McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER14CHAPTER14 CHAPTER14CHAPTER14 Disposition and Renovation of Income Properties

14-2 Copyright ©2008 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 Opportunity Cost of not selling the property Reduced interest payments and lower tax deduction

14-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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?

14-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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?

14-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Estimate of From Sale Today

14-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Pro Forma For Next 5 Years

14-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Cash Flow From Sale in 5 Years

14-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Disposition Decisions The ATIRR = 15.60% is what the investor gives up by selling the property and taking $70,978 today. Is there an equivalent risk investment that can earn a greater ATIRR?  If yes, sale is justified  If not, property should be kept.

14-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 What can a new investor earn given the changes?  Compute an ATIRR for the new investor

14-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

14-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved

14-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Marginal Rate of Return for Next 10 Years

14-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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: Constant or rising Should reflect market rates and return on alternative investments

14-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Holding Period Analysis with Constant Reinvestment Rate

14-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Holding Period Analysis with Increasing Reinvestment Rate

14-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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?

14-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Pro Forma Assuming Renovation

14-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Incremental Return From Renovation