The hold-sell decision.
Making the hold-sell decision has traditionally been more of an art than a science. Today, even with widespread computer use, the decision involves much judgment. But we now have financial theory and electronic spreadsheets which enable the decision maker to refine his or her judgment greatly.
The purpose of this article is to demonstrate use of an after-tax, discounted-cash-flow (DCF) model as an aid in making the hold-sell decision. The model makes it possible to interrelate, on an after-tax basis, the many variables that influence a property's profitability and therefore the investor's decision making.
In broad terms, size of the investment, financing, taxes, holding period, transaction costs, and economic outlook are just a few of the many variables that an investor must take into account. Any of these variables may influence the cash flows to be obtained from a property, which may be interrelated by time-value-of-money TVM) analysis.
The assumption that the investor seeks to maximize wealth or rate of return is the usual criterion for making the hold-sell, or disinvestment, decision. Subjective goals, such as desire for cash flow or capital gains, are best factored in following analysis using the model.
A sound working knowledge of the DCF model, the variables it takes into account, and the financial measures of performance it produces should be a must for today's asset managers. A working knowledge of the DCF model is assumed here, so that we may get to the hold-sell decision quickly. For readers not familiar with the model, professional courses or texts are available.(1) Figures 1 and 2 show printout from a DCF case example to be used in discussing the hold-sell decision.
Research has determined which variables to watch for in successful decision making about income-producing properties, and therefore, which are important to use in the DCF model. Austin Jaffe and David Walters, working independently, identified essentially the same six variables as most crucial allowing for differences in terminology and methodology), using a technique called sensitivity analysis? These six variables are:
* Cost, or purchase price
* Effective gross income (EGI)
* Total operating expenses Tot)
* Loan-to-value ratio (LVR)
* Interest rate on loan
* Market-value growth rate
The DCF model takes all six of these variables into account.
After being identified, the variables make considerable sense. The lower the cost, or purchase price, the greater the opportunity for value increases, all of which goes to the equity investor. Maximizing EGI and controlling operating expenses serves to maximize the net operating income (NOI), meaning higher cash flows for debt service and the investor. Including EGI and TOE in the calculations also reflects on the importance of sound day-to-day property management.
A high LVR and a low interest rate translate into positive financial leverage for the investor. A high growth rate in a property's market value translates into a higher selling price, which, in turn, means a higher equity reversion and greater profitability for the investor.
Alternatives other than sale, such as renovation, refinancing, or a change of use, are not taken up here, although each offers a possible advantage to an owner. The DCF model can handle each of these decisions, but each involves a distinct type of analysis. The intent here is to look only at the holdsell decision; these other alternatives may be the basis of a follow-up article. Case example and
A case example is used to illustrate the technique for resolving the hold or sell decision. Our example begins with an investor buying Champion Apartments for $640,000, of which 90,000 is for the site.
For tax purposes, using a 27.5-year life, straight-line depreciation gives a figure of 20,000 per year. The property is financed with a 10.5-percent, 25-year monthly pay loan of 500,000, which results in annual debt service of 56,651. The necessary cash equity investment from the new owner is 140,000. The investor is assumed to be in the 28-percent tax bracket.
Figure 1 begins with gross scheduled income projected at 108,000 and NOI at $64,000 in the first year. The gross income is expected to increase at a decreasing rate as the property ages and newer buildings are being constructed. Calculated cash flow after tax from operations, CFATO, for each year of ownership appears in the last line of Figure 1.
Figure 2 shows projected cash flow after tax from sale, CFATs, if Champion Apartments were sold at the end of any of the first 10 years of ownership. CFATs is also known as net, after-tax equity reversion,
Figure 3 summarizes the investor's year-by-year, after-tax cash flows. Financial measures of investment performance Figure 4 shows five measures useful in making decisions about an investment's financial performance on an after-tax basis. In brief, these measures are as follows:
* After-tax internal rate of return (ATIRR)
* Present value of investor's equity position
* Net present value (NPV)
* Profitability index (PI)
* Marginal (after-tax) rate of return (MRR)
Our investor is considered to have an after-tax required rate of return (ATRRR) of 11 percent. ATRRR is known also as the investor's "hurdle rate" for investing, meaning that the investor must get this rate or higher from the subject property because the investor has alternatives that will give at least an 11 percent rate of return. The hurdle rate comes from an analogy to the track event in which a runner must jump over hurdles (barriers) to win.
In self-interest, the investor is assumed to invest in that alternative giving the highest rate of return, other things equal; therefore no less than 11 percent should be expected of Champion Apartments.
The buy decision
NPV and the profitability index are best used jointly to determine which investments should be undertaken. NPV equals the present value of aH after-tax cash flows to the equity position less the initial equity. A positive NPV means the investment should be considered, as it is expected to yield a return greater than the required rate of return.
But when an investor has two or more investments of differing sizes, each with a positive NPV, another measure is needed. This is where the PI is useful. PI equals the present value of cash flows from an investment, discounted at the required rate of return and divided by the initial equity investment.
The benefit of calculating profitability indexes is that the higher the PI of an investment, the greater its return per dollar invested. For Champion Apartments, the PI reaches its maximum of 1.25 at the end of year 9. Based on the NPVs and PIs in Figure 4, Champion Apartments represented a good investment and so was bought.
Incidentally, our investor could have paid 675,000 for the property and realized his required 11 percent rate of return, assuming all projections held. The 675,000 equals the present value of after-tax cash flows to the equity position discounted at 11 percent $175,521 at EOY9), plus the available loan of $500,000.
The hold or sell decision When should our investor sell Champion Apartments? We look to the ATIRR and the marginal rate of return measures from Figure 4 for this decision. These two measures are graphed in Figure 5. The MRR is the return an investor expects to receive on equity if the property is held one more year.
MRR equals: CFAT.sub.o + CFAT.sub.o for the coming year - CFAT.sub.s for the current year) current CFAT.sub.s. Thus, using figures from Figure 4, the MRR for year 2 equals: ($11,918 + $151,162 - 128,645) [divide] 128,645; completing the calculation gives a MRR of 26.77 percent.
The ATIRR is that rate of return that makes the present value of all future cash flows equal to the initial investment. In a sense, ATIRR is the average rate of return to equity. It is also the rate that makes the NPV of the investment equal to zero. As shown in year 1, ATIRR equals MRR. But in years 2 to 6, MRR is greater than ATIRR, and so ATIRR keeps going up. In years 7 to 9, MRR is a little lower than ATIRR, and so ATIRR falls slightly. In year 10, MRR drops to 8.91 percent, and ATIRR drops more sharply.
The time to sell, based on these projections, is at the end of year 9, as the investor's MRR for year 10 falls below the investor's 11 percent required rate of return. What this means is that the investor would be better off taking his or her equity out of Champion Apartments and investing it in another property that promises a return of 11 percent or more.
Judgment still needed
Our investor's situation is almost certain to change as years go by. So an asset manager, in practice, should periodically update the projections and analysis for Champion Apartments to determine more currently when a sale is advisable. Here we are back to judgment. Judgment is needed in projecting the rates of change for gross income, operating expenses, and sale price. A DCF model simply converts an asset manager's judgments into financial measures that are helpful in making necessary decisions.
As indicated earlier, sale should not be the only alternative to be considered by an owner. Our asset manager might also investigate whether refinancing or renovation might not yield a higher return than selling. The DCF model may be used to generate cash flows and financial measures for these decisions as well. The analysis to make these decisions is much more complex than appropriate at this time. Indeed, either would provide the basis for a follow-up article.
Note that the above discussion is based on the usual "wealth maximization" assumption of finance. Other owner goals are possible. An elderly retired owner, seeking to maximize cash flow, would exercise a different type of analysis and judgment for the hold-sell decision. Further, issues of risk avoidance, pride of ownership, or sentimental attachment would require yet other types of judgment.
Finally, it should be noted that an experienced asset manager would use considerable judgment in estimating the inputs for the DCF model. One recent monograph on this topic is Forecasting: Market Determinants Affecting Cash Flows and ReversionS.(3)
1. See, for example, Real Estate Principles and Practices, 11th edition, by Jerome Dasso and Alfred Ring, published by PrenticeHall. Courses teaching DCF include IREM's Course 400 and the CommercialInvestment Real Estate Council's Course CI 101.
2. Austin Jaffe, Property Management in Real Estate Investment Decision Making (Lexington, Mass.: D.C. Heath, 1979), chapters 5-7, and David @ Walters, Just How Important Is Property Management?" Journal of Property Management, July/ August, 1973.
3. W. Lee Minnerly and Joy M. White, "American Institute of Real Estate Appraisers Research Report 4," Chicago, May 1989.
Jerome Dasso, Ph.D., M.B.A., is the H.T Miner Chairholder in Finance and Real Estate at the University of Oregon Graduate School of Management, Eugene. He is the author of many books and articles on real estate subjects, including Real Estate Principles and Practices, 11th edition Prentice-Hall); Real Estate Finance, with Gerald Kuhn (Prentice-Hall); and "Corporate Real Estate: Course Outline and Rationale," with William Kinnard and Joseph Rabianski (Journal of Real Estate Research, Fall 1989).
Dr Dasso is president-elect of the American Real Estate Society, a member of the board of governors of the American Institute of Corporate Asset Management, and a past president of the Real Estate Educators Association of America.