RE3104

REIA
Disposition and Renovation of
Income Properties

RE3104 Semester 1

Disposition
Investment

climate changes over time

Evaluate time for disposition.

Equity building up over time = opportunity cost
of not selling the property = funds tied up with
the property.
Interest expense decreases each year for an
amortizing mortgage => any positive leverage
would decrease.

RE3104 Semester 1

Disposition Worked Example

Acquired

property 5 years ago at

$200,000.

75% financing, 11% p.a. 25-year amortizing loan.

Assume no depreciation allowance.
Tax @ 20%
Property can be sold today for $250,000.
Tax-deductible selling expense @ 6% of selling price.
Assume gain from sale is taxable.

RE3104 Semester 1

Compute Debt Service

Use

your calculator to work out the annual debt

service

N = 12 times 25 = 300
I/Y = 11
PV=-0.75 times 200,000=-150,000 (Loan Amount)
FV = 0 (fully-amortizing loan)
COMPUTE PMT
Answer = 1,470.17 per month or 17,642 per year.

RE3104 Semester 1

You have the following operating

CF
Year

NOI
Less DS
BTCF
Tax

2
19,500
17,642
1,858
?

3
20,280
17,642
2,638
?

4
21,091
17,642
3,449
?

5
21,935
17,642
4,293
?

To compute taxable income,

youd need to know interest
expense since interest expenses
are tax-deductible
RE3104 Semester 1

22,812
17,642
5,170
?

Calculate Taxable Income and

Taxes on CF from Operations
Year

NOI
Less
Interest
Expense

19,500
16,441

20,280
16,302

21,091
16,147

21,935
15,973

22,812
15,780

Taxable
income

3,059

3,978

4,944

5,962

7,032

612

796

989

1,192

1,406

Tax
@20%

RE3104 Semester 1

BTCF and ATCF from

Operations
Year
1
2
3
4
5
NOI
19,500 20,280 21,091 21,935 22,812
Less DS
17,642 17,642 17,642 17,642 17,642
BTCF

1,858

2,638

3,449

4,293

5,170

TI
Tax
ATCF

3,059
612
1,246

3,978
796
1,842

4,944
989
2,460

5,962
1,192
3,101

7,032
1,406
3,764

RE3104 Semester 1

Assume sale today (EOY5)

Sale Price

$250,000

Less Selling costs

Less Mortgage balance

15,000
142,432

N = 5*12 = 60
I/Y = 11%
PV = 0.75*$200,000 (Loan Amt.)
PMT = Debt Service

Solve for FV
RE3104 Semester 1

Compute BTER and ATER

(EOY5)
Sale Price

$250,000

Less Selling costs

15,000

Less Mortgage balance

142,432

BTER

92,568

Tax

ATER

RE3104 Semester 1

Compute Tax Due on Sale

EOY5
Gross Profit

50,000

Less sales expense

15,000

Chargeable Income

35,000

Tax @ 20%

7,000

RE3104 Semester 1

10

Compute CF from Sale at

EOY5
Sale Price

$250,000

Less Selling costs

15,000

Less Mortgage balance

142,432

BTER

92,568

Tax

7,000

ATER

85,568

RE3104 Semester 1

11

Cash Flow Summary

Assuming Sale Today (EOY5)
0

BTCF

-50,000 1,858

2,638

3,449

4,293 97,738

ATCF

-50,000 1,246

1,842

2,460

3,101 89,332

BTIRR

18.26%

ATIRR

15.14%

IRRsfrom
fromSale
SaleToday
Today
IRRs

RE3104 Semester 1

12

Discussion
ATER

of $85,568 is funds available for

reinvestment if the investor were to sell the
property immediately to acquire another.

RE3104 Semester 1

13

Alternatives to selling today

An

investor will typically weigh his options.

To sell today or to wait.

To sell today or to renovate (and hold).

DCF

can help us decide on the disposition

decision.

RE3104 Semester 1

14

Case 1: To sell today or to wait

(Holding versus Sale today)
To

determine whether to keep the property,

we must evaluate the expected future
performance of the property.
Suppose we were thinking of holding the
property for another 5 years (EOY10).

Same Debt Service (i.e. same loan since we are

not refinancing).

RE3104 Semester 1

15

Hold for 5 more years

Year

10

NOI

23,725

24,436

25,170

25,925

26,702

Less DS

17,642

17,642

17,642

17,642

17,642

BTCF

6,083

6,794

7,528

8,283

9,060

TI

8,160

9,112

10,113

11,168

12,279

Tax

1,632

1,822

2,023

2,234

2,456

ATCF

4,451

4,972

5,505

6,049

6,605

Suppose that at the end of another 5 years, the

property will sell for $289,819.
RE3104 Semester 1

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CF from Sale EOY10

Sale Price

289,819

Less Selling expense

Less Mortgage Balance
BTER
Chargeable Income
Tax @ 20%
ATER

17,389
129,348
143,082
72,430
14,486
128,596

RE3104 Semester 1

17

ATIRR on equity
Note

that if the property were sold EOY5, the

after tax equity reversion is $85,568.
Instead of utilizing this equity elsewhere, by
keeping the property for an additional 5
years, you are forgoing the opportunity to use
the equity on other investment/consumption.
$85,568 is the opportunity cost and must be
accounted for.
RE3104 Semester 1

18

ATIRR on equity
Year

ATCF - 85,568

7
4,451

8
4,972

9
5,505

10
6,049 135,201

ATIRR = 13.91%

RE3104 Semester 1

19

Discussion

How should we interpret the ATIRR of 13.91%?

Since the ATER of $85,568 is the amount available for
reinvestment. The investor must now consider whether
$85,568 can be reinvested at a greater rate of return than
the return that would be earned if the investment was not
sold. The sale is therefore justified if the funds from the
sale of the property EOY 5 is invested in an investment of
an equal risk and earns more than 13.91% of ATIRR on
equity.
13.91% is the hurdle rate. It is the minimum ATIRR that
would have to be earned on an alternative investment.

RE3104 Semester 1

20

Marginal Rate of Return

When

an investor is thinking of disposing the

property, he/she may wish to evaluate the
return for holding onto the investment for one
additional year.
Similar calculation as previously but project
only one additional year of operating cash
flow.
This one-year ATIRRe is the marginal rate of
return.
RE3104 REIA Semester 1, 2014

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Calculation of ATCF from Operations

Year

10

11

12

13

14

15

NOI

23,725

24,436

25,170

25,925

26,702

27,503

28,329

29,178

30,054

30,955

DS

17,642

17,642

17,642

17,642

17,642

17,642

17,642

17,642

17,642

17,642

6,083

6,794

7,528

8,283

9,060

9,861

10,687

11,536

12,412

13,313

1,632

1,822

2,023

2,234

2,456

2,691

2,939

3,201

3,480

3,776

4,451

4,972

5,505

6,049

6,605

7,171

7,748

8,335

8,932

9,538

BTCF
Tax
ATCF

Calculation of ATER from Sale

Year
Sale
Price
O/S Bal
Selling
Exp
BTER
Tax
ATER

10

11

12

13

14

15

257,500

265,225

273,182

281,377

289,819

298,513

307,468

316,693

326,193

335,979

140,355

138,038

135,452

132,567

129,348

125,757

121,750

117,280

112,292

106,727

15,450

15,914

16,391

16,883

17,389

18,448

19,002

19,572

20,159

101,695

111,274

121,339

131,927

143,081

154,845

167,270

180,411

194,329

209,093

8,410

9,862

11,358

12,899

14,486

16,120

17,804

19,538

21,324

23,164

93,285

101,412

RE3104119,029
Semester 1 128,595
109,981

138,725

149,466

22
160,873

173,005

185,929

17,911

Calculating MRR (6th year)

Substituting

the numbers, we have,

= 14.22%
The investor could invest the $85,568 elsewhere or he
could sell the property in year 6. In return, he gets the
ATCFo and the ATER (in year 6). The rate of return from
the opportunity cost of $85,568 is 14.22%.

RE3104 REIA Semester 1, 2014

23

Marginal Rate of Return

Year

MRR

14.22

14.04

13.88

13.73

10

13.59

11

13.45

12

13.33

13

13.21

14

13.09

15

12.98

Property should be
sold in the 8th year.
Suppose the
reinvestment rate is
13.91%.

RE3104 Semester 1

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Comparison of MRR and

reinvestment rate
15.80%

15.70%

MRR

Return

15.60%

MRR

15.50%

Reinvestment rate

15.40%

Optimal Holding
Period

15.30%

From BF
page 457.

15.20%
6

10

11

12

RE3104 REIA Semester 1, 2014

13

14

15

Year25

Case 2: to sell today or to

renovate and hold
Suppose

you can renovate and hold the

property for another 5 years versus
holding the property for another 5 years
without renovating (slide 15).
You project that ATCF from operations
and sale will be higher after renovation.
It costs $13,000 of equity to renovate.

RE3104 Semester 1

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You project the following

cash flow if you were to
renovate...
NOI

after renovation will be 24,000 in

the 6th year (assuming, for simplicity,
renovation will be quick and that you
observe NOI in the 6th year).
NOI after renovation will increase at 5%
after the 6th year.
Debt service remains the same because
we didnt take up any new loan. Tax
rate remains the same at 20%.
RE3104 Semester 1

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You project the following

cash flow from
operations...
Year

10

NOI

24,000

25,200

26,460

27,783

29,172

Less DS

17,642

17,642

17,642

17,642

17,642

BTCFR

6,358

7,558

8,818

10,141

11,530

TI

8,435

9,875

11,404

13,025

14,749

Tax

1,687

1,975

2,281

2,605

2,950

ATCFR

4,671

5,583

6,537

7,536

8,580

RE3104 Semester 1

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Projections of CF from
Sale EOY10
Suppose

you project that the renovated

property will sell for a higher price at
$306,308.
Compute BTER and ATER

RE3104 Semester 1

29

CF from Sale of
Renovated Property
EOY10
306,308

Sale Price
Less Selling expense
Less Mortgage Balance
BTERR
Chargeable Income
Tax @ 20%
ATERR

RE3104 Semester 1

18,378
129,348
158,581
87,930
17,586
140,995

30

Renovation as an
Alternative
Incremental Analysis
5

10

ATCFR

4,671

5,583

6,537

7,536

149,575

ATCF

4,451

4,972

5,505

6,049

135,201

220

611

1,032

1,487

14,374

ICF

-13,000

IRR

6.94%

IRR on incremental cash flow

RE3104 Semester 1

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Renovation as an
alternative
The

incremental CF IRR of 6.94% is not

IRR for the entire investment.
That is, it does not tell us whether the
property is a good or bad investment.
Its the IRR on the additional $13,000
on renovation. Is this a good way to
invest $13,000?
It depends on what returns one can get
for $13,000 on investments of
comparable risk.
RE3104 Semester 1

32

References
Disposition

Chapter 14 of BF

RE3104 Semester 1

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