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PERSONAL
FINANCE FOR
ENGINEERS
CS 007: SESSION 9
REAL ESTATE
CS 007
WHY DOES REAL ESTATE MATTER?
• People need a place to live


• The largest financial
commitment that most
households in the US make.


• It has a complicated & arcane
purchase process


• For many it is the largest
portion of their net worth.


• Significant portion of national
(and international) wealth.
BUYING REAL ESTATE
why & how
WHY DO PEOPLE BUY (VS. RENT) REAL ESTATE?
• Need a place to live


• They are looking for control
over where they live for a
long period of time.


• They have an emotional
attachment to the idea of
owning a place to live.


• They believe it is a good
investment
HOW IS REAL ESTATE BOUGHT & SOLD?
• Typically a brokered transaction. US
standard is 6% of the sales price is
split between real estate agents.


• Average home takes 35 days to sell
as of July 2020, down from 37 in
July 2019. (2018: 35, 2017: 39)*

• Significant costs involved, for both
buyer & seller.


• Significant due diligence is required
by all parties.


• Heavily regulated process.
* https://www.redfin.com/blog/data-center
WHAT ARE THE IMMEDIATE COSTS FOR BUYERS?
• Down payment. Typically 20% of the
total purchase price. Otherwise, often
need mortgage insurance.


• Closing costs. Average of 2-5% closing
costs for buyers in the US ($3,700)*
* https://www.zillow.com/mortgage-learning/closing-costs/
Direct Costs
Implicit Costs
• Opportunity cost. There are alternate
uses for that capital, for example, in a
long-term diversified portfolio.


• Liquidity cost. Very difficult /
expensive to access that capital once
locked in.
WHAT ARE THE ONGOING COSTS FOR BUYERS?
• Property Tax. Varies by state / locality,
typically ~1% of property value per yr.


• Home Insurance. Average of ~$1000
per year in the US, varies with value of
the home.


• Mortgage. While some of the payment
is principal, interest is a significant
expense.


• Home Owners Association (HOA). If a
condo / community, a monthly payment
for common services that can rise
annually.


• Maintenance. Owners can easily spend
1% of the value of the house every year.
HOW DO YOU GET A MORTGAGE?
* https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/
• Most banks base mortgage qualification on
two factors.


• Do you have access to the down
payment? (assets)


• Will your income cover the expected
monthly expenses associated with a
house


(liabilities & income)


• Debt / income ratio of 43% is limit in the US for
a qualified mortgage (higher in some parts of
the country)


• Fixed vs. Adjustable Rate (ARM)


30-Year Fixed or 5/1 ARM


• Closing costs vs. interest rate


• 14 day period to shop to minimize impact to
credit score, which can be significant.
RENTING
benefits & costs
WHY DO PEOPLE RENT (VS. BUY) REAL ESTATE?
• Need a place to live


• They are looking for flexibility
in where they live.


• They have an emotional fear of
the idea of committing to a long
term location and/or large
financial commitment.


• They lack the financial
resources to purchase.


• Financial management of cash
flow is much simpler.
WHAT DO YOU NEED TO RENT REAL ESTATE?
• Find a landlord with a property that meets
your needs and is available for rent.


• Damage deposit, often equal to one
month’s rent.


• In some cases, 1-2 months rent up front.


• Landlords can require application process,
credit score, references, criminal records,
financials.


• Legal rights for tenants vary significantly
by state & locality.


• Landlords must apply application
standards uniformly without bias or
discrimination.
WHAT ARE THE MAJOR COSTS FOR RENTERS?
• Application Fee


• Security Deposit. Typically 1-2 months of
rent.


• First Month’s Rent.


• Moving Costs.
Immediate Costs
Ongoing Costs
• Utilities. Electricity, Gas, Water, Cable.


• Renters Insurance. ~$150 per year in US.


• Parking. In urban areas, there can be a
separate charge.


• Yard Maintenance.


• Rent increases. Can vary unpredictably.
BUY VS. RENT
one of largest financial decisions
BIG DECISION, STRONG EMOTIONS
• Significant non-financial considerations.


• High transaction costs mean purchasing
real estate is very risky over short
periods of time.


• Fixed location can significantly limit
career opportunities.


• Social connection of community &
schools significant.


• For most people, it’s the largest
investment in their lifetime.


• Some people have strong political
beliefs about renting vs. buying.
FINANCIAL BENEFITS OF RENTING
• Liquidity. Your capital is not tied up in a large
down payment, and you are not forced to make
large principal payments.

• Location Flexibility. You have significant
flexibility to move to a new location as needed.


• Diversification. Concentrating most of your
wealth in one asset has a number of
concentrated risks.


• Avoid Geographical Market Risk. Buying a home
in Silicon Valley turned out great in the past 50
years. Detroit didn’t. Hard to predict the future.


• Maintenance. Most costs tied to the ownership
of the property are pushed to the owner. No
need to plan for large expenses (e.g. new roof)


• Competitive Market. In most cases, rents move
with wage inflation. Ideally, you have competition
between landlords in terms of quality & price.
FINANCIAL BENEFITS OF OWNING
• Leveraged Investment. Most of the investment
is made with an inexpensive loan, with leverage
of 5x (or more). Gains accrue to the owner, not
the bank.


• Tax Advantages. Mortgage interest & property
taxes are deductible. Capital improvements are
included in the cost basis of the home.

• Long term investment. Real estate has, on
average, had a positive return above inflation
with relatively low volatility compared to other
asset classes.


• Financial Control. Owners can control what
investments they make in the property, and at
what price, to increase long term return. (e.g.
remodel a kitchen)


• Optional Additional Income. In many cases,
there is a long term option to rent the property.
Rental income rises with inflation.
RENT VS. BUY: EXAMPLE (MONTHLY COSTS)
• Rent: $5,235 / mo

• Renter’s Ins: $400 / mo
• Purchase Price: $1.1M


• Down Payment: $220K


• Mortgage: $880K @ 3.5%


• Marginal Tax Rate: 40%


RENT
BUY
2 BEDROOM APARTMENT IN MOUNTAIN VIEW 2017 (1140 SQ FT)
* Mortgage interest is based off the first month’s payment, and will decrease every month.
NOTE: DEDUCTIBILITY OF MORTGAGE
INTEREST & PROPERTY TAX MATTERS
RENT VS. BUY: EXAMPLE (LONG TERM VALUE)
• Opportunity Cost. Need to example
what your return would have been on
down payment if invested separately.


• Long Term Costs. There are significant
investments that must be made
periodically.


• Transaction Costs. Selling the property
typically has costs of 6-8%.


• Mortgage Drop Off. Paid over time,
potential interest rate risk if you don’t
get a 30 year loan.


• Capital Gain. Need to project likely
sale price, which has significant
uncertainty.
* https://www.zillow.com/palo-alto-ca/home-values/
NO ONE SHOULD EXPECT PALO ALTO REAL ESTATE TO BE THE NORM
😳
WHY DOES REAL ESTATE CREATE WEALTH FOR MOST PEOPLE?
• Forced savings


• Down payment is locked away, cannot
easily be spent.


• Principal payments in mortgage are a form
of forced savings.


• Both amounts are significant relative to
most buyers income.


• Leveraged Investment. Most of the investment
is made with an inexpensive loan, with leverage
of 5x (or more). Gains accrue to the owner, not
the bank.


• Positive long term investment. Over the past 7
decades, real estate has had a positive return
over inflation.


• Long time frames. The holding period for most
investors is fairly short. People own homes for
longer periods, on average, giving more time for
value to compound.
INVESTING IN REAL ESTATE
historical data, approaches, pros & cons
REAL ESTATE
• Real estate is a combination of
land & facilities that occupy
that land.


• Investment real estate typically
excludes your primary
residence.


• Returns based both on rental
income & capital appreciation.


• Real Estate Investment Trusts
(REITs) trade on the public
markets.
COMMON WAYS TO INVEST
• With over 100 years of data,
price trends on different asset
classes are fairly clear.


• Real return is return net of
inflation, which measures how
money devalues over time. (in
this chart, dollars)


• Stocks have the highest
annualized return over long time
periods, but also higher volatility.


• … but are US Home Prices the
best metric for real estate?
* http://www.econlib.org/library/Enc/StockMarket.html
HISTORY OF REAL ESTATE VS. OTHER ASSET CLASSES
• Still significant debate in financial community,
based on different time periods, geographies &
sub-sectors of real estate.

• Return is based on both capital appreciation
and value from rent.


• Based on recent paper (still actively debated),
global real estate seems to have offered real
returns comparable to equities, with lower
volatility. US numbers appear lower than
equities, but above bills & bonds.


• REITs seem to confirm this, as 1970-2015 return
from US REITs is comparable to US Equities
(less tax efficient, however)


• Remember: averages don’t necessarily
describe what any single investment will do!
https://www.frbsf.org/economic-research/files/wp2017-25.pdf
https://www.investopedia.com/ask/answers/060415/what-average-annual-return-typical-long-term-investment-real-estate-sector.asp
REAL RETURN OF EQUITIES VS. HOUSING (BY DECADE)
https://www.frbsf.org/economic-research/files/wp2017-25.pdf
RISK / RETURN OF EQUITIES VS. HOUSING
https://www.frbsf.org/economic-research/files/wp2017-25.pdf
RENTAL PROPERTIES
rationale, financial costs & benefits
WHAT IS A RENTAL PROPERTY?
• Any property owned with
the purpose of leasing to a
tenant for income.

• Wide variety of units,
ranging from single family
homes to apartments.


• Can be residential or
commercial properties.
FINANCIAL DETAILS FOR RENTAL PROPERTIES
• Purchasing a rental property is
similar to purchasing a property for
occupancy.


• Mortgage qualification is different,
and typically results in higher rates.


• Tax treatment is more like a business
(depreciation, income, expenses)


• Capitalization Rate: Rate of return
of income vs. market value




cap rate = income / market value
WHY DO PEOPLE LOVE RENTAL PROPERTIES?
• People are often very emotional about the
benefits of owning rental properties.


• Most fixed costs for real estate are up front, while
rental income grows with inflation over time.


• The process of paying off the mortgage can leave
an asset that generates inflation-adjusted income.


• It typically evolves organically from owning
property.


• Most people have direct experience with both the
costs of ownership & the process of renting.


• Many people feel like it is more transparent &
tangible vs. financial assets / markets.


• It has some of the psychological benefits (and
costs) of owning your own business.
PROBLEMS WITH RENTAL PROPERTIES
• Time. This is another job. Unpredictable &
significant commitment at times.


• Cash flow. Very easy to make an
investment that will be profitable long
term, but cash flow negative in short term.


• Occupancy. Vacancy can be expensive &
unpredictable.


• People. Managing ongoing relationship
with tenants, finding new tenants, etc.


• Legal Issues. Significant regulations &
requirements around tenant rights.
Eviction can be extremely difficult &
expensive.
REAL ESTATE


TAX ADVANTAGES
REAL ESTATE HAS SIGNIFICANT TAX ADVANTAGES
• Primary Residence


• Mortgage Interest Deduction


• Property Tax Deduction

• $250K Capital Gain Exclusion


• Investment Properties


• Prop 13 (California)


• Mortgage Interest


• Property Tax


• Depreciation


• Expenses


• 1031 Exchanges


• Capital gains taxes only due on sale


• Step Up Cost Basis for Heirs
QUESTIONS
CS 007
WEEK 10: PEOPLE’S CHOICE
• Student Selected Topics

• Final Thoughts


• CS 007 Alumni

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Personal finance guide to real estate investing

  • 3. WHY DOES REAL ESTATE MATTER? • People need a place to live • The largest financial commitment that most households in the US make. • It has a complicated & arcane purchase process • For many it is the largest portion of their net worth. • Significant portion of national (and international) wealth.
  • 5. WHY DO PEOPLE BUY (VS. RENT) REAL ESTATE? • Need a place to live • They are looking for control over where they live for a long period of time. • They have an emotional attachment to the idea of owning a place to live. • They believe it is a good investment
  • 6. HOW IS REAL ESTATE BOUGHT & SOLD? • Typically a brokered transaction. US standard is 6% of the sales price is split between real estate agents. • Average home takes 35 days to sell as of July 2020, down from 37 in July 2019. (2018: 35, 2017: 39)* • Significant costs involved, for both buyer & seller. • Significant due diligence is required by all parties. • Heavily regulated process. * https://www.redfin.com/blog/data-center
  • 7. WHAT ARE THE IMMEDIATE COSTS FOR BUYERS? • Down payment. Typically 20% of the total purchase price. Otherwise, often need mortgage insurance. • Closing costs. Average of 2-5% closing costs for buyers in the US ($3,700)* * https://www.zillow.com/mortgage-learning/closing-costs/ Direct Costs Implicit Costs • Opportunity cost. There are alternate uses for that capital, for example, in a long-term diversified portfolio. • Liquidity cost. Very difficult / expensive to access that capital once locked in.
  • 8. WHAT ARE THE ONGOING COSTS FOR BUYERS? • Property Tax. Varies by state / locality, typically ~1% of property value per yr. • Home Insurance. Average of ~$1000 per year in the US, varies with value of the home. • Mortgage. While some of the payment is principal, interest is a significant expense. • Home Owners Association (HOA). If a condo / community, a monthly payment for common services that can rise annually. • Maintenance. Owners can easily spend 1% of the value of the house every year.
  • 9. HOW DO YOU GET A MORTGAGE? * https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/ • Most banks base mortgage qualification on two factors. • Do you have access to the down payment? (assets) • Will your income cover the expected monthly expenses associated with a house 
 (liabilities & income) • Debt / income ratio of 43% is limit in the US for a qualified mortgage (higher in some parts of the country) • Fixed vs. Adjustable Rate (ARM) 
 30-Year Fixed or 5/1 ARM • Closing costs vs. interest rate • 14 day period to shop to minimize impact to credit score, which can be significant.
  • 11. WHY DO PEOPLE RENT (VS. BUY) REAL ESTATE? • Need a place to live • They are looking for flexibility in where they live. • They have an emotional fear of the idea of committing to a long term location and/or large financial commitment. • They lack the financial resources to purchase. • Financial management of cash flow is much simpler.
  • 12. WHAT DO YOU NEED TO RENT REAL ESTATE? • Find a landlord with a property that meets your needs and is available for rent. • Damage deposit, often equal to one month’s rent. • In some cases, 1-2 months rent up front. • Landlords can require application process, credit score, references, criminal records, financials. • Legal rights for tenants vary significantly by state & locality. • Landlords must apply application standards uniformly without bias or discrimination.
  • 13. WHAT ARE THE MAJOR COSTS FOR RENTERS? • Application Fee • Security Deposit. Typically 1-2 months of rent. • First Month’s Rent. • Moving Costs. Immediate Costs Ongoing Costs • Utilities. Electricity, Gas, Water, Cable. • Renters Insurance. ~$150 per year in US. • Parking. In urban areas, there can be a separate charge. • Yard Maintenance. • Rent increases. Can vary unpredictably.
  • 14. BUY VS. RENT one of largest financial decisions
  • 15. BIG DECISION, STRONG EMOTIONS • Significant non-financial considerations. • High transaction costs mean purchasing real estate is very risky over short periods of time. • Fixed location can significantly limit career opportunities. • Social connection of community & schools significant. • For most people, it’s the largest investment in their lifetime. • Some people have strong political beliefs about renting vs. buying.
  • 16. FINANCIAL BENEFITS OF RENTING • Liquidity. Your capital is not tied up in a large down payment, and you are not forced to make large principal payments. • Location Flexibility. You have significant flexibility to move to a new location as needed. • Diversification. Concentrating most of your wealth in one asset has a number of concentrated risks. • Avoid Geographical Market Risk. Buying a home in Silicon Valley turned out great in the past 50 years. Detroit didn’t. Hard to predict the future. • Maintenance. Most costs tied to the ownership of the property are pushed to the owner. No need to plan for large expenses (e.g. new roof) • Competitive Market. In most cases, rents move with wage inflation. Ideally, you have competition between landlords in terms of quality & price.
  • 17. FINANCIAL BENEFITS OF OWNING • Leveraged Investment. Most of the investment is made with an inexpensive loan, with leverage of 5x (or more). Gains accrue to the owner, not the bank. • Tax Advantages. Mortgage interest & property taxes are deductible. Capital improvements are included in the cost basis of the home. • Long term investment. Real estate has, on average, had a positive return above inflation with relatively low volatility compared to other asset classes. • Financial Control. Owners can control what investments they make in the property, and at what price, to increase long term return. (e.g. remodel a kitchen) • Optional Additional Income. In many cases, there is a long term option to rent the property. Rental income rises with inflation.
  • 18. RENT VS. BUY: EXAMPLE (MONTHLY COSTS) • Rent: $5,235 / mo • Renter’s Ins: $400 / mo • Purchase Price: $1.1M • Down Payment: $220K • Mortgage: $880K @ 3.5% • Marginal Tax Rate: 40% RENT BUY 2 BEDROOM APARTMENT IN MOUNTAIN VIEW 2017 (1140 SQ FT) * Mortgage interest is based off the first month’s payment, and will decrease every month. NOTE: DEDUCTIBILITY OF MORTGAGE INTEREST & PROPERTY TAX MATTERS
  • 19. RENT VS. BUY: EXAMPLE (LONG TERM VALUE) • Opportunity Cost. Need to example what your return would have been on down payment if invested separately. • Long Term Costs. There are significant investments that must be made periodically. • Transaction Costs. Selling the property typically has costs of 6-8%. • Mortgage Drop Off. Paid over time, potential interest rate risk if you don’t get a 30 year loan. • Capital Gain. Need to project likely sale price, which has significant uncertainty. * https://www.zillow.com/palo-alto-ca/home-values/ NO ONE SHOULD EXPECT PALO ALTO REAL ESTATE TO BE THE NORM 😳
  • 20. WHY DOES REAL ESTATE CREATE WEALTH FOR MOST PEOPLE? • Forced savings • Down payment is locked away, cannot easily be spent. • Principal payments in mortgage are a form of forced savings. • Both amounts are significant relative to most buyers income. • Leveraged Investment. Most of the investment is made with an inexpensive loan, with leverage of 5x (or more). Gains accrue to the owner, not the bank. • Positive long term investment. Over the past 7 decades, real estate has had a positive return over inflation. • Long time frames. The holding period for most investors is fairly short. People own homes for longer periods, on average, giving more time for value to compound.
  • 21. INVESTING IN REAL ESTATE historical data, approaches, pros & cons
  • 22. REAL ESTATE • Real estate is a combination of land & facilities that occupy that land. • Investment real estate typically excludes your primary residence. • Returns based both on rental income & capital appreciation. • Real Estate Investment Trusts (REITs) trade on the public markets.
  • 23. COMMON WAYS TO INVEST • With over 100 years of data, price trends on different asset classes are fairly clear. • Real return is return net of inflation, which measures how money devalues over time. (in this chart, dollars) • Stocks have the highest annualized return over long time periods, but also higher volatility. • … but are US Home Prices the best metric for real estate? * http://www.econlib.org/library/Enc/StockMarket.html
  • 24. HISTORY OF REAL ESTATE VS. OTHER ASSET CLASSES • Still significant debate in financial community, based on different time periods, geographies & sub-sectors of real estate. • Return is based on both capital appreciation and value from rent. • Based on recent paper (still actively debated), global real estate seems to have offered real returns comparable to equities, with lower volatility. US numbers appear lower than equities, but above bills & bonds. • REITs seem to confirm this, as 1970-2015 return from US REITs is comparable to US Equities (less tax efficient, however) • Remember: averages don’t necessarily describe what any single investment will do! https://www.frbsf.org/economic-research/files/wp2017-25.pdf https://www.investopedia.com/ask/answers/060415/what-average-annual-return-typical-long-term-investment-real-estate-sector.asp
  • 25. REAL RETURN OF EQUITIES VS. HOUSING (BY DECADE) https://www.frbsf.org/economic-research/files/wp2017-25.pdf
  • 26. RISK / RETURN OF EQUITIES VS. HOUSING https://www.frbsf.org/economic-research/files/wp2017-25.pdf
  • 28. WHAT IS A RENTAL PROPERTY? • Any property owned with the purpose of leasing to a tenant for income. • Wide variety of units, ranging from single family homes to apartments. • Can be residential or commercial properties.
  • 29. FINANCIAL DETAILS FOR RENTAL PROPERTIES • Purchasing a rental property is similar to purchasing a property for occupancy. • Mortgage qualification is different, and typically results in higher rates. • Tax treatment is more like a business (depreciation, income, expenses) • Capitalization Rate: Rate of return of income vs. market value 
 
 cap rate = income / market value
  • 30. WHY DO PEOPLE LOVE RENTAL PROPERTIES? • People are often very emotional about the benefits of owning rental properties. • Most fixed costs for real estate are up front, while rental income grows with inflation over time. • The process of paying off the mortgage can leave an asset that generates inflation-adjusted income. • It typically evolves organically from owning property. • Most people have direct experience with both the costs of ownership & the process of renting. • Many people feel like it is more transparent & tangible vs. financial assets / markets. • It has some of the psychological benefits (and costs) of owning your own business.
  • 31. PROBLEMS WITH RENTAL PROPERTIES • Time. This is another job. Unpredictable & significant commitment at times. • Cash flow. Very easy to make an investment that will be profitable long term, but cash flow negative in short term. • Occupancy. Vacancy can be expensive & unpredictable. • People. Managing ongoing relationship with tenants, finding new tenants, etc. • Legal Issues. Significant regulations & requirements around tenant rights. Eviction can be extremely difficult & expensive.
  • 33. REAL ESTATE HAS SIGNIFICANT TAX ADVANTAGES • Primary Residence • Mortgage Interest Deduction • Property Tax Deduction • $250K Capital Gain Exclusion • Investment Properties • Prop 13 (California) • Mortgage Interest • Property Tax • Depreciation • Expenses • 1031 Exchanges • Capital gains taxes only due on sale • Step Up Cost Basis for Heirs
  • 35. WEEK 10: PEOPLE’S CHOICE • Student Selected Topics • Final Thoughts • CS 007 Alumni