A home-builder client and I were discussing a large plat he is working on. It’s in the dirt-work phase, so he has not yet committed to building homes. When I asked what his plans were he said, “In this market, I’m a seller.” He will most likely sell the finished plat to another home-builder when complete. He went on to say, “I could probably get more for the lots later, but as you know, ‘Pigs get fat, hogs get slaughtered’.”
I’ve always loved that saying. It’s a simple way of reminding us to not get too greedy in our dealings. Like home-building, the commercial real estate industry is in the “up” part of the real estate cycle, but when is it the right time to sell? To make the call, several things must be taken into consideration.
I always begin any analysis at the top. What is the overall strategy of the firm? For instance, if you are a developer, your strategy is most likely one of two things: build-then-hold or build-then-sell. Maybe you invest for cash flow. If you are a family who just inherited 10 properties, you probably have a different strategy or are still developing one. (And if you don’t have a strategy, don’t do anything until you do!)
Next, consider your long term plan for the real estate portfolio. If diversification is important, are you now weighted too much in one category? Maybe you need to harvest some locked-up cash for other needs. (Consider refinancing opportunities first.)
How is the real estate market? Are businesses doing well and growing? Are vacancies tightening and rental rates increasing, or is the opposite true?
Finally, consider the subject property. Ask yourself if you want to own this asset long term. Is it an irreplaceable property in an A+ location with entitlement constraints and a good value against replacement cost? Is there high rent appreciation potential due to market constraints? Alternatively, does it have a lot of rollover coming up in a declining market, stiff loan prepayment penalties, or take a lot of management time and attention?
Financial Metrics – Hold
In a hold vs. sell analysis, you want to take the view of an investor with two options. One is to invest the proceeds of sale in a new property. The other is to invest the same proceeds into the existing property. The basic principal is: “If you have not agreed to sell the asset, you have effectively agreed to purchase the asset yourself.”
Here’s where it gets tricky. Your equity to invest, or investment base, is not your original down payment. It is the amount that could be freed up by a sale today. This is the property’s value, less closing costs, less debt payoff, less taxes. You then create a proforma for the anticipated hold period for the existing property. What is your current Cash-on Cash return if you divide your proforma cash flow (after debt service) into the potential proceeds from sale? Also, prepare a 10-year forecast to project what a long-term hold IRR might be. Together these metrics give you a good look at how your existing asset might perform if you were purchasing it today.
Financial Metrics – Sell
To make a valid comparison between holding the existing asset or selling and reinvesting the proceeds, it is necessary to select an alternative property to be considered as a replacement property. Maybe you already have a target property in mind. Ideally, you will only consider selling if you have a better alternative available.
Prepare the same analysis for the “target” property assuming you will be using 100% of the net proceeds from the sale of the existing asset as the equity investment. How do the proforma returns for the Sell scenario compare with the returns for the Hold scenario?
Income Tax Consequences
To further complicate this decision we must consider the income tax consequences of each alternative, and this will be different for each investor. The primary driver is typically long-term vs. short-term capital gains. If you are selling a property inside the short-term capital gains window, what is the risk of holding until you get into long-term capital gains range? Is there a risk cap rates will increase to a point that erases the tax benefit of deferring the sale?
If you have a large amount of profit in the existing building, seeking a 1031-exchange opportunity will greatly increase the returns by deferring the taxes until a later date.(if you can find and close on the new asset within 180 days).
Also consider pending changes to the tax code that prompt selling an asset today such as anticipated increases in the capital gains tax rate.
Once all of the above metrics have been considered, you will be in position to make an informed decision to keep or sell the asset. Hopefully all signals point in the same direction. Remember, it’s not all about the numbers. You may have a very important strategic reason to sell that out-weighs the financial analysis saying you should keep it.