Jan042018

## Ownership cost calculations for family homes

##### The OC Housing News provides detailed ownership cost calculations for every family home for sale on the local MLS.

## A point-in-time analysis

Today is reality; tomorrow is a fantasy. The ownership cost calculation is a snapshot of the cost of ownership at the time of first payment. It makes no projections for future changes such as home price appreciation. This analysis purposely does not project future changes for two reasons: First, the costs at the time of first payment are concrete and knowable. It requires fewer assumptions and no crystal ball. Second, most people who estimate future appreciation wildly overestimate. Very small changes in rates of appreciation make very large differences over 10 or more years. Overestimating appreciation always makes owning a property look very desirable financially. It’s a mistake many people made who bought at the peak of the housing bubble.

# Concise Description of Ownership Cost Terms

Below is a concise description of each line item displayed on the MLS property details, why the item is important, and how it’s calculated. For more detailed descriptions, links to posts on these topics is provided at the bottom of this post.

## Asking Price

This is the current asking price on the MLS.

## Down Payment

A conventional loan requires a down payment that is 20% of the purchase price. Down payments will less than 20% down require private mortgage insurance, a policy paid by the borrower that protects the lender from loss. FHA down payments are generally 3.5% of the purchase price. The down payment is calculated by multiplying the asking price by 20% for a conventional loan and 3.5% for an FHA loan.

## Mortgage Interest Rate

Mortgage Interest rates are set by lenders competing to offer loans to borrowers who are buying or refinancing real estate. Mortgage Interest Rates are quoted on many websites, such as Bankrate.com. If the loan is over the conforming limit, a jumbo premium of 0.35% is added to the market rate. The OC Housing News calculations uses the interest rate prevailing when the listing first came on the market. The interest rate is periodically updated. **The mortgage interest rate shown is not a quote.** It is provided for estimating payments and cost of ownership.

## Number of Years

The terms of a loan generally require repayment over time. A mortgage with a fixed repayment schedule is called an amortizing mortgage, and the period of time over which the mortgage amortizes is called its term. The term of mortgages is generally 30 years, but 15 year terms are also common, and lenders offer other schedules. The OCHN calculations assume a 30-year fixed-rate amortizing mortgage because it is a stable balance between low payments and reasonable repayment period, and it’s the most common form of home financing.

## Mortgage

The mortgage balance for a conventional mortgage is the asking price minus the down payment. The mortgage is 80% of the purchase price in these calculations, but buyers executing a move-up sale may have larger down payments and smaller mortgage balances.

The FHA mortgage is not as simple to calculate as a conventional mortgage because the FHA charges a 1.75% up front fee that gets rolled into the mortgage. The amount borrowed is 96.5% of the purchase price (100% – 3.5%) plus the 1.75% charge, for a total mortgage balance of 98.25% of the purchase price (96.5% + 1.75%). This is why the FHA mortgage plus the down payment does not equal the asking price.

## Income Requirement

The income requirement is based on standards set by Fannie Mae, Freddie Mac, and the Federal Housing Administration (GSEs and FHA). The monthly cash outlays (described later) multiplied by 12 gives a yearly payment burden. The yearly payment burden must not exceed 31% of a borrowers income under most circumstances (FHA often makes exceptions). The formula is as follows: Income Requirement = Monthly Cash Outlays X 12 / 0.31

## Monthly Mortgage Payment

The monthly mortgage payment is determined by lenders using a formula outlined below. It’s based on the mortgage amount, mortgage interest rate, and loan term (number of years) as described above.

The following formula is used to calculate the fixed monthly payment (P) required to fully amortize a loan of L dollars over a term of n months at a monthly interest rate of c. [If the quoted rate is 6%, for example, c is .06/12 or .005].

P = L[c(1 + c)n]/[(1 + c)n – 1]

## Property Tax

Proposition 13 sets property taxes in California are set at 1% of purchase price (assumed asking price).

## Mello Roos & Special Taxes

Mello Roos are an example of a special tax levy put on the property by the developer in California. The local Assessor’s office has this information online, but it is not organized in a way permitting easy download, so it must be estimated. Not every developer creates a Mello Roos district, so some properties developed since 1985 may have no Mello Roos. For those properties, the cost of ownership calculations will overstate the true cost.

The calculations on the OCHN estimate as follows:

If the year of construction is 2002 or later, Mello Roos = Property Cost Basis × 0.04.

If the year of construction is 1994 or later but earlier than 2002, Mello Roos = Property Cost Basis × 0.02.

If the year of construction is 1985 or later but earlier than 1994, Mello Roos = Property Cost Basis × 0.01.

## Homeowners Insurance

Homeowners insurance rates vary widely, but the standard estimation is $25 for each $100,000 in home value.

## HOA Dues

The HOA dues is taken straight from the MLS. Sometimes agents input this information incorrectly, but for the most part, the numbers are accurate.

## FHA Mortgage Insurance

Conventional mortgages with 20% down pay no private mortgage insurance. FHA insures mortgages with as little as 3.5% down, and the cost of this insurance is 1.3% percentage of the loan balance — it’s higher than property taxes in California.

## Monthly Cash Outlays

The monthly cash outlays — also known as PITI — is a standard lender calculation of housing costs. It is the sum of the costs listed above: payment, property tax, Mello Roos, Insurance, HOAs, and mortgage insurance.

## Tax Savings

The tax savings is the most complicated of the calculations. Based on the income requirement, the borrowers income is compared to both Federal and California tax tables to determine the marginal tax rates for both entities. To determine the maximum potential tax savings, the marginal tax rate (both Federal and State) is multiplied by the sum of mortgage interest, property taxes, and mortgage insurance (those are deductible expenses). However, to calculate the actual tax savings the marginal tax rate must be multiplied by the standard deduction, *and this number must be subtracted from the maximum potential tax savings*. This adjustment is necessary because in order to claim the deduction, a tax filer must itemize, and this requires surrendering the standard deduction. This calculation is so complex because it must be repeated for both State and Federal taxes, and both have different tax rates, different income thresholds, and different standard deductions.

## Principal Amortization

Since part of the mortgage payment is principal, and since this is effectively a forced savings account, the amount of principal amortization must be backed out because it is not a true cost of ownership.

The payment is calculated by the formula detailed above. The interest on the debt is the outstanding loan balance multiplied by the interest rate and divided by 12. The interest is subtracted from the payment to ascertain principal amortization. Over time, principal amortization grows and mortgage interest declines. However, since this is a point-in-time analysis, only the amortization of the first payment is counted.

## Opportunity Cost

Opportunity cost is perhaps the least understood of the adjustments to ownership cost. When a down payment is applied to a home purchase, that money came from somewhere. If the buyer would have chosen to rent, that money could have been invested in any number of safe investment alternatives. The loss of this investment income is the opportunity cost.

The calculation herein takes the mortgage interest rate, divides it by 3, then adds 1% to it. This generally approximates the yield on medium-term CDs, money-market accounts, or Treasuries. For example, at 4.5% interest rates, the opportunity cost would be 2.5% (4.5% / 3 + 1%).

## Maintenance and Reserves

Real property requires routine maintenance. Further, over time, more expensive items such as roofs or exterior paint need replacement. Budgeting for the irregular expenses of routine maintenance and the slow depletion of wear and tear requires establishing a monthly allowance for maintenance and replacement reserves.

The formula used here is asking price times three-tenths of one percent divided by twelve (0.003/12).

## Monthly Ownership Cost

The monthly ownership cost is the monthly cash outlays adjusted for tax savings, principal amortization, opportunity cost, and maintenance reserves.

## Comparable Rental

Comparable rental rates are determined by an advanced algorithm for selecting comparable properties. When I was actively flipping properties in Las Vegas, I evaluated both resale and rental comps on over 1,500 properties. I developed a series of steps to gradually loosen the various parameters until I obtained a sufficient number of comparable properties to make a reasonable estimate of value. These algorithms are proprietary. As this is an automated analysis, there is a degree of error in these estimates, and the actual comparable rental rate may be significantly higher or lower than the rate shown.

## (Savings) or Loss

The savings or loss is the monthly ownership cost minus the cost of a comparable rental. If this number is negative (in parenthesis), then the property costs less to own that to rent, which is a good sign. If the number is positive, it costs more to own than to rent.

## Furnishing and Move In

Furnishing and move in costs vary considerably depending on the tastes of the buyer. There are generally fixed costs for movers and other service providers, and variable costs for furnishings. In general, people will furnish a house in proportion to its cost. The following formula is a low-cost estimate; most people when moving in to a family home will spend much more.

The formula used here to estimate is 1% of the asking price plus $3,500.

## Closing Costs

The buyer and seller often split certain costs at closing, and some costs are entirely the responsibility of the buyer. What’s paid by the buyer and what is a split cost varies by local custom. For financed purchases, the buyer must pay closing costs including loan origination fees and other lender costs.

The formula used here to estimate is 1% of the asking price plus $3,500.

## Down Payment

The down payment is calculated above. It’s repeated here because it’s part of the calculation of total cash costs.

## Total Cash Costs

The total cash costs is the amount of money a buyer must have available to complete the sale including furnishing and move in, closing costs, and the down payment. People often forget about closing costs and furnishing cost and go into debt shortly after the sale to cover these costs.

## Emergency Cash Reserves

Though not an actual cost of acquiring the property, financial advisors always recommend having sufficient cash reserves to cover expenses in case of an emergency. Further, lenders often require liquid cash reserves in addition to the down payment as a condition to funding. Most borrowers do not reserve much if anything when buying a home. Almost none have an additional six-month’s income like most financial advisors recommend.

The calculation herein only estimates three month’s of income based on the income requirement generated above.

## Total Savings Needed

The total amount of savings necessary to have a stress-free purchase is the total cash costs plus sufficient emergency reserves.

## For more information

Should you rent, or should you own?

Ownership cost: income, payments and house prices

Ownership cost: interest rates and down payment requirements

Ownership cost: property taxes, insurance, Mello Roos, and HOAs

As I mentioned at in yesterday in the context of my defense of rental parity as a key component of a non-mechanical decision method, I’m not certain about the day-one point-in-time approach.

Since no one buys a property with the intention of only keeping for 1 year (let alone one month, which is what I feel this approach implies), I believe it is safe to assume that one will remain in a property of an “average” duration, about 10 years. Over a 10-year period, the INT payment within a 30-year P+I decreases by more than 20%, decreasing my non-principal outflow by around 15%. At the same time, rent inflating at 3.5% PA increases more that 40%. So after just a few years, the rental parity calculation changes dramatically. I believe that this accounts for the disparity that Jimmy and others have pointed out.

As for appreciation assumptions, this should equal the inflation factor you use against rent. Unless the purchase is 100% speculation, I see any real-dollar appreciation as gravy, so 3.5% is a mathematical “whatever”.

When I first started writing about the housing bubble, I used to see many comments about how appreciation and increasing rents could justify any asking price. I had a realtor post at the IHB that with only five years of 5% annual rent increases that the cost of ownership would align with the cost of a rental. While I couldn’t argue with the math, I could argue with the assumption that rents would rise that fast. Of course, rents actually went down during the housing bust, so anyone who accepted the foolishly rosy projections of future growth got burned.

Plus, back when I studied real estate economics in school, I had a professor who was hard-core about stabilized year-one proformas. He drove into us the point that if a deal doesn’t make sense today, believing that it will make sense tomorrow, a year from now, or a decade from now, was merely wishful thinking and fantasy. It is the kind of thinking that always crops up during a financial bubble. It tends to get wiped out along with Ponzi schemes and other unsustainable ideas during a bust, but with the moral hazard of housing bailouts, you see people who cling to these ideas.

Introducing growth rates brings in extra variables rife with opportunity for abuse and wishful thinking. I won’t use them, and I won’t invest in anything that requires me to use them to justify a purchase price.

IR, I take your point though I don’t fully agree. While there will be short-term performance exceptions, basing a decision on mean historical growth rates seems more sensible than to assume none at all. Also, doing so may subject one to something like to opposite of winner’s curse – likely, you will always value properties lower than anyone else. In a market with a normal level of inventory, this may be a good value-hunting strategy, but in a thin market it may ensure that you will never close a deal. I am trying to bear in mind that normally one is competing against buyers who are at best making a calculation based on trailing comps. Ponzi-schemers for the most part were not making the mistake of over-estimating long-term renatl growth, but rather short-term appreciation. Nor do I think that this is a matter of rent eventually catching up and aligning to asking price. For most people, owning is superior (or so they feel when making the decision, as with having children they tend to discount future work, expense, and risk). We all know the reasons people feel this way, so let’s just say that there is an emotional component that in some markets buyers are consistently willing to pay a premium for (more pointedly, perhaps the more wealthy one is, the more one is willing / able to pay for the privilege of being able to tell the rest of the world to go f**k itself and assert one’s “personal style”; a “premium market” behavior. And with all due respect to your professor, the Finance professor in my MBA program (a well respected guy who also taught at LSE) an I came to loggerheads on daily basis over the egghead mumblings of Fama and the academic fraud that is most of the “efficient markets hypothesis”. I wonder what he’s babbling now. (I actually at this point I was to no avail hounding James Montier for a job, but that’s another story.)

Maybe we can grudgingly split the difference. Even if one makes the extremely conservative assumption of zero rent growth over 10 years, the amortization schedule alone ensures that the ratio will change. I don’t think this is a case of “hoping that the deal will make sense tomorrow”, as you are entering into a long-term stream of cash flows, even if you aren’t certain about when this arrangement will terminate, and most of those cash flows are of a time and amount certain.

I think your method would lead a novice real estate investor to settle for deals that aren’t necessarily that good. Part of being successful in this game is finding the deals that make overwhelming sense without any help from amortization or assumed future growth rates. Sometimes the best course of action is to stay out of the market altogether, and I think only Larry’s method will allow an investor to clearly see when those times are.

jimmy has been commenting on real estate blogs for years, and I know he was buying properties late into the bubble and for the longest time wouldn’t admit that prices in the high end zip codes had taken a hit. Only recently did he finally concede that, yes, Corona Del Mar took a hit when things crashed. I like the perspective that jimmy brings to this blog, but you need to recognize that he is pursuing a high risk / high reward strategy. If something does go wrong, cashflow will not bail him out. Larry’s advice is a solid low risk, sleep-well-at-night kind of strategy that will still yield some nice rewards.

Mellow, thanks for your comments. However, I am struggling to see how introducing amort increases risk, as this is a certainty. The part that is risk is that rents won’t actually decrease, but in that case the amort is still a known.

I suppose the issue that I’m struggling with above all is reconciling Larry’s belief (to which I subscribe) that the market will likely drift upward another 20% over several years) with the reality that using this conservative model, there is nothing one will be able to close a deal on, at least in prime / near prime locations.

I don’t think amortization increases risk (it actually decreases it), but if you are relying on amortization for a deal to pencil out, it’s probably not a good deal. It means you are paying too much. A good rule of thumb is to find properties where the monthly rent = 1% of purchase price. Larry’s new property search calculator will make searching for these types of properties easier. Most of them will not be in beach zip codes.

jimmy’s strategy is based on investing in properties where there is the potential to add value in the form of tearing down the existing shack to build a mansion. He’s banking on the fact that the wealthy will always pay a premium for these teardown lots so they can build their dream homes. Cashflow and amortization don’t factor in to his decision so much as the desirability of the location and the teardown potential. This is a very narrow and specific niche that the usual rules of RE investing are not going to apply to due to the value added nature of the opportunity.

Mellow, your comments get right to the heart of the matter. I’m not a speculator, I’m looking to buy in a near-prime area as and owner-occupier and using this calculation to avoid overpaying. (In truth, as I sometimes travel for several months at a time for my work, I will sometimes lease it for short periods). But I cannot imagine that condos have ever (or ever will) gross yield 12pct PA in the areas that I’m looking at. For example, a Sunset Strip-area property which would lease at $3500 doesn’t go at $350K – more like $600K. Same in the safer parts of Hollywood, Hancock park and Larchmont. Maybe I’m wrong, but I don’t think this is far off the historical yield. It is the owner-occupier part which complicates the issue. If it were pure investment, I would buy in West Chester or Torrance and be done with it.

For owner occupied, I would calculate the after tax cost of ownership INCLUDING principal, interest, taxes, & insurance and see how it compares to rent. Most likely, it will be higher than rent even after tax deductions, but at that point you can decide how much of a monthly premium you are willing to pay for this consumer item you are buying.

Maybe Im being thick, but I don’t see why this should change the calculation. Either rent it to myself, or to someone else. The yield is the same. Maybe the trick is to only buy in a “normal” area as investment and to rent in the near-term prime area with its attendant low yields.

I think you can accept a lower return when renting to yourself because you get the benefit of shelter (a dividend of sorts).

I am getting shelter when I rent. I see this as a “control premium” – I can decorate to taste, and now one can sell the property from under me forcing me to move. That’s about it. However, accepting a lower yield = paying more for the rental cash flow, which means I should be willing to pay more than a *sensible* investor, no?

Well, when it comes to any consumer item, if you plan to use the item temporarily, it makes better financial sense to rent. If you plan to use it long term, it usually makes sense to buy assuming you can pay a reasonable price.