What factors should be considered when deciding whether to renovate a property

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Why is refinancing often done in conjunction with renovation?

 

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1i. A property could be sold today for $2 million. It has a loan balance of $1 million and, if sold, the investor would incur a capital gains tax of $250,000. The investor has determined that if it were sold today, she would earn an IRR of 15 percent on equity for the past five years. If not sold, the property is expected to produce after-tax cash flow of $50,000 over the next year. At the end of the year, the property value is expected to increase to $2.1 million, the loan balance will decrease to $900,000, and the amount of capital gains tax due is expected to increase to $255,000.

a.What is the marginal rate of return for keeping the property one additional year?

b.What advice would you give the investor?

 

1ii. What factors should an investor consider when trying to decide whether to dispose of a property that he has owned for several years?

 

2i. Refer to problem 1. The owner determines that if the property were renovated instead of sold, after-tax cash flow over the next year would increase to $60,000 and the property could be sold after one year for $2.4 million. Renovation would cost $250,000. The investor would not borrow any additional funds to renovate the property.

a.What is the rate of return that the investor would earn on the additional funds invested in renovating the property?

b.Would you recommend that the property be renovated?

(For Reference Problem 1)

A property could be sold today for $2 million. It has a loan balance of $1 million and, if sold, the investor would incur a capital gains tax of $250,000. The investor has determined that if it were sold today, she would earn an IRR of 15 percent on equity for the past five years. If not sold, the property is expected to produce after-tax cash flow of $50,000 over the next year. At the end of the year, the property value is expected to increase to $2.1 million, the loan balance will decrease to $900,000, and the amount of capital gains tax due is expected to increase to $255,000.

a.What is the marginal rate of return for keeping the property one additional year?

b.What advice would you give the investor?

 

2ii. Why might the actual holding period for a property be different from the holding period that was anticipated when the property was purchased?

 

3i. Lonnie Carson purchased Royal Oaks Apartments two years ago. An opportunity has arisen for Carson to purchase a larger apartment project called Royal Palms, but Carson believes that he would have to sell Royal Oaks to have sufficient equity capital to purchase Royal Palms. Carson paid $2 million for Royal Oaks two years ago, with the land representing approximately $200,000 of that value. A recent appraisal indicated that the property is worth about $2.2 million today. When purchased two years ago, Carson financed the property with a 70 percent mortgage at 10 percent interest for 25 years (monthly payments). The property is being depreciated over 27.5 years (1/27.5 per year for simplicity). Effective gross income during the next year is expected to be $350,000, and operating expenses are projected to be 40 percent of effective gross income. Carson expects the effective gross income to increase 3 percent per year. The property value is expected to increase at the same 3 percent annual rate. Carson is currently in the 36 percent tax bracket and expects to remain in that bracket in the future. Because Carson has other real estate investments that are now generating taxable income, he does not expect any tax losses from Royal Oaks to be subject to the passive activity loss limitations. If he sells Royal Oaks, selling expenses would be 6 percent of the sale price.

a.How much after-tax cash flow (ATCFs) would Carson receive if Royal Oaks was sold today (exactly two years after he purchased it)?

b.What is the projected after-tax cash flow (ATCFo) for the next five years if Carson does not sell Royal Oaks?

c.How much after-tax cash flow (ATCFs) would Carson receive if he sold Royal Oaks five years from now?

d.Using the results from (a) through (c), find the after-tax rate of return on equity (ATIRRe) that Carson can expect to earn if he holds Royal Oaks for an additional five years versus selling it today.

e.What is the marginal rate of return (MRR) if Carson holds the property for one additional year (if he sells next year versus this year)?

f.Why do you think the MRR in (e) is higher than the return calculated in (d)?

g.Can you think of any other strategies that Carson could use to purchase Royal Palms and still retain ownership of Royal Oaks?

h.What is your recommendation to Carson?

i.Optional for computer users. What is the MRR for each of the next 10 years? How can this calculation be used to determine when Royal Oaks should be sold?

 

3ii.What is the marginal rate of return?  How is it calculated?

 

4i.Richard Rambo presently owns the Marine Tower office building, which is 20 years old, and is considering renovating it. He purchased the property two years ago for $800,000 and financed it with a 20-year, 75 percent loan at 10 percent interest (monthly payments). Of the $800,000, the appraiser indicated that the land was worth $200,000 and the building $600,000. Rambo has been using straight-line depreciation over 39 years (1/39 per year for simplicity). At the present time Marine Tower is producing $90,000 in NOI, and the NOI and property value are expected to increase 2 percent per year. The current market value of the property is $820,000. Rambo estimates that if the Marine Tower office building is renovated at a cost of $200,000, NOI will be about 20 percent higher next year ($108,000 versus $90,000) due to higher rents and lower expenses. He also expects that with the renovation the NOI will increase 3 percent per year instead of 2 percent. Furthermore, Rambo believes that after five years, a new investor will purchase the Marine Tower office building at a price based on capitalizing the projected NOI six years from now at a 10 percent capitalization rate. Selling costs would be 6 percent of the sale price. Rambo is in the 28 percent tax bracket and expects to continue to be in that bracket. He also would not be subject to any passive activity loss limitations. If Rambo does the renovation, he believes he could obtain a new loan at an 11 percent interest rate and a 20-year loan term (monthly payments).

a.Assume that if Rambo does the renovation, he will be able to obtain a new loan that is equal to the balance of the existing loan plus 75 percent of the renovation costs. What is the incremental return (ATIRRe) for doing the renovation versus not doing the renovation? Assume a five-year holding period.

b.Repeat (a) but assume that Rambo is able to obtain a new loan that is equal to 75 percent of the sum of the existing value of the property ($820,000) plus the renovation costs ($200,000). (This assumes that after renovation the value of the property will at least increase by the cost of the renovation.)

c.Explain the difference between the returns calculated in (a) and (b). Is there a difference in the risk associated with each financing alternative?

d.What advice would you give Rambo?

 

4ii. What causes the marginal rate of return to change over time?  How can the marginal rate of return be used to decide when to sell a property?

 

5i. Excel. Refer to the “Ch14 Renovation” tab in the Excel Workbook provided on the Web site. This worksheet calculates the incremental return if the Apex property is renovated as illustrated in the chapter. Suppose the NOI after renovation is $42,000 instead of $45,000. How does this affect the after-tax incremental return?

 

5ii. Why might the after-tax internal rate of return on equity (ATIRRe) differ for a new investor versus an existing investor who keeps the property?

 

6i. Excel. Refer to the “Ch14 MRR” tab in the Excel Workbook provided on the Web site. Suppose both the NOI and property value growth rate are 5 percent instead of 3 percent. How would this change the marginal rate of return for years 1 to 10? Does the MRR increase or decrease for the first year? Does it decrease at a faster or slower rate over time?

 

6ii. What factors should be considered when deciding whether to renovate a property?

 

7i. An investor is considering selling a property that has an adjusted basis of $1.5 million for $2 million. The property has a loan balance of $1.75 million. She is exploring different disposition strategies. All capital gains would be taxed at 20 percent (whether from depreciation recapture or price appreciation) and ordinary income would be taxed at 35 percent.

a.Suppose the property is sold using an installment sale with the buyer assuming the loan and making a payment of $50,000 at the time of sale and then installment payments of $50,000 per year for the next four years. Interest at a rate of 10 percent would be charged on the unpaid balance due the seller. Is this better than a cash sale?

b.Now suppose the investor is considering doing a tax-deferred exchange rather than an installment sale. She would acquire a second property for $4 million and assume a loan for $3,750,000. She believes that the land would be about 20 percent of the purchase price and the building would be about 80 percent. If she does the exchange, she plans to sell the second property after five years. It would be depreciated over 30 years. Is the exchange strategy better than just selling the property for cash and then purchasing the second property?

 

7ii. Why is refinancing often done in conjunction with renovation?

 

8.Why would refinancing be an alternative to sale of the property?

 

9.How can tax law changes create incentives for investors to sell their properties to other investors?

 

10.How important are taxes in the decision to sell a property?

 

11.Are tax considerations important in renovation decisions?

 

12.What are the benefits and costs of renovation?

 

13.Do you think renovation is more or less risky than a new investment?

 

14.What is meant by the “incremental cost of refinancing?”

 

15.In general, what kinds of tax incentives are available for rehabilitation of real estate income property?

 

16.Why would an investor consider doing an exchange or an installment sale?

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