1. ©2008 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 14: Disposition and Renovation of Income Properties

2. 14-2 Disposition Decisions  Disposition Consideration –Changes in expectations over an anticipated holding period  Market rent problems  Tax law changes –Equity build-up  There 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

3. 14-3 Disposition 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?

4. 14-4 Disposition 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?

5. 14-5 Disposition 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.

6. 14-6 Disposition Decisions  The future expected net cash flows for a three-year holding period are –ATCF 0 = ($100,000) –ATCF 1 = $10,000 –ATCF 2 = $11,000 –ATCF 3 = $12,000 –ATCF 3 (sale) = $103,000 –Compute IRR = 11.82%

7. 14-7 Disposition 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.

8. 14-8 Disposition 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.

9. 14-9 Disposition 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.

10. 14-10 Disposition 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 conditions  Should reflect market rates and return on alternative investments

11. 14-11 Exhibit 14-9 Holding Period Analysis

12. 14-12 Exhibit 14-10 Holding Period Analysis

13. 14-13 Disposition Decisions  Refinancing as an Alternative –Increase the current LTV ratio by refinancing  Provides additional funds to invest –Incremental cost of refinancing  What 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

14. 14-14 Disposition Decisions  Tax Deferral Strategies upon Disposition –Installment Sale  In essence, a form of “seller financing”  Profit ratio  Contract price

15. 14-15 Tax 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 established  Safe harbor rules ∙Qualified escrow accounts, trusts, and intermediaries  Balancing equities ∙Unrecognized gain = realized gain – boot  Reverse exchanges are also possible

16. 14-16 Disposition Decisions  Renovation as an alternative –What are economic trends?  Is property improvement justified? ∙Enlarged or quality upgraded  Should it be converted? ∙Alternative use to reflect market changes –What is the renovation cost?  Does it require additional equity?  What are available financing sources?

17. 14-17 Disposition 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.

18. 14-18 Disposition Decisions  Additional Considerations –Combined renovation and refinancing –Portfolio balancing –Rehabilitation Investment Tax Credits  Dollar for dollar reduction in taxes  10% credit if placed into service before 1936, 20% if certified historic structure –Low-Income Housing Tax Credit  Creation of Tax Reform Act of 1986