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Disposition and Renovation Analysis
- As you hold a property, its relative attractiveness as an investment will change over time. a) An increasing amount of equity will be tied up in the property.
b) As a result, the benefits from positive financial leverage will lessen over time.
c) The opportunity cost of holding the property is the cash you would receive from selling it today.
- Periodically, you will need to evaluate and compare the various alternatives that are available for properties that you currently own.
b) Hold
c) Sell
d) Refinance
e) Renovate
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- Basic steps for analyzing these alternatives:
a) Define the specific alternatives to be considered.
b) Estimate the cash flows from each alternative.
Hold Sell Refinance Renovate
Initial cash flows
Operating cash flows
Terminal cash flows
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a) If Bob chooses to sell the property today, what will his return on this property have been over his holding period? Up-front cash flows (5 years ago)
Sale cash flows (today)
If he sells today, the total cash flows he will have received from this investment over the past 5 years are as follows:
Year Cash Flow
0 1 2 3 4 5
NPV @ 16% =
IRR =
NOTE: This is an ex post , or after the fact, measure of the investment return. This is NOT the right way to determine whether selling today is a good decision, but it is sometimes interesting and useful to verify what the ex post return on the investment was.
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b) The proper way to analyze the sale decision is to do a prospective analysis.
If Bob sells the property he will receive $824,000 cash today and nothing in the future.
If Bob keeps the property, his annual cash flows will be:
At the end of five more years, the cash flows from sale will be:
Prospective analysis:
Year Keep Sell Difference
PV
PMT
FV
P/Y =
N =
The NPV of the differential cash flows is _______________.
The IRR of the differential cash flows is _______________.
These cash flows “look like” a(n) ____________________.
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Bob can do this on a year-by-year basis. For the second year, the cash flow table is:
Year Keep Sell Difference
PV 0 824,000 (824,000)
PMT 108,000 0 108,
FV 1,203,684 0 1,203,
P/Y = 1
N = 1
The NPV of the differential cash flows is ________________.
The IRR of the differential cash flows is _______________.
These cash flows “look like” a(n) ____________________.
More generally, Bob should continue to hold the property as long as:
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- Renovation and Refinancing Decisions
a) The basic layout of these decisions is the same as above: Estimate the cash flows for each alternative, calculate the differential cash flows between the two options, and calculate the NPV/IRR of the difference.
b) Refinancing is a tax free event, so it is a great way to get cash out of the property.
c) Renovation will likely create multiple depreciation schedules for your property. Renovations are typically all depreciable, however. You don’t need to allocate the basis between land and buildings, because all of the renovations are building.
