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Sidi

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Buy or rent house case question

Hi everybody, how would you structure the following case?

"You want to advise your mother on whether buying a house for 300k$ or rent one at 800$/month. She has 300k$ in her bank account"

I think this is the classic investment analysis between two options, so I would ask some more questions about the woman's income, other constraints, extra costs deriving from the two options, willingness to invest that amount of money elsewhere in the rent scenario.

All that said, I would assume that the observation period is 20 years (assuming the woman is at age 60 with 80 years of life expectancy), and I would proceed in calculating the NPV of the two options.

At this stage I have some doubts about the usage of the discount rate (should I apply it or should I consider that house-related prices would simply "adjust" during time?).

How would you go further in the case?

Thanks in advance

Hi everybody, how would you structure the following case?

"You want to advise your mother on whether buying a house for 300k$ or rent one at 800$/month. She has 300k$ in her bank account"

I think this is the classic investment analysis between two options, so I would ask some more questions about the woman's income, other constraints, extra costs deriving from the two options, willingness to invest that amount of money elsewhere in the rent scenario.

All that said, I would assume that the observation period is 20 years (assuming the woman is at age 60 with 80 years of life expectancy), and I would proceed in calculating the NPV of the two options.

At this stage I have some doubts about the usage of the discount rate (should I apply it or should I consider that house-related prices would simply "adjust" during time?).

How would you go further in the case?

Thanks in advance

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Hi Lorenzo,

here I would radically simplify in order to showcase a clear line of thinking! So this is what I would align/double check with the interviewer:

1. Time horizon of 20 years

2. Basic living expenditures can be covered by her running income (making sure that spending the $300k is actually an option!)

3. Constant real estate value of the house

4. No financial structure design (e.g., leveraging up via debt financing) considered

This means that it is all about the objectives of your mother. Does she want to maximize personal conumption over the next 20 years, or does she want to pass on a significant asset base to her children?

  • Renting: The total cost of $800*12months*20years= $192,000 leaves room for additional consumption worth $108,000 over the 20 years time span. So her asset base at the end of the 20 years will be a cash amount of anything between $0 (full additional consumption, nothing is passed on) and $108,000 (no additional consumption, full amount is passed on).
  • Buying: if she buys the house, her asset base remains nominally unchanged, it just transforms from $300,000 cash to $300,000 real estate property. There is no room for additional consumption beyond basic living expenditures. Her asset base at the end of the 20 years will still be $300,000, which she passes on.

You may want to point out that, given how the question is framed, you would advise your mother based on HER objectives, not on yours (hint hint: "Client first" ;)) )

Cheers, Sidi

Hi Lorenzo,

here I would radically simplify in order to showcase a clear line of thinking! So this is what I would align/double check with the interviewer:

1. Time horizon of 20 years

2. Basic living expenditures can be covered by her running income (making sure that spending the $300k is actually an option!)

3. Constant real estate value of the house

4. No financial structure design (e.g., leveraging up via debt financing) considered

This means that it is all about the objectives of your mother. Does she want to maximize personal conumption over the next 20 years, or does she want to pass on a significant asset base to her children?

  • Renting: The total cost of $800*12months*20years= $192,000 leaves room for additional consumption worth $108,000 over the 20 years time span. So her asset base at the end of the 20 years will be a cash amount of anything between $0 (full additional consumption, nothing is passed on) and $108,000 (no additional consumption, full amount is passed on).
  • Buying: if she buys the house, her asset base remains nominally unchanged, it just transforms from $300,000 cash to $300,000 real estate property. There is no room for additional consumption beyond basic living expenditures. Her asset base at the end of the 20 years will still be $300,000, which she passes on.

You may want to point out that, given how the question is framed, you would advise your mother based on HER objectives, not on yours (hint hint: "Client first" ;)) )

Cheers, Sidi

(edited)

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Hi,

Agree with Sidi. Don't forget about adding things like:

  • The Total Cost of Ownership - e.g. how much you will invest in improvements during the lifetime of a house
  • Additional cost savings - e.g. if the rented house will be in a better location and you can save on transportation
  • The Fair Value of Assets - e.g. in the future the land price might blow up because there will be a new district built around

Best

Hi,

Agree with Sidi. Don't forget about adding things like:

  • The Total Cost of Ownership - e.g. how much you will invest in improvements during the lifetime of a house
  • Additional cost savings - e.g. if the rented house will be in a better location and you can save on transportation
  • The Fair Value of Assets - e.g. in the future the land price might blow up because there will be a new district built around

Best

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