Hold vs. Dispose Analysis Full Book 2413

Ward Center for Real Estate Studies
www.ccim.com
Hold versus
Dispose
Analysis for
Commercial
Real Estate
Reference
Manual
EXCELLENCE
SUCCESS
SKILL
LEADERSHIP
CHALLENGE
STRENGTH
Dear Student,
The CCIM Institute’s Ward Center for Real Estate Studies and Real Property Strategies, LLC
welcome you to the course, Hold versus Dispose Analysis for Commercial Real Estate.
This course is designed for the commercial real estate professional who wants to expand and
sharpen their hold versus dispose decision analysis skills and integrate technological applications
into the hold versus dispose analysis process.
To receive the maximum benefit from this course, students are advised to complete all case studies
and activities.
Course Material
All Ward Center courses are designed to ensure a highly effective learning experience. This course
consists of the following components:
Reference Manual
The reference manual is designed to be used as an in-class textbook and an after-class reference
tool. This manual includes conceptual material, calculations, examples, and activities. The activities
are real-life real estate scenarios that require application of the skills, calculations, and theories
presented in the course manual.
Excel Spreadsheets
These customized spreadsheets will be your tools for performing User cost of occupancy analyses.
Hold versus Dispose Analysis for Commercial Real Estate was developed by Real Property Strategies, LLC
(RPS)
© Copyright 2012 by Real Property Strategies, LLC
Licensed to the CCIM Institute
Hold Versus Dispose Analysis for Commercial Investment Real Estate
In This Module
1 Module Snapshot ...................................... 1.1
Module Goal ........................................................ 1.1
Objectives ............................................................. 1.1
Life Cycle of a Real Estate Investment ......... 1.3
Hold Versus Investment Base ........................................ 1.4

Investment Base for Hold Alternatives ............... 1.5
Dispose
Investment Base for Dispose Alternatives .......... 1.6
After Tax Cash Flow Model .......................... 1.8
Sample Problem 1-1 .................................. 1.8
Analysis “Hold as Is” Alternative ....................................... 1.8

“Hold and Refinance” Alternative .................... 1.12
“Sell and Buy” Other Real Estate Alternative... 1.16
“Exchange” into Other Real Estate Alternative 1.21
Summary ............................................................ 1.27
Activity 1-1: Excel Workbook Analysis ............ 1.30
Activity 1-2: Discussion Questions .................... 1.32
Case Study .............................................. 1.34
Case Objectives .................................................. 1.34
Case Setup .......................................................... 1.34
Complete a Five-Year Before and After-Tax
Analysis for the First Option (Hold as is) ......... 1.35
Analysis for the Second Option (Hold and
Refinance) .......................................................... 1.36
Analysis for the Third Option (Sell and Buy) .. 1.37
Analysis for the Fourth Option (Exchange) ...... 1.39
Activity 1-2: Discussion Questions-Answers ..... 1.42
Hold Versus Dispose Analysis
Module Snapshot
Module Goal
After completing this course, you will be able to perform a hold versus dispose
analysis analyzing four investment alternatives, “hold as is”, “hold and
refinance”, “sell and buy” another property, and “exchange” into the other
property.
Objectives
 Identify the phases of the life cycle of a real estate investment
 Define and calculate investment base for two hold alternatives and two
dispose alternatives
 Forecast annual cash flows after tax for each of the four alternatives
 Forecast sale proceeds after tax for each of the four alternatives
 Compare measures of investment performance for the four alternatives
o Internal Rate of Return
o Net Present Value
o Capital Accumulation
Hold Versus Dispose Analysis for Commercial Real Estate •1.1

NOTES
1.2 • Hold Versus Dispose Analysis for Commercial Investment Real Estate
Life Cycle of a Real Estate Investment
The life cycle of a real estate investment is comprised of the following three
phases:
The following diagrams illustrate the three phases of the life cycle of a real
estate investment and some of the decisions investors are confronted with in
each phase.
Hold Versus Dispose Analysis for Commercial Investment Real Estate •1.3
In this course we’ll explore two ownership/operation phase alternatives, “hold
as is” and “hold and refinance”. We will also explore two disposition phase
alternatives, “sell and buy” another property and “exchange” into the other
property.
The steps in the process to analyze each of the four alternatives are as follows:
1. Determine “Investment Base”
2. Forecast the annual cash flows after tax over the projected holding
period
3. Forecast the sale proceeds after tax at the end of the projected holding
period
4. Calculate the IRR
Investment Base
Once an investor has acquired a real estate investment there are many decisions
that must be made while the property is owned. Decisions involving property
management, tenancy and capital expenditures are examples of the issues that
must be addressed.
Of all the issues that the investor much face on an ongoing basis the hold versus
dispose decision is perhaps the most difficult. Simple advice such as “buy low
and sell high” sounds helpful but it is nearly impossible to time the market so
that the asset is sold in the most favorable conditions.
There is a process however that is very useful in creating a decision matrix to
fully understand the hold and dispose alternatives and the benefits of each.
This process begins with an understanding of what the investor forgoes by
continuing to hold the investment. In other words, should the investor sell for
cash at this decision time how much money could the investor take away from
the investment and place elsewhere? This cash flow is the investment that
remains in the decision to hold rather than sell the investment. In order to
accurately judge the performance of the investment from this decision point
forward the investor must consider this amount as the initial investment.
Many times investors make the mistake of judging investments based on the
original investment amount with no consideration for the change in this
investment over time. Consider the example of a land investor who acquired a
tract for $500,000 in cash ten years previously. The value of the land today is
$3,000,000. To make an informed decision the investor must consider the Sale
Proceeds After Tax from a cash disposition of the tract as the amount invested
in a decision to continue to own the asset. Rather than having $500,000
invested in the tract the correct decision is based on $2,500,000 as the
investment amount. That is, the $3,000,000 sale price less the taxes on the
long-term capital gain. This alternative use money that could be taken from the
investment and placed in another investment is called the Investment Base in
the alternative of continuing to own the current property from the point of
decision forward.
Every investment alternative has an Investment Base. To quantify this amount
for any alternative, ask the question, “if the investor chooses this alternative how
much money is the investor giving up the right to use in another investment?”
The money given up is the amount invested in the alternative being considered.
This Investment Base can then be used to measure the performance of the
investment from the decision point forward.
Investment Base for Hold Alternatives

The Investment Base of the continue to “hold as is” alternative is the Sale
Proceeds After Tax realized if the property were sold for cash at the decision
point. This investment base is calculated as follows:
Sale Price
- Cost of Sale
- Mortgage Balance
= Sale Proceeds Before Tax
- Tax on Sale
= Sale Proceeds After Tax (Investment Base in “hold as is”
alternative
This money left invested becomes the EOY 0 cash flow. The projected annual
cash flows after tax and the projected sales proceeds after tax at the end of the
holding period are the future after tax benefits received from continuing to own
the property currently owned. The investment performance of the “hold as is”
alternative can then be measured by calculating the after tax IRR.
Another hold alternative is to retain the investment but to refinance and to
place some or all of the refinance proceeds in another investment. This would
reduce the Investment Base in the hold “refinance” alternative. The “hold and
refinance” Investment Base is calculated as follows:
New Loan
- Existing Loan
= Gross Loan Proceeds
- Loan Costs
= Net Loan Proceeds
Investment Base of “Hold as is” Alternative

- Net Loan Proceeds
= Investment Base in “Hold and Refinance” Alternative
This money left invested after pulling out the net loan proceeds of the refinance
becomes the EOY 0 cash flow. The projected annual cash flows after tax with
the new loan in place and the projected sales proceeds after tax paying off the
new loan balance at the end of the holding period are the after tax benefits
received. The investment performance of the “hold and refinance” alternative
can then be measured by calculating the after tax IRR.
Investment Base for Dispose Alternatives

In order to calculate the investment base of the “sell and buy” alternatives first
calculate the available Sales Proceeds After Taxes from the current investment.
The investment base for the “sell and buy” other real estate alternative then will
be the Sales Proceeds After Taxes from the current property plus any cash
added to purchase the other real estate investment, less any cash taken out from
the sale of the current property.
The “sell and buy” Investment Base is calculated as follows:
Sale Price
- Cost of Sale
- Mortgage Balance
- Tax on Sale
= Sale Proceeds After Tax
+ Any Cash Added to Purchase the “other real estate”
Or – Any Cash Taken Out from the Sale of the Current
Investment
= Investment Base in “sell and buy” alternative
The calculation of the Investment Base for the “exchange” into the other real
estate is similar. The Sales Proceeds After Taxes from the sale of the current
investment plus any cash added in the exchange, less any cash taken out during
the exchange will be the Investment Base in this alternative.
The “sell and buy” Investment Base is calculated as follows:
Sale Price
- Cost of Sale
- Mortgage Balance
- Tax on Sale
= Sale Proceeds After Tax
+ Any Cash Added to “exchange” into the “other real estate”
Or – Any Cash Taken Out from the Sale of the Current
Investment
= Investment Base in “exchange” alternative
Using Investment Base the Internal Rate of Return can be calculated for each
alternative being considered allowing the investor to choose between investment
alternatives based on investment performance measures.
In addition to Internal Rate of Return these hold versus dispose alternatives can
be compared using Net Present Value and Capital Accumulation. Using the
projected cash flows and sales proceeds from each alternative and applying the
appropriate reinvestment rate and the appropriate discount rate the future
capital accumulation and the Net Present Value for each alternative can be
calculated.
Using the Investment Base concept, calculating the Internal Rate of Return, Net
Present Value, and Capital Accumulation for each alternative and comparing
these measures of investment performance creates an informed method of
analysis for hold versus dispose decisions.
After Tax Cash Flow Model

The following diagram is the after tax cash flow model that will be used to
analyze all four of the hold versus dispose alternatives:
EOY $
0 (Initial investment)
1 Cash Flow After Tax
5 Cash Flow After Tax + Sale Proceeds After Tax
Sample Problem 1-1

Consider an investment that was purchased 5 years ago. At the time of the
purchase the investor paid $5,000,000 plus $50,000 in acquisition costs for the
multi-tenant industrial property using a mortgage of $3,500,000. When the
loan was placed on the property, the terms were as follows: 6% interest rate, 20-
year amortization with a 10 year call and monthly payments. Loan costs were
2% of the loan amount. The assessed value of the improvements at the time of
purchase was $2,400,000 and the total value assessed at $3,000,000.
“Hold as Is” Alternative

The value of the investment if sold today is $5,525,000 with sales costs of 4% of
the sales price. The loan balance today is $2,971,486. The investor is in the
35% ordinary income tax bracket and will qualify for long-term capital gain
treatment at disposition, 20% tax on the capital gain from appreciation and 25%
tax on the gain caused by cost recovery. The property has performed very well
and the NOI expected for the next year of operation is $470,000 and is
expected to increase 2% annually. The anticipated disposition price 5 years
from today will be determined by capitalizing the year 6 NOI at 8.5% and sales
costs are expected to be 4% of the sales price.
“Hold as is” Investment Base

The following is the calculation of Investment Base for the “Hold as is”
alternative
Calculation of Adjusted Basis

Original Basis $5,050,000
+ Capital Improvements $0
- Cost Recovery Taken $509,284
- Basis in Partial Sales $0
= Adjusted Basis $4,540,716
Calculation of Capital Gain

Sale Price $5,525,000
- Cost of Sale $221,000
- Adjusted Basis $4,540,716
= Total Gain $763,284
= Capital Gains $254,000
Items Taxed as Ordinary Income

- Unamortized Loan Costs ($35,000)
= Ordinary Taxable Loss ($35,000)
Sale Proceeds Aftet Tax

- Mortgage Balance $2,971,486
= Sale Proceeds Before Tax $2,332,514
- Tax (Savings) on Ordinary Taxable Loss ($12,250)
- Tax on Cost Recovery Recapture $127,321
- Tax on Capital Gains $50,800
= Sale Proceeds After Tax $2,166,643
This $2,166,643 is the “Hold as is” Investment Base
Annual Cash Flows After Tax
The following are the calculations of the annual cash flow after tax for the
“Hold as is” alternative:
Taxable Income
EOY 1 2 3 4 5 6
Potential Rental Income $470,000 $479,400 $488,988 $498,768 $508,743 $518,918
- Vacancy & Credit Losses $0 $0 $0 $0 $0 $0
= Effective Rental Income $470,000 $479,400 $488,988 $498,768 $508,743 $518,918
+ Other Income $0 $0 $0 $0 $0 $0
= Gross Operating Income $470,000 $479,400 $488,988 $498,768 $508,743 $518,918
- Operating Expenses $0 $0 $0 $0 $0 $0
= Net Operating Income $470,000 $479,400 $488,988 $498,768 $508,743 $518,918
- Mortgage Interest $174,860 $167,087 $158,833 $150,071 $140,768
- Cost Recovery (Improvements) $103,586 $103,586 $103,586 $103,586 $99,263
- Loan Cost Amortization $7,000 $7,000 $7,000 $7,000 $7,000
= Taxable Income $184,554 $201,727 $219,569 $238,111 $261,712
Tax Liability (Savings) at 35% $64,594 $70,605 $76,849 $83,339 $91,599
Cash Flows After Tax

EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
- Annual Debt Service $300,901 $300,901 $300,901 $300,901 $300,901
= Cash Flow Before Tax $169,099 $178,499 $188,087 $197,867 $207,842
- Tax Liability (Savings) $64,594 $70,605 $76,849 $83,339 $91,599
= Cash Flow After Tax $104,505 $107,894 $111,238 $114,528 $116,243
Projected Sale Proceeds After Tax-EOY 5
The following is the calculation of sale proceeds after tax for the “Hold as is”
alternative:
- Cost Recovery Taken $1,027,214

= Total Gain $1,838,014

- Unamortized Loan Costs $0
= Ordinary Taxable Loss $0

- Tax (Savings) on Ordinary Taxable Loss $0
Internal Rate of Return
The following is the calculation of the after tax Internal Rate of Return for the
“Hold as is” alternative:
EOY $
0 ($2,166,643)
1 $104,505
2 $107,894
3 $111,238
4 $114,528
5 $116,243 + $3,183,237
“Hold and Refinance” Alternative

The value of the investment if sold today is $5,525,000 with sales costs of 4% of
the sales price. The loan balance today is $2,971,486. There is a new loan
available for the property at 6% interest, a 20 year amortization with a 10 year
call, and loan costs of 2% of the loan amount. The loan amount will be based
on a 75% Loan to Value and a 1.2 Debt Service Coverage Ratio, limited to the
lower of the two amounts rounded down to the nearest $1,000. The investor is
in the 35% ordinary income tax bracket and will qualify for long-term capital
gain treatment at disposition, 20% tax on the capital gain from appreciation and
25% tax on the gain caused by cost recovery. The property has performed very
well and the NOI expected for the next year of operation is $470,000 and is
expected to increase 2% annually. The anticipated disposition price 5 years
from today will be determined by capitalizing the year 6 NOI at 8.5% and sales
costs are expected to be 4% of the sales price.
“Hold and Refinance” Investment Base

Calculation of New Loan Amount
Loan to Value
Property Value $5,525,000
x Loan to Value Ratio 75.00%
= Loan Amount $4,143,750
Debt Service Coverage Ratio

First Year NOI $470,000
Debt Service Coverage Ratio 1.20
Interest Rate 6.00%
Amortization Period 20
Payments Per Year 12
Number of Periods 240

Periodic Interest Rate 0.50%
*Periodic Payment $32,638.89
Future Value $0
Present Value (Loan Amount) $4,555,761
*$470,000 ÷ 1.20 ÷ 12 = $32,638.89
Loan Amount
The lower of the two loan
amounts rounded down to the
nearest $1,000 $4,143,000
Calculation of “Hold and Refinance” Investment Base
"Hold and Refinance" Investment Base

New Loan Amount $4,143,000
- Old Loan Balance $2,971,486
= Gross Loan Proceeds $1,171,514
- Loan Costs $82,860
= Net Loan Proceeds $1,088,654
+ Tax Savings from Unamortized Loan Costs $12,250
= Total Funds from Refinance $1,100,904
"Hold as is" Investment Base $2,166,643

- Total Funds from Refinance $1,100,904
= "Hold and Refinance" Investment Base $1,065,739

“Hold and Refinance” alternative:
Taxable Income
EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
= Taxable Income $112,557 $128,779 $145,610 $163,079 $185,542

EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
The following is the calculation of sale proceeds after tax for the “Hold and
Refinance” alternative:


= Total Gain $1,838,014


“Hold and Refinance” alternative:
EOY $
0 ($1,065,739)
1 $74,424
2 $78,146
3 $81,844
4 $85,509
5 $87,623 + $1,938,947
“Sell and Buy” Other Real Estate Alternative

If the investor opts to dispose of the current industrial property there is an
excellent office property investment that is available. This investment could be
acquired by selling the current industrial property investment for cash and
acquiring the office investment with the available financing. The purchase
price of the office investment is $8,500,000 and there would be acquisition costs
of $100,000. The county property appraiser’s allocation for improvements is
80%. Financing is available at 6% interest to complete the purchase. The
amortization period is 20 years with a 10-year call, monthly payments, and loan
costs of 2% of loan amount. The investor will only require a loan amount
necessary to complete the purchase using all of the cash from the disposition of
the industrial asset.
The office investment NOI for the next year is $725,000 and is projected to
increase 2% annually. The anticipated disposition price 5 years from today will
be determined by capitalizing the year 6 NOI at 8.5% and sales costs are
expected to be 4% of the sales price.
“Sell and Buy” Investment Base
The question for investment base is always, “if I do this, how much money am I
giving up to use in an alternative investment?” In this case, assuming no money
is added to affect the purchase and no money is taken out from the sale of the
current property, the investment base for “Sell and Buy” would be the after tax
proceeds from the sale of the current property which is illustrated below.
This $2,166,643 is the “Sell and Buy” Investment Base
Loan Needed to Purchase
The calculation for the loan needed to purchase the “other property” is shown
below.
Loan Needed to Purchase
Purchase Price $8,500,000
+ Acquisition Costs $100,000
- Proceeds of Sale from Current Property $2,166,643
= Net Loan Proceeds Needed $6,433,357
+ *Loan Costs $131,293
= Gross Loan Proceeds Needed $6,564,650
*Net loan proceeds needed ÷ (1-2%) -

Net loan proceeds needed = Loan Costs $131,293

The following are the calculations of the annual cash flow after tax for the “Sell
and Buy” the other property alternative:
Taxable Income
EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
= Taxable Income $153,718 $171,666 $197,933 $225,203 $260,888

EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
The following is the calculation of sale proceeds after tax for the “Sell and Buy”
other property alternative:


= Total Gain $1,307,613


“Sell and Buy” other property alternative:
EOY $
0 ($2,166,643)
1 $106,825
2 $115,043
3 $120,639
4 $126,181
5 $129,078 + $3,185,048
“Exchange” into Other Real Estate Alternative

If the investor opts to dispose of the current industrial property there is an
excellent office property investment that is available. This investment could be
acquired by exchanging the equity in the current industrial property investment
into the office investment using the available financing. The price of the office
investment is $8,500,000 and there would be acquisition costs of $100,000.
Financing is available at 6% interest to complete the exchange. The
amortization period is 20 years with a 10-year call and monthly payments. The
investor will only require a loan amount necessary to complete the exchange
using all of the equity from the industrial asset. There will be an additional fee
of $5,000 charged for an exchange accommodator.
The office investment NOI for the next year is $725,000 and is projected to
increase 2% annually. The sale price at the end of the projected 5 year holding
period will be based on an 8.5% cap rate with 4% sales costs.
“Exchange” into Another Property Investment Base

The question for investment base is always, “if I do this, how much money am I
giving up to use in an alternative investment?”. In this case, assuming no money
is added to affect the exchange and no money is taken out from the sale of the
current property, the investment base for “Exchange” would be the after tax
proceeds from the sale of the current property which is illustrated below.


= Total Gain $763,284


This $2,166,643 is the “Exchange” Investment Base
Loan Needed to Exchange
The calculation for the loan needed to exchange into the “other property” is
shown below.
Loan Needed for Exchange

Acquisition Price $8,500,000
+ Exchange Accomodator Fee $5,000
- *Equity From Current Property $2,332,514
- Tax Savings from Unamortized Loan Costs $12,250
= Net Loan Proceeds Needed $6,260,236
+ **Loan Costs $127,760
= Gross Loan Proceeds Needed $6,387,996
*Before Tax Proceeds of Sale from

Current Property $2,332,514
**Net Loan Proceeds Needed ÷ (1-2%) -

Net Loan Proceeds Needed = Loan Costs $127,760
Substitute Basis
In a completely tax deferred exchange the gain that would be taxed at the time
of disposition if the property is sold is deferred until the ultimate sale of the
property exchanged into. However this deferred gain is reflected in the property
exchanged into by having a lower basis which lowers the cost recovery
deductions and increases the gain on the ultimate sale. The calculation of the
substitute basis for the property exchanged into is shown below.
Substitute Basis
Market Value of New Property $8,500,000
+ Exchange Accomodator Fee $5,000
- Deferred Gain $763,282
= Substitute Basis $7,841,718
“Exchange” into the other property alternative:
Taxable Income
EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
= Taxable Income $179,447 $197,753 $223,711 $250,653 $285,341

EOY 1 2 3 4 5 6
+ Other Income $0 $0 $0 $0 $0 $0
The following is the calculation of sale proceeds after tax for the “Exchange”
into other property alternative:


= Total Gain $1,989,424


“Exchange” into other property alternative:
EOY $
0 ($2,166,643)
1 $113,007
2 $121,099
3 $126,804
4 $132,460
5 $135,707 + $3,176,405
Summary
The following diagrams compare the after-tax IRRs, after-tax Net Present
Values, and after-tax Capital Accumulations of the four alternatives that have
been analyzed in Sample Problem 1-1.
After-tax Internal Rates of Return

"Hold as is" "Hold and Refinance"
EOY $ EOY $
0 ($2,166,643) 0 ($1,065,739)
1 $104,505 1 $74,424
2 $107,894 2 $78,146
3 $111,238 3 $81,844
4 $114,528 4 $85,509
5 $116,243 + $3,183,237 5 $87,623 + $1,938,947
IRR = 12.41% IRR = 18.81%
"Sell and Buy" "Exchange"

EOY $ EOY $
0 ($2,166,643) 0 ($2,166,643)
1 $106,824 1 $113,007
2 $115,043 2 $121,099
3 $120,639 3 $126,804
4 $126,181 4 $132,460
5 $129,078 + $3,185,048 5 $135,707 + $3,176,405
IRR = 12.75% IRR = 12.94%
After-tax Net Present Values
EOY $ EOY $
0 $0 0 $1,100,904
1 $104,505 1 $74,424
2 $107,894 2 $78,146
3 $111,238 3 $81,844
4 $114,528 4 $85,509
5 $116,243 + $3,183,237 5 $87,623 + $1,938,947
NPV @ 5.00% = $2,972,935 NPV @ 5.00% = $2,971,584

EOY $ EOY $
0 $0 0 $0
1 $106,824 1 $113,007
2 $115,043 2 $121,099
3 $120,639 3 $126,804
4 $126,181 4 $132,460
5 $129,078 + $3,185,048 5 $135,707 + $3,176,405
NPV @ 5.00% = $3,010,811 NPV @ 5.00% = $3,031,106
After-tax Capital Accumulations

"Hold as is"
EOY $
0 $0
1 $104,505 5.00%
2 $107,894 5.00%
3 $111,238 5.00%
4 $114,528 5.00%
5 $116,243 + $3,183,237 + $120,254 + $122,640 + $124,901 + $127,027 = $3,794,302
"Hold and Refinance"

EOY $
0 $1,100,904 5.00%
1 $74,424 5.00%
2 $78,146 5.00%
3 $81,844 5.00%
4 $85,509 5.00%
5 $87,623 + $1,938,947 + $89,785 + $90,233 + $90,464 + $90,463 + $1,405,063 = $3,792,577
"Sell and Buy"

EOY $
0 $0
1 $106,824 5.00%
2 $115,043 5.00%
3 $120,639 5.00%
4 $126,181 5.00%
5 $129,078 + $3,185,048 + $132,490 + $133,005 + $133,176 + $129,846 = $3,842,642
"Exchange"
EOY $
0 $0
1 $113,007 5.00%
2 $121,099 5.00%
3 $126,804 5.00%
4 $132,460 5.00%
5 $135,707 + $3,176,405 + $139,083 + $139,802 + $140,188 + $137,360 = $3,868,545
Annual Compound Growth Rate of Capital
EOY $ EOY $
0 ($2,166,643) 0 ($2,166,643)
1 $0 1 $0
2 $0 2 $0
3 $0 3 $0
4 $0 4 $0
5 $3,794,302 5 $3,792,577
I= 11.86% I= 11.85%

EOY $ EOY $
0 ($2,166,643) 0 ($2,166,643)
1 $0 1 $0
2 $0 2 $0
3 $0 3 $0
4 $0 4 $0
5 $3,842,642 5 $3,868,545
I= 12.14% I= 12.29%
Alternatives Comparison
AT Capital AT Growth Rate of
AT IRR AT NPV
Accumulation Capital
“Hold as is” 12.41% $2,972,935 $3,794,302 11.86%
“Hold and
18.81% $2,971,584 $3,792,577 11.85%
Refinance”
“Sell and Buy” 12.75% $3,010,811 $3,542,642 12.14%
“Exchange” 12.94% $3,031,106 $3,868,545 12.29%
Activity 1-1: Excel Workbook Analysis
Part A-“Hold as is” versus “Hold and Refinance”
Using the excel workbook provided perform a five year before and after tax
analysis of the “hold as is” and “hold and refinance” alternatives using the
following assumptions:
Property Assumptions
 Original acquisition price: $5,000,000
 Original acquisition costs: $50,000
 Original improvement allocation: 80.00%
 Original useful life: 39 years
 Years property held: 5 years
 Sale price if sold today: $5,525,000
 Cost of sale if sold today: 4.00%
 Next year projected NOI: $470,000
 Projected NOI annual escalation: 2.00%
Financing Assumptions-New Loan
 Loan amount is calculated using LTV and DSCR and the lower of the
two amounts rounded down to the nearest $1,000 is the amount of the
loan used in this analysis.
o Maximum LTV ratio: 75%
o Minimum DSCR ratio: 1.20
o Interest rate: 6.00%
o Amortization: 20 years
o Loan term: 10 years
o Payments per year: 12
o Loan costs (percent of loan amount): 2.00%
Financing Assumptions-Existing Loan
 Principal balance: $2,971,486
 Interest rate: 6.00%
 Remaining amortization period: 15 years
 Remaining term: 5 years
 Payments per year: 12
 Unamortized loan costs: $35,000
Investor /Owner Assumptions
 Ordinary tax rate: 35.00%
 Capital gains tax rate: 20.00%
 Cost recovery recapture tax rate: 25.00%
 After tax reinvestment rate: 5.00%
 Anticipated holding period: 5 years
 Disposition cap rate: 8.50%
 Disposition cost of sale: 4.00%
Part B-“Sell and Buy” versus “Exchange”

Using the excel workbook provided perform a five year before and after tax
analysis of the “sell and buy” and “exchange” alternatives using the following
assumptions:
Existing Property Assumptions
 Original acquisition price: $5,000,000
 Original acquisition costs: $50,000
 Original improvement allocation: 80.00%
 Original useful life: 39 years
 Years property held: 5 years
 Current Existing Loan Balance: $2,971,486
 Current Unamortized Loan Costs: $35,000
 Sale price if sold today: $5,525,000
 Cost of sale if sold today: 4.00%
 Next year projected NOI: $470,000
 Projected NOI annual escalation: 2.00%
Property to be Acquired Assumptions
 Acquisition Price/Market Value: $8,500,000
 Acquisition Costs: $100,000
 Improvement Allocation (Percent): 80.00%
 Useful Life: 39 Years
 Next Year’s NOI: $725,000
 NOI Annual Escalation: 2.00%
Financing Assumptions-Acquire By Purchase
 Loan Costs: 2%
Financing Assumptions-Acquire By Exchange
 Loan Costs: 2%
Exchange Assumptions
 Exchange Intermediary Fee: $5,000
Investor /Owner Assumptions
 Ordinary tax rate: 35.00%
 Capital gains tax rate: 20.00%
 Cost recovery recapture tax rate: 25.00%
 After tax reinvestment rate: 5.00%
 Anticipated holding period: 5 years
 Disposition cap rate: 8.50%
 Disposition cost of sale: 4.00%
Activity 1-2: Discussion Questions

1. Why is the Investment Base concept important in the “Hold versus
Dispose” decision?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
2. Why is the IRR of the “Hold and Refinance” alternative (18.81%) so
much higher than the IRR of the “Hold as is” alternative (12.41%)?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
3. How is the Investment Base for the “Sell and Buy” calculated?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
4. How is the Investment Base for the “Exchange” alternative calculated?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
5. What is the Substitute Basis in the exchange property and how is it
calculated?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
6. Why is the loan needed to acquire the new property by exchange less
than the loan needed to acquire the property using cash?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
7. Which of the four alternatives has the highest wealth accumulation?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
8. How is the After Tax Growth Rate of Capital calculated? What is the
significance of this growth rate?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
9. The cash flows and sales proceeds from each alternative are reduced to
a Net Present Value at 5%. Which alternative has the highest Net
Present Value? How does this compare to the Capital Accumulation?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
10. The highest Capital Accumulation is the Exchange. In the Hold and
Refinance the investor has substantial refinance proceeds to invest.
What rate would the refinance proceeds have to earn in order for the
Hold and Refinance Capital Accumulation to be as high as the
Exchange Capital Accumulation?
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
Case Study
This case study profiles the alternatives available to an owner of an office
building. Five years into the holding period, he has received a letter of intent
offering to purchase his office building. He also is considering exchanging his
office building for a free-standing industrial building that has a solid tenant in
place. These events prompt him to ask an analyst to look at the possible
alternatives that are available to him regarding his office building. Four possible
alternatives are evaluated individually and then compared using internal rate of
return (IRR), Net Present Value, and capital accumulation to determine the
best course of action for the office building owner.
Case Objectives
 Calculate the investment base for various alternatives.
 Quantitatively analyze an owner’s option to hold and do nothing.
 Quantitatively analyze an owner’s option to hold and refinance.
 Quantitatively analyze an owner’s option to sell a property and buy another
one.
 Quantitatively analyze an owner’s option to exchange a property for another
one.
 Determine the best course of action based on a comparison of different
investment alternatives using capital accumulation.
 Describe the advantages and disadvantages of each alternative.
Case Setup
Scenario: Five Years Later
Almost five years have passed since an investor acquired an office building for
$10,000,000, with an additional $100,000 in acquisition costs. The investor
chose to pay all cash and not use debt financing to acquire the property. At the
time of purchase, 20 percent of the original basis was allocated to land, and 80
percent was allocated to improvements for tax purposes. The fifth year of
ownership will result in a net operating income (NOI) of approximately
$790,000, which represents approximately a 2 percent annual growth rate for
NOI for the five years of his ownership.
The office building owner has hired your company as a consultant to help him
manage his portfolio and maximize the growth of his available resources. The
office building owner has received a letter of intent from an institutional
investor to purchase his office building for $11,500,000. The first thing the
office building owner would like to know is how much cash he would have
available for other investments if he were to accept the offer represented by the
letter of intent. The sale would incur a 2 percent cost of sale. The office
building owner’s accountant informs you that his ordinary income tax rate is 35
percent; his capital gains tax rate is 15 percent; and his cost-recovery recapture
tax rate is 25 percent.
The office building owner would like to know what some of his available
options are at this point in time. Following is a list of some of the options
available to the office building owner:
1. Continue to own his office building for five more years with no change in
the ownership or financing structure (Hold as is)
2. Continue to own his office building for five more years, but place the
maximum debt financing available on his office building.
3. Sell his office building and buy another real estate investment with the
minimum financing needed to buy the other property and hold the other
property for five years (Sell and Buy)
4. Exchange his office building for the other property considered for purchase
in option 3 using the minimum financing needed to effect the exchange and
hold the other property for five years (Exchange)
Use the information on the following pages to analyze each of these alternatives
for the office building owner.
Complete a Five-Year Before and After-Tax Analysis for

the First Option (Hold as is)
The first option is to continue to own his office for five more years with no
change in the ownership or financing structure. Assume the following
information in your analysis:
 Investment base: The sale proceeds after tax that would be available for
alternative investments if the property were sold.
 NOI: The NOI for the first year of the projection is $805,000. This
represents a 2 percent growth from last year’s NOI, which has been the
approximate growth rate of the NOI during the last five years. Use 2
percent as the annual growth rate for subsequent years of the projection.
 Cost recovery: Continue the cost-recovery schedule set up when Mr.
Nichols acquired the property.
 Disposition cap rate: 8.0 percent (Capitalize the year six NOI and round to
the nearest thousand.)
 Disposition cost of sale: 4 percent
 After-tax reinvestment rate: 5 percent
 Total capital to invest: $10,839,859 (sale proceeds after tax if sold)
Calculate the following measures of investment performance:
 Before-tax IRR
 After-tax IRR
 After-tax Net Present Value
 After-tax capital accumulation
 After-tax annual compound growth rate of capital

the Second Option (Hold and Refinance)
The second option is to continue to own his office building for five more years,
but to place the maximum debt financing available on his office building and
invest the finance proceeds in available non-real estate investments. Assume
the following in your analysis:
 Investment base is the investment base for hold as is less the funds taken
out from the refinance.
 NOI: The NOI for the first year of the projection is $805,000. This
represents a 2 percent growth from last year’s NOI, which has been the
approximate growth rate of the NOI during the last five years. Use 2
percent as the annual growth rate for subsequent years of the projection.
 Cost recovery: Continue the cost-recovery schedule set up when the office
building owner acquired the property.
 Total capital to invest: $10,839,859 (sale proceeds after tax if sold)
The financing assumptions are:
 Loan amount: Calculate the loan amounts using the loan-to-value (LTV)
ratio and debt service coverage ratio (DSCR), select the lesser of the two
amounts, and round it down to the nearest thousand.
 Interest rate: 6 percent
 Payments per year: 12
 Amortization period: 20 years
 Term: 10 years
 Loan costs: 2 percent
 Maximum LTV ratio: 70 percent
 Minimum DSCR: 1.20
 Before-tax IRR
 After-tax IRR
Scenario Continued
The office building owner would like to know what other real estate investments
might be available. Your firm recently listed for sale and leaseback an industrial
warehouse/distribution industrial building owned by a national grocery chain.
The building is 200,000 square feet (sf), is in excellent condition, and is in a
premier location. The firm would like to raise capital to invest in their core
retail grocery business.

the Third Option (Sell and Buy)
The third option is to sell office building and then buy the national grocery
chain’s warehouse/distribution industrial building with the minimum financing
needed and to hold it for five years. Use the sale proceeds after tax from the
sale of office building as the equity in the national grocery chain’s
warehouse/distribution building.
Use the following assumptions for this analysis:
 Investment base is the investment base for option one if no money is added
or taken out to affect the purchase of the industrial building
 Purchase price: $20,000,000
 Acquisition costs: $200,000
 Type of lease: Absolute net
 Lease term: 10 years with two five-year options at the same terms as the
base lease
 Rent: First-year rent is calculated by capitalizing the purchase price at 7.5
percent.
 Rent escalation: 2 percent annually
 Tax assessment
◘ Land: $4,000,000
◘ Improvements: $12,000,000
 Total capital to invest: Investment base for this alternative
The financing assumptions are
 Term: 10 years
 Before-tax IRR
 After-tax IRR
the Fourth Option (Exchange)
The fourth option is to exchange the office building for the national grocery
chain’s warehouse/distribution industrial building using the minimum financing
needed to affect the exchange and to hold the property for five years. Use the
following assumptions for this analysis:
 Investment base: Investment base for option one
 Purchase price: $20,000,000
 Acquisition costs: $200,000
 Exchange accommodator fee: $10,000
 Type of lease: Absolute net
 Lease term: 10 years with two five-year options at the same terms as the
base lease
 Rent: First-year rent is calculated by capitalizing the purchase price at 7.5
percent.
 Rent escalation: 2 percent annually
 Tax assessment
◘ Land: $4,000,000
◘ Improvements: $12,000,000
 Substitute basis: Purchase price of the new property, plus acquisition costs,
plus exchange intermediary fee, minus deferred gain
 Total capital to invest: Investment base for this alternative
The financing assumptions are
 Term: 10 years
 Before-tax IRR
 After-tax IRR
Answer Section
Activity 1-2: Discussion Questions-Answers
1. Why is the Investment Base concept important in the “Hold versus
Dispose” decision?
a. Investment Base quantifies, at the decision point, the amount of
money that can be taken out of an owned investment and placed
in an alternative investment. In order to make an informed
investment decision the investor must know how much money is
invested.
2. Why is the IRR of the “Hold and Refinance” alternative (18.81%) so
much higher than the IRR of the “Hold as is” alternative (12.41%)?
a. The increase in yield (IRR) from the “Hold as is” to the “Hold
and Refinance” is caused by positive leverage. In a positive
leverage environment as the Loan to Value increases, the yield
increases. The refinance scenario has $1,100,904 in additional
financing over the as is scenario.
3. How is the Investment Base for the “Sell and Buy” calculated?
a. The Investment Base for the “Sell and Buy” is the Sales
Proceeds After Tax from the industrial property, plus and cash
added to the new investment, less any cash taken out at the sale.
In the sample problem there is no cash added or taken out, so
the Investment Base is $2,166,643.
4. How is the Investment Base for the “Exchange” alternative calculated?
a. The Investment Base for the ”Exchange” alternative is the Sales
Proceeds After Tax from the industrial property, plus any cash
added to the exchange property, less and cash taken out in the
exchange. There is not cash added or taken out in the sample
exchange, so the Investment Base is $2,166,643.
5. What is the Substitute Basis in the exchange property and how is it
calculated?
a. The Substitute Basis in the exchange property is $7,841,718.
This is calculated by subtracting the deferred gain in the
industrial property from the total basis acquired in the new
office property, including the acquisition cost and exchange
costs.
6. Why is the loan needed to acquire the new property by exchange less
than the loan needed to acquire the property using cash?
a. The loan amount needed in the exchange is reduced by the tax
savings. The Sales Proceeds Before Tax are available for the
purchase as well as the tax savings from expensing the
unamortized loan costs.
7. Which of the four alternatives has the highest wealth accumulation?
a. The Exchange, $3,868,545.
8. How is the After Tax Growth Rate of Capital calculated? What is the
significance of this growth rate?
a. The growth rate is calculated using the Investment Base
($2,166,643) as the Present Value and the Capital Accumulation
for the alternative as the Future Value over an investment period
of 5 years. Solve for I or interest. This rate is the after tax rate
of return on the $2,166,643 for the 5 year period and can be
used to compare these alternatives to each other or to compare
to a different investment. An example would be comparing this
real estate to mutual fund returns on an after tax basis.
9. The cash flows and sales proceeds from each alternative are reduced to
a Net Present Value at 5%. Which alternative has the highest Net
Present Value? How does this compare to the Capital Accumulation?
a. The Exchange has the highest Net Present Value, $3,031,106.
This is the same result as the Capital Accumulation, Exchange is
highest. This is looking at the same decision two different times,
EOY 0 and EOY 5.
10. The highest Capital Accumulation is the Exchange. In the Hold and
Refinance the investor has substantial refinance proceeds to invest.
What rate would the refinance proceeds have to earn in order for the
Hold and Refinance Capital Accumulation to be as high as the
Exchange Capital Accumulation.
a. 6.11% After Tax Rate
Exchange Capital Accumulation $3,868,545

Hold and Refinance Capital Accumulation $3,792,577
Difference $75,967
Capital Accumulation from Refinance Proceeds $1,405,063

Additional Funds to Equalize $75,967
Total $1,481,031
EOY $
0 ($1,100,904)
1 $0
2 $0
3 $0
4 $0
5 $1,481,031

Hold vs. Dispose Analysis Full Book 2413

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Hold vs. Dispose Analysis Full Book 2413

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Ward Center for Real Estate Studies

Hold Versus Investment Base ........................................ 1.4

Analysis “Hold as Is” Alternative ....................................... 1.8

Hold Versus Dispose Analysis for Commercial Real Estate •1.1

Investment Base for Hold Alternatives

Investment Base of “Hold as is” Alternative

Investment Base for Dispose Alternatives

After Tax Cash Flow Model

Sample Problem 1-1

“Hold as Is” Alternative

“Hold as is” Investment Base

Calculation of Adjusted Basis

Calculation of Capital Gain

Items Taxed as Ordinary Income

Sale Proceeds Aftet Tax

This $2,166,643 is the “Hold as is” Investment Base

Cash Flows After Tax

Calculation of Capital Gain

Items Taxed as Ordinary Income

Sale Proceeds Aftet Tax

“Hold and Refinance” Alternative

“Hold and Refinance” Investment Base

Debt Service Coverage Ratio

Number of Periods 240

"Hold and Refinance" Investment Base

"Hold as is" Investment Base $2,166,643

Annual Cash Flows After Tax

Cash Flows After Tax

Calculation of Adjusted Basis

Calculation of Capital Gain

Items Taxed as Ordinary Income

Sale Proceeds Aftet Tax

“Sell and Buy” Other Real Estate Alternative

This $2,166,643 is the “Sell and Buy” Investment Base

*Net loan proceeds needed ÷ (1-2%) -

Annual Cash Flows After Tax

Cash Flows After Tax

Calculation of Adjusted Basis

Calculation of Capital Gain

Items Taxed as Ordinary Income

Sale Proceeds Aftet Tax

“Exchange” into Other Real Estate Alternative

“Exchange” into Another Property Investment Base

Calculation of Adjusted Basis

Calculation of Capital Gain

Items Taxed as Ordinary Income

Sale Proceeds Aftet Tax

This $2,166,643 is the “Exchange” Investment Base

Loan Needed for Exchange

*Before Tax Proceeds of Sale from

**Net Loan Proceeds Needed ÷ (1-2%) -

Cash Flows After Tax

Calculation of Adjusted Basis

Calculation of Capital Gain

Items Taxed as Ordinary Income

Sale Proceeds Aftet Tax

After-tax Internal Rates of Return

"Sell and Buy" "Exchange"

"Sell and Buy" "Exchange"

After-tax Capital Accumulations

"Hold and Refinance"

"Sell and Buy"

"Sell and Buy" "Exchange"