Problem
A. A property could be sold today for $2.5 million. It has a loan balance of $1.25 million and, if sold, the investor would incur a capital gains tax of $300,000. If not sold, the property is expected to produce net operating cash flow of $55,000 over the next year. Assuming selling costs of 5% of the purchase price:
a. What is the investor's Return on Investment Base (or Investable Equity)?
b. If they have their eye on another investment opportunity with an expected return of 7.5%, should they sell?
B. 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 $65,000 and the property could be sold after one year for $2.90 million. Renovation would cost $300,000. 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?