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McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Chapter 14: Disposition and Renovation of

Income Properties

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Disposition DecisionsDisposition Decisions Disposition Consideration

– Changes in expectations over an anticipated holding periodMarket rent problemsTax law changes

– Equity build-upThere is an opportunity cost of not selling the

property. Over time, the equity that is built up represents substantial buying power that could be redeployed to buy additional properties.

Reduced interest payments and lower tax deduction

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Disposition DecisionsDisposition Decisions

Decision Rule: Property Disposition– What can the investor net if the property is

sold today?– What is the future expected performance of

the property for the current investor if not sold?

– Should the property be sold and the funds invested in another property?

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Disposition DecisionsDisposition Decisions

Expected cash flows are adjusted for current expectations– New rental income growth rate assumptions.– Original cost and depreciation stay in place.– Tax rates change to reflect current laws.– Mortgage and interest stay the same.– What is the expected future sale price of the

property?

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Disposition DecisionsDisposition Decisions

If the investor will net $100,000 after all taxes and expenses if the property is sold today, can it be invested and earn a greater return than if the property is not sold?

Basically, it’s a matter of comparing future streams of cash flow.

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Disposition DecisionsDisposition Decisions

The future expected net cash flows for a three-year holding period are– ATCF0 = ($100,000)

– ATCF1 = $10,000

– ATCF2 = $11,000

– ATCF3 = $12,000

– ATCF3(sale) = $103,000

– Compute IRR = 11.82%

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Disposition DecisionsDisposition Decisions

The ATIRR = 11.82% is what the investor gives up by selling the property and taking $100,000 today.

Is there an investment of comparable risk that can earn a greater ATIRR?– If yes, the sale is justified. – If not, property should be held onto.

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Disposition DecisionsDisposition Decisions

Return to a New Investor– New investor has a new adjusted basis in the

property.– New investor depreciates the property based on

current tax law.– The point is that changes in tax law can influence sale

decisions as it may favor new investors more or less favorably.

What can a new investor earn given the changes?– Compute an ATIRR for the new investor.

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Disposition DecisionsDisposition Decisions

Marginal Rate of Return– Property Disposition:

Evaluate disposition for a one-year holding period. Repeat the evaluation for subsequent one-year holding

periods. This generates a series of marginal returns based on one-

year holding periods.

)(

)()1()1(

tATCF

tATCFtATCFtATCFMRR

S

SOS

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Disposition DecisionsDisposition Decisions

Marginal Rate of Return– Disposition Rule:

Sell when MRR falls below assumed reinvestment rate for funds from property sale

Optimal holding period

– Reinvestment Rate:Could be constant or could change with overall

market conditionsShould reflect market rates and return on

alternative investments

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Exhibit 14-9Exhibit 14-9Holding Period AnalysisHolding Period Analysis

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Exhibit 14-10Exhibit 14-10Holding Period AnalysisHolding Period Analysis

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Disposition DecisionsDisposition Decisions Refinancing as an Alternative

– Increase the current LTV ratio by refinancing Provides additional funds to invest

– Incremental cost of refinancingWhat are the additional funds obtained by

refinancing?What are the additional cash outflows?Solve for i: can this be earned or borrowed funds?

– Diversification benefits from reinvesting loan proceeds

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Disposition DecisionsDisposition Decisions

Tax Deferral Strategies upon Disposition– Installment Sale

In essence, a form of “seller financing”Profit ratioContract price

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Tax Deferral StrategiesTax Deferral Strategies

Tax Deferral Strategies upon Disposition– Like kind or tax free exchange

Also known as a “1031 exchange”. It is so named because it is a creation of Section 1031 of the United States tax code.

Specific time frames must be establishedSafe harbor rules

∙ Qualified escrow accounts, trusts, and intermediaries

Balancing equities∙ Unrecognized gain = realized gain – boot

Reverse exchanges are also possible

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Disposition DecisionsDisposition Decisions Renovation as an alternative

– What are economic trends? Is property improvement justified?

∙ Enlarged or quality upgradedShould it be converted?

∙ Alternative use to reflect market changes

– What is the renovation cost?Does it require additional equity?What are available financing sources?

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Disposition DecisionsDisposition Decisions

Renovation as an alternative – Calculate the incremental change in the

expected future operating cash flows.– Calculate the incremental change in the future

expected selling price of the property.– Determine the IRR on the additional equity

investment.– Compare the IRR to alternative equivalent risk

investments.

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Disposition DecisionsDisposition Decisions

Additional Considerations– Combined renovation and refinancing– Portfolio balancing– Rehabilitation Investment Tax Credits

Dollar for dollar reduction in taxes10% credit if placed into service before 1936, 20%

if certified historic structure

– Low-Income Housing Tax CreditCreation of Tax Reform Act of 1986