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Hello,
Can you please explain the logic and reasoning behind using the current market value of the subject property in a hold/sell analysis as the year 0 investment amount? I have an idea as to why we would do this, but getting your thoughts on this would be helpful.
One specific questions I have is why we would use the market value as the year 0 investment amount when in reality we would not be making this investment (since we already own the property).
Thanks,
RyanHi Ryan,
Great question on a concept that often trips people up. Let me first quote a portion of lecture 2.4 of this course that addresses this concept:
“For purposes of performing hold/sell analysis of an owned asset, the asset’s current market value less selling costs is entered as a sole Investment Cash Flow in time zero of the analysis.
“Now why use market value rather than actual cost basis you might ask? In the case of Lakefront Industrial I, we’re assessing two possible scenarios. Scenario one, we hold the asset for an additional 10 years. Scenario two, we sell the asset and use the proceeds to acquire a different property.
“So what’s the cost of choosing scenario one over scenario two? The cost is not our current basis, but rather is what we miss out on (i.e. the opportunity cost) by not going with scenario two. Or in other words, the net proceeds we would have taken in from selling the property had we gone with scenario two.”
Now to your question: why we would use the market value as the year 0 investment amount when in reality we would not be making this investment (since we already own the property)?
In hold/sell analysis, choosing the ‘hold’ scenario is making an investment. The investment we make is that we forego the net proceeds we’d earn from selling the property (i.e. the opportunity cost), and trade that for some period of operating cash flows plus a reversion cash flow at the end of the analysis. Thus the investment we make (i.e. opportunity cost) is represented by the market value of the property (less selling costs) in time zero of the hold asset’s DCF.
Happy to answer follow-up questions!
Spencer
Thanks a lot, Spencer. This is very helpful.
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