Real Estate Investment

& Finance
Joseph Shaw
Agenda – Week 7

 Review of Week 6 – Any Questions?

 Lecture – Chapters 14 & 15
 Chapter 14
Disposition and renovation
of income properties

©2022 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written
consent of McGraw-Hill Education.
Disposition Decisions
 Disposition – sale of the property

 Equity Buildup –
◦ The result of positive amortization when the outstanding
mortgage balance decreases and the investor’s equity position
increases
◦ Represents the opportunity cost of not selling.
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?
Disposition Decisions
 If the investor will net $100,000 after all taxes and
expenses if the property is sold today…
◦ Can it be invested and earn a greater return than if the property
is not sold?
◦ The investor gives up the following cash flow stream by
selling the property….
Disposition Decisions
 The future expected net cash flows for a three-year
holding period are
◦ ATCF0 = ($100,000)
◦ ATCF1 = $10,000
◦ ATCF2 = $11,000
◦ ATCF3 = $12,000
◦ ATCF3(sale) = $103,000
◦ Compute IRR = 11.82%
Disposition Decisions
 The ATIRR = 11.82% is what the investor gives up by
selling the property and taking $100,000 today.

 Is there an equivalent risk investment that can earn

a greater ATIRR?
◦ If yes, sale is justified
◦ If not, property should be kept.
Return to a New Investor
 Tax law changes affect the relative benefits of existing
versus new investments in the same property.
◦ New investor has a new adjusted basis in the property
◦ New investor depreciates the property based on current tax
law
◦ If the tax law becomes less favorable it tends to favor
existing investors.
◦ If the tax law becomes more favorable, then new investors
tend to be favored.
Return to a New Investor
 Marginal Rate of Return –
◦ The return that would result from holding the property only one additional
year.
◦ Each year, the marginal rate of return is based on the benefit of receiving
ACTF0 for one additional year and ATCFS at the end of the additional year.

 Reinvestment Rate is assumed to be constant

 Optimal Holding Period – is the point at which the marginal rate of return
curve intersects the reinvestment rate curve.
Refinancing as an Alternative to
Disposition
 Incremental Cost of Refinancing
◦ What are the additional funds obtained by refinancing?
◦ What are the additional cash outflows?
◦ Solve for i: can this be earned or borrowed funds?
 Leveraged Return from Refinancing and Holding –
calculates the impact of refinancing on the investor’s
return from holding after refinancing.
 Diversification Benefits
 Additional funds can be obtained by refinancing a property with
equity buildup.
 The additional funds can be reinvested in a second property.
Renovation as an Alternative to
Disposition
 Improvements to a property by making major capital
improvements to upgrade quality and reduce operating
costs.

 Converting the improvement to accommodate a

different economic use.
Renovation and Refinancing
 The total amount of funds that the investor will be able
to borrow is usually based on a percentage of estimated
value of the property after renovation is completed.

 This value would be based on an appraisal.

Other Disposition Considerations –
Portfolio Balancing
 An investor with a portfolio of properties should take
into consideration how sale of a property affects the
mix of properties in the portfolio.

 The investors must balance the benefits of a diversified

portfolio versus efficient management.
Tax-Deferral Strategies Upon
Disposition
 Tax-Deferred Exchanges
◦ Typically used when a property owner wants to sell a property
and then purchase another property within a specified period.
◦ Instead of paying a capital gains tax in the year of sale, the
equity that the owner has in the property being exchanged is
established and carried over as the equity in the acquired
property.
◦ When the acquired property is eventually sold, the deferred
capital gains taxes are paid at that time.
Tax-Deferral Strategies Upon
Disposition
 Installment Sales
◦ When a property is sold, the buyer makes periodic payments to
the seller after the year of sale.

◦ The contract of sale provides that instead of paying the full

price when the property is purchased, the buyer shall make
payments over time.
Installment Sales
 May include transactions in which the seller also provides financing and
will receive interest payments for the amount financed as well as
installment payments due on the purchase price over time.

 To qualify for installment sale reporting, the amount of the capital gain
subject to tax each year is qual to the amount of the installment payment
multiplied by the profit ratio.
Tax-Deferred Exchanges
 IRC Section 1031 – states that no gain or loss shall be
recognized on the exchange of property held for productive
use in a trade or business or for investment if such property
is exchanged solely for property of like kind, which is to be
held either for productive use in a trade or business or for
investment.
 Specific Time Frames Must be Established – the property
be identified within 45 days and the exchange completed not
more than 180 days after the title transfer of the exchanged
properties.
 Balancing Equities – the investor must give up equity in
real property and acquire equity in real property
Tax-Deferred Exchanges: Recognized Gain
 Section 1031 allows an investor to transfer equity from one property
to another thereby deferring some or all the gain into a future period.
◦ Substitute Basis – the basis in a property acquired in a tax-deferred exchange.
◦ Unlike Property (Boot) – property that is not real property resulting in a taxable
event
◦ Cash – if received in an exchange, must be reported as gain
◦ Mortgage Relief – if the investor owes less on the replacement property than on
the property given up in the exchange, the investor is considered to have
received mortgage relief
 Unrecognized Gain = realized gain - boot
 Economics of an Exchange – is the exchange beneficial?
◦ There is less depreciation each year because of the lower basis of the second
property.
◦ Because the gain on the exchanged property has been deferred, there will be
larger capital gains upon sale of the second property.
Rehabilitation Investment Tax Credits
 Investment tax credits are available for certain rehabilitation expenditures
during the year.
 These credits reduce the investor’s tax liability.
 Low-Income Housing
◦ A tax credit can be claimed by owners of residential rental property providing low-
income housing.
◦ The credits are claimed annually for a period of 10 years.
◦ Maximum rates:
 9% for new construction and rehabilitation
 4% for the acquisition cost of existing housing
◦ Qualifications:
 Expenditure for construction or rehabilitation must exceed $2,000/unit
 Either:
 At least 20% of the housing units are occupied by individuals with incomes <=50% of area median
income
 At least 40% of the housing unites are occupied by individuals with incomes <= 60% of area median
income
 Chapter 15
Financing Corporate Real Estate

©2022 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written
consent of McGraw-Hill Education.
Corporate Real Estate: User Firms
 Why do corporations own real estate?
◦ Needed for operations and choose to own rather than lease
◦ Ownership provides diversification from core business
◦ Retain property from previous business operations
◦ Acquire real estate for future expansion or relocation
Corporate Real Estate: User Firms
 Benefits
◦ Save on lease payments
◦ Tax benefits of depreciation
◦ Property value appreciation and sale
 Can lease back the property if the space is needed
 Potential Negatives
◦ Opportunity cost of capital invested in real estate
◦ Impact of ownership on financial statements
◦ Inefficient use of space
Lease-versus-Own Analysis
 Corporation can use the
space without investing
corporate equity, freeing the
equity capital for other
investment opportunities
available to the firm.
Leasing
 Essentially investing in real
estate
 May decide to finance the
purchase by taking out a
mortgage secured by the
property in addition to
equity capital or may use
only equity capital
Owning
Cash Flow from Owning Versus Leasing
 The decision to own the
space involves an
additional equity
investment in the property
that is not required when
leasing.
 Must consider the

difference in the cash flow

to the corporation if it
leases the space rather than
owns the space.
Return from Owning Versus Leasing
 Compute Residual Cash Flow Difference
◦ There is no residual value when leasing
◦ Owning gives a residual value when the property is sold
 Compute the IRR on the equity investment in the
property.
◦ Does the IRR justify the ownership risk?
Importance of the Residual Value of
Real Estate
 A corporation that chooses to own real estate has also
invested in its residual value.

 Estimating the Residual Value

◦ Possible assumptions:
 Residual value will be equal to the book value of the property
which is the original acquisition cost less accounting depreciation
at the expiration of the lease term
 No residual value because the residual sale price received must be
reinvested in a lease or on a new facility at that time
The Investor’s Perspective
Factors Affecting Own-versus-Lease Decisions

 Space Requirements – leasing is preferable when the company’s space

requirements are far less than the optimal development on a given site.
 Amount of Time Needed – when the expected life of an asset far exceeds
the company’s period of use, companies will choose to lease.
 Risk Bearing – larger companies with broadly dispersed operations are
more likely to own than are smaller companies with geographically
concentrated operations.
Factors Affecting Own-versus-Lease Decisions
 Management Expertise – Real estate is not part of the business model
 Maintenance – companies are more likely to own assets whose values are
highly sensitive to the level of maintenance.
 Special Purpose Buildings – companies are more likely to own buildings
that have been customized for their operations
 Tax Considerations – If the lessor is in a higher tax bracket than the
lessee, then leasing puts ownership of the asset in the hands of the party
that can most benefit from the tax shelter provided by depreciation.
Factors Affecting Own-versus-Lease Decisions

 Access to Capital Markets – owning is preferable to corporations with a

high credit rating because the lease rate must cover the owner’s cost of
capital
 Control – the corporation may want to control the real estate by owning
the property
 Effect on Financial Statements – real estate ownership distorts corporate
balance sheets
Impact on Lessee Financial
Reporting
 Off-Balance Sheet financing
◦ Operating lease
 No impact on balance sheet

◦ Capital lease
 Long-term asset and long-term liability equal to present
value of lease payments
 Increases debt-to-assets ratio
Impact on Lessee Financial
Reporting
 Operating Lease – a contract wherein the owner
(lessor) permits the user (lessee) to use an asset for a
period which is shorter than the economic life of the
asset without any transfer of ownership rights.
 Capital Lease – meets any of the following criteria:
 Extends for 75% of asset’s life
 Ownership transferred to lessee at the end
 “Bargain Purchase” option
 Present value of lease payments ≥ 90% of market value
of the asset
Impact of Lease on Income
Statement and Balance Sheet
 The Problem of Hidden Value arises:
◦ Because accounting conventions require companies to carry real
estate assets on a lower of cost or market basis; and
◦ Many properties contribute little to reported earnings
 Special problems
◦ The costs for outside investors to ascertain the values of such
real estate may be large enough to warrant a large discount
◦ Investors may discount too heavily the expected future value of
real estate that produces no current operating cash flow
◦ Because accounting depreciation charges generally exceed true
economic depreciation, the reported earnings of real estate
companies typically understate the level of operating cash flow
The Role of Real Estate in
Corporate Restructuring
 Real estate assets are often a focal point in
restructurings.
 Corporate real estate assets are part of local and

regional property markets.

 Unless the company is a dominant force in a small

local economy, the market value of those assets is

typically governed by factors very different from those
that drive the value of the firm’s operating business.
Sale-Leaseback
 Company wants to sell the real estate, but needs the
space

 Company receives cash from property sale

 Company loses remaining depreciation allowance

 Company removes residual value risk

Sale-Leaseback
 Analysis
◦ Compute the ATCF if the property is sold today
◦ Compute the incremental ATCF from operations that occur
with leasing
◦ Compute the residual value lost with the sale today
◦ Compute the IRR
 This is the return from owning or cost of leasing
Sale-Leaseback
 Financial statement implications
◦ Additional income from gain on sale
◦ Increase in earnings per share
 Removes a financing option for potential raiders
 Gives the corporation freedom to relocate if it is a

short-term lease
Refinancing
 An alternative to sale-leaseback might be to refinance
the real estate with a mortgage.

 Mortgage financing may be a substitute for corporate

debt if it is shown on the balance sheet and increases
the corporation’s debt ratio.
Investing in Real Estate for
Diversification
 Corporations may view ownership of real estate as a
way of diversifying their business activities.

 This may lead to the purchase of more real estate than

it needs for its operations.