Chapter 14:
Disposition and Renovation of
Income Properties
McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies,
All Rights Reserved
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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
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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?
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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?
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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.
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Disposition 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 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 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 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 oneyear holding periods.
ATCFS (t  1)  ATCFO(t  1)  ATCFS (t )
MRR 
ATCFS (t )
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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
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Exhibit 14-9
Holding Period Analysis
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Exhibit 14-10
Holding Period Analysis
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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
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Disposition Decisions
 Tax Deferral Strategies upon Disposition
– Installment Sale
 In essence, a form of “seller financing”
 Profit ratio
 Contract price
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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
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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?
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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.
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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
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