the metropolitan median price for existing single-family homes. “Close to the median” can be determined through casual browsing of listings, or determined or guided by the NAR metro median home prices posted on Brightspace. Assume that in addition to the purchase cost you’ll invest $50,000 in remodeling and repairs before renting it out. Note: Assume this is an all-cash transaction, you do not take out a mortgage on this property. The tab with the mortgaged version is included for comparison only.
Initial Monthly Rent. Estimate a realistic initial monthly rent from on-line listing services for comparable properties (of roughly the same size, number of bedrooms and bathrooms, etc.) in the same or comparable neighborhoods of your metro. You do not have to do exhaustive market research to determine the rent—a handful of comps will suffice.
Rate of Rent Increase: Formulate assumptions regarding a plausible rate of annual rent increase over a 10-year hold period. You can base your estimates of the rent increase rate on the strength of recent employment or income gains in the metro area, on the recent historical growth of rents in your metro (using the ZORI index, linked in Brightspace), on the expected rate of inflation over the 10-year period (you can use the TIPS break-even expected inflation rate, linked in Brightspace), or a combination of the above.
Monthly Operating Cost. Use a figure of $682/month for monthly operating costs, which was taken from a 2021 study by the National Association of homebuilders. Use an annual average increase in operating costs of 2.5% (which is very close to the 10-year TIPS breakeven rate as of 10/30//23).
Rate of Property Appreciation. Formulate an estimate of the annual rate of appreciation for the home over the 10-year hold period, and assume the property is sold at the end of the period for the price implied by its initial value and its appreciation rate. You can base your estimates of the price appreciation rate on the strength of recent employment or income gains in the metro area, on the recent historical growth of home prices in your metro (using the Case-Shiller Home Price Index, posted on Brightspace, or the FHFA Home Price Index, linked to on Brightspace), on the expected rate of inflation over the 10-year period, or a combination of the above.
Discount Rate: In your baseline analysis, assume an 8% discount rate (which can be interpreted as your Opportunity Cost of Capital).
Important! Don’t “doctor” your assumptions in order to make the project the work in the sense of initially showing a positive or zero NPV. It’s part of our class experiment to see in how many metro areas such a home-to-rent deal makes RE sense if the assumptions are honestly and realistically formulated.
Questions: Answer the following questions based on your model and the results it gives, using your initial assumptions as a baseline.
Using the initial purchase price and your estimate of first year Net Operating Income, what cap rate did you pay for the property?
What Net Present Value (NPV) does your baseline model produce?
What is the Internal Rate of Return (IRR) implied by your baseline model?
If your baseline model using an 8% discount rate produces a NPV <0, what initial rent would you need to bring it to 0? If it produces a NPV>0, what is the minimum initial rent that you could charge and still have a NPV=0?
Holding all of your other baseline assumptions constant, what is the original purchase price that would produce an NPV=0 at an 8% discount rate? (Note: Don’t change your estimate of the final sales price.)
If the property appreciates at an annual rate 2 percentage points faster than your baseline estimate, what would be the effect on the investment’s IRR?
If the property appreciates at an annual rate 2 percentage points slower than your baseline estimate, what would be the effect on the investment’s IRR?
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