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CHAPTER TWELVE

CHAPTER TWELVE. FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES. Chapter Objectives. The effects of financial leverage (both positive and negative) on a property’s internal rate of return The conditions necessary for positive financial leverage

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CHAPTER TWELVE

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  1. CHAPTER TWELVE FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES

  2. Chapter Objectives • The effects of financial leverage (both positive and negative) on a property’s internal rate of return • The conditions necessary for positive financial leverage • The use of participation loans, convertible mortgages, and other alternatives • Understand the sale- leaseback as a financing alternative

  3. Financial Leverage • The use of borrowed funds to complete an investment purchase.

  4. The Borrower’s Decision Making Process • Two basic reasons real estate investors use borrowed funds: • To increase the size of their purchase (affordability) • To magnify their expected rate of return • Positive and negative leverage

  5. Positive Leverage- Before Tax • When the unlevered BTIRR is greater than cost of debt • BTIRRE= BTIRR on equity investment • BTIRRP= BTIRR on total investment • D/E= portion of debt to equity • BTIRRD= BTIRR on debt • BTIRRE= BTIRRP+ (BTIRRP- BTIRRD) (D/E)

  6. Positive Leverage- After Tax • ATIRRE= ATIRR on equity • ATIRRP= ATIRR on total funds invested • ATIRRD= ATIRR on debt • D/E= ratio of debt to equity • ATIRRE= ATIRRP+ (ATIRRP- ATIRRD) (D/E)

  7. Break-Even Interest Rate • BTIRRD= ATIRRP 1-t

  8. The Effect of Leverage • Increased financial risk • Increased variability of returns • Effect on before and after tax cash flows • Effect on before and after tax equity reversion • Equity reversion is the lump-sum benefit that an investor receives or expects to receive at the termination of an investment.

  9. The Effect of Leverage

  10. Underwriting on Income Properties • Loan application • Property description and legal aspects • Cash flows estimates • Appraisal report and market or feasibility study

  11. Loan Underwriting • The property and borrower • Property type, quality, and location • Tenant quality and lease terms • Environmental concerns • Borrower experience and resources

  12. The Maximum Loan Amount • The loan to value ratio: • LTV=Vm/Vo • The debt service coverage ratio: • DCR=NOI/ debt service • Max debt service: • NOI/Desired DCR

  13. Chapter ends!

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