Chapter 12

1. Chapter 12 Financial Leverage and Financing Alternatives

2. Overview • Financial Leverage • Financial Leverage: Before-Tax • Financial Leverage: After-Tax • Break-Even Interest Rate • Underwriting Loans • Alternative Financing Structures • Conventional Loan • Equity Participation Loan

3. Financial Leverage • What is financial leverage? • Benefit of borrowing at a lower interest rate than the rate of return on the property. • Why use financial leverage? • Diversification benefits of lower equity investment • Can invest in other property • Mortgage interest tax benefit • Magnify returns if the return on the property exceeds the cost of debt

4. Financial Leverage: Before-Tax • Positive Financial Leverage • Returns are higher with debt • Unlevered BTIRR • Return with no debt • If unlevered BTIRR > interest rate on debt • The BTIRR on equity increases with debt • There is positive financial leverage

5. Financial Leverage: Before-Tax • BTIRRE= BTIRRP + (BTIRRP – BTIRRD)(D/E) • BTIRRE = Before-Tax IRR on equity invested • BTIRRP = Before-Tax IRR on total investment in the property • BTIRRD = Before-Tax IRR on debt (effective cost including points) • D/E =Debt/Equity ratio

6. Financial Leverage: Before-Tax • Equation shows that as long as: • BTIRRP > BTIRRD, thenBTIRRE > BTIRRP • This implies increasing D/E…… • But the use of debt is limited • Debt coverage ratio restrictions • Higher loan to value ratios are riskier to lenders…leading to higher interest rates • Higher debt levels increase risk to equity investor

7. Financial Leverage: Before-Tax • Negative Financial Leverage • If BTIRRD > BTIRRP, thenBTIRRE < BTIRRP • The use of debt reduces the return on equity

8. Financial Leverage: After-Tax • ATIRRE= ATIRRP + (ATIRRP – ATIRRD)(D/E) • ATIRRE = After-Tax IRR on equity invested • ATIRRP = After-Tax IRR on total investment in the property • ATIRRD = BTIRRD (1-t) • After-Tax IRR on debt (effective cost after taxes including points) • D/E =Debt/Equity

9. Example • Assumptions: • Total value: $100,000 (Building: $80,000, Land: $15,000) • Loan amount: vary for demonstrations • Loan interest rate: 10.00% at moderate levels of debt • Loan term is same as holding period: 5 years • NOI: $12,000 constant • All tax rates: 28.00% • Depreciation: 31.5 years • Sale price: $100,000

10. BTCF – No Leverage

11. ATCF – No Leverage

12. BTCF – $80,000 Loan

13. ATCF – $80,000 Loan

14. Break-Even Interest Rate • Break-even interest rate: Maximum interest rate before negative financial leverage • ATIRRD= ATIRRP • ATIRRD= BTIRRD(1-t)

15. Underwriting Loans • Market Study • Economic base • Submarkets • Appraisal • Borrower Financial Statements • Nonrecourse clause may be included • Loan to Value Ratio • Debt Coverage Ratio • DCR = NOI / Debt Service • Lenders prefer DCR to be at least 1.2 • Using a desired DCR we can determine maximum debt service = NOI / Desired DCR

16. Underwriting Loans • Additional Considerations: • Approval of new leases by lender • Approval of lease modifications by lender • Approval of construction by lender • Borrower submits period financials • Annual property appraisal • Notify lender of legal problems • Notify lender when correcting property defects • Lender has right to visit

17. Underwriting Loans • Lockout Clause • Prohibits prepayment of loan for a specified period of time • Yield Maintenance Fee • Guarantees a yield to the lender after a lockout period expires

18. Alternative Financing Structures • Mismatch between early year property income and constant payment loans • Income is expected to increase • Inflation effects • New building not fully leased • Leases may be below market • Results in different loan structures

19. Alternative Financing Structures • Equity Participation Loans • Lower interest rate from lender • Lender shares in property cash flow • Percent of PGI, NOI or BTCF, etc. • Lender motivations • Guaranteed minimum return and some protection of real return • Investor motivations • Easier to meet debt service requirements

20. Conventional Loan • Assumptions: • Total value: $1,000,000 (Building: $900,000, Land: $100,000) • Loan amount: $700,000 • Loan interest rate: 10.00% • Loan term: 15 years • Holding period: 5 years • NOI: $100,000 first year growing at 3.00% per year • All tax rates: 28.00% • Depreciation: 27.5 years • Sale price: Growing at 3.00% per year

21. Conventional Loan – BTIRR

22. Conventional Loan – ATIRR

23. Equity Participation Loan • Assumptions: • Total value: $1,000,000 (Building: $900,000, Land: $100,000) • Participation loan information: • Loan amount: $700,000 • Loan interest rate: 8.00% • Loan term: 15 years • Participation in 50.00% of any NOI in excess of $100,000 • Participation in 45.00% of gain in property value • Holding period: 5 years • NOI: $100,000 first year growing at 3.00% per year • All tax rates: 28.00% • Depreciation: 27.5 years • Sale price: Growing at 3.00% per year

24. Equity Participation Loan – BTIRR

25. Equity Participation Loan – ATIRR

26. Alternative Financing Structures • Sale-Leaseback of Land • Own building and lease land from a different investor • Motivations • 100% financing possible • Lease payments are tax deductible • Building is depreciable; land is not • Possible purchase option at end of lease

27. Alternative Financing Structures • Interest Only Loans: “Bullet Loans” • No amortization for a specified period • Balloon payment or amortization afterward • Accrual Loans • Negative amortization • Pay Rate • Interest rate used to calculate loan payment • Accrual Rate • Interest rate used to calculate the interest charged

28. Alternative Financing Structures • Structuring the payment for a targeted debt coverage ratio • Not always fully amortizing • Balloon payment • Convertible Mortgage • Lender has an equity investment option • Mezzanine Loan • Preferred Equity