Disposition of Real Estate

As with any other income-generating asset, replacing real estate makes sense only if the funds obtained from selling it can be invested in another asset with better returns at the same level of risk—or, more precisely, if there is an expectation of such returns.

Buy-sell transactions are often driven by differing expectations between the buyer and the seller. However, it is also possible for both parties to have the same expectations, yet the asset may generate different returns under different ownership (e.g., due to tax benefits from depreciation or diversification considerations).

How to Make the Decision?

Let’s consider an example: imagine you own a property purchased five years ago, which you’ve been renting out, and now you have the opportunity to sell it. After paying capital gains tax, you will net $71,000. Your historical cash flows, including the sale transaction, are as follows (BT = Before Tax, AT = After Tax):

Based on this, your historical IRR would be 16.25% if you sell the property.

Now, let’s assume you decide not to sell. This means you forgo the $71,000. Instead, you will continue to earn rental income, and after five more years, you predict you could sell the property for $99,000. Based on your forecasted cash flows, the expected IRR would be 15.60%.

This indicates that a decision to replace the property should only be made if a new investment promises a return greater than 15.60%.

If we generalize this approach, similar calculations can be made for each subsequent year to determine the Marginal Rate of Return (MRR).

Now, imagine that an alternative real estate investment offers an IRR of 15.50%. Based on this, the property should be sold around the 14th year after purchase:

Alternatively, if the expected return on the new investment increases over time rather than being fixed, the crossover point would move closer in time:

The complete Excel model, which I built based on the book’s example, can be found here: Excel File.

Source:
Real Estate Finance & Investments by William B. Brueggeman and Jeffrey D. Fisher