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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. The Effects of Mortgage Financing on Cash Flows, Values, and Returns • Effect on the initial investment • Effect on the cash flows from operations • Effect on the cash flow from sale

  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 (leverage) • 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 I-T

  8. The Effect of Leverage • Increased financial risk • Increased variability of returns • Effect in before and after tax cash flows • Effect on before and after tax equity reversion

  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/minimum DCR

  13. Permanent Mortgages with Equity Participation • Participation Mortgages • Income kickers • Equity kickers • Contingent interest

  14. Other Equity Participation Arrangements • Joint Ventures • Sale Leasebacks

  15. Financing Alternatives • Participation loans • Lender gets percent of NOI and/ or resale • Borrower pays lower interest rate • Debt coverage ratio is higher • Participation is tax deductible (vs.only interest on loan) • May not be riskier for lender than fixed rate mortgage • E.g. interest rate is 10% on regular lean but 8% on participation loan with lender receiving 25% of NOI in excess of first year NOI and 25% increase in value when the property is sold. • Note that the participation payment is never negative Note: leverage will depend on effective cost of participation loan

  16. Financing Alternatives Continued • Convertible mortgage • Lender has option to convert loan balance to an ownership interest in the property • Borrower pays lower interest rate • Debt coverage ratio is higher • E.g. interest rate is 10% on regular loan but 8% on convertible loan with lender having the option in year 5 to convert the loan balance into an 80% ownership position • Note: if loan is non-recourse, lender gets the property if there is default

  17. Financing Alternatives Continued • Sale- leaseback of land • Owner of property sells land under building and leases it back, e.g. for 99 years • Owner can still get mortgage on building • Analogous to 100% financing on land • Land lease payment is tax deductible (vs. only interest on a mortgage) • Note that land not depreciable but building is

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