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A Closer Look at Equity Returns

Revisiting the Effect of Leverage on Equity Yields. Leverage increases the yield to equityPositive spread between the going in cap rate and the cost of debt financingDebt service should take disproportionately less cash flow relative to its share of the capital structureLeverage also enhances the

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A Closer Look at Equity Returns

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    1. A Closer Look at Equity Returns Discussion Outline Review of the impact of leverage on equity yields The effect of loan refinancing on yield Calculating equity level IRR Before tax After tax

    2. Revisiting the Effect of Leverage on Equity Yields Leverage increases the yield to equity Positive spread between the going in cap rate and the cost of debt financing Debt service should take disproportionately less cash flow relative to its share of the capital structure Leverage also enhances the tax shield offered by real estate Depreciation benefits provide the basic shield Deductibility of interest expense enhances the shield Higher yield indicates greater risk associated with the capital structure

    3. Evaluating Loan Refinancings Refinancing makes sense when present value of savings produced by the new loan exceeds the costs of replacing the existing loan Methodology involves: Treating those costs as a new investment and calculating a return on that investment Comparing the effective costs of the new and old loans Evaluating whether refinancing is justified giving holding period objectives

    4. Cost of Refinancing as a New Investment Determine the total costs of refinancing Discount points, prepayment penalties, closing costs Calculate the payment savings The monthly difference in loan payments Calculate the return on your “investment; does it meet your minimum return hurdle, or could you do better elsewhere? PV = sum of the costs PMT = net monthly savings in debt service payments N = # of months of payment savings FV = 0 I = the “return” on investment

    5. Loan Refinancing Example – Part I Loan A: $200,000, 8.5%, 30 year amort. Opportunity to refinancing outstanding balance in year 5 @ 7 ľ%, 2.5% discount points, 25 year amort. Methodology: Calculate payments on both loans Subtract payment A from payment B Calculate the outstanding balance in year 5 Calculate the yield

    6. Part I (cont.) Loan A PV = - $200,000 N = 30 x 12 I = 8.5 / 12 FV = 0 PMT = $1,537.83 Balance = $190, 980.91 The PV of the remaining 25 years of payments Loan B PV = -$190,980.91 N = 25 x 12 I = 7.75 / 12 FV = 0 PMT = $1,442.52 Monthly savings = $1,537.83 - $1,443.52 = $95.30

    7. Part I (cont.) Out of pocket costs of new Loan B: 2.5% discount points x $190,980.91 = $4,774.52 What is the yield on the costs? PV = -$4,774.52 N = 25 X 12 PMT = $95.30 FV = 0 I = 23.88%

    8. Other Refinancing Scenarios Refinance at lower rate but shorter term Calculate yield on the new payment term Refinance at lower rate but longer term Calculate an IRR based on savings over the original term plus the new payments over remaining term Refinance at a higher loan amount At a lower interest rate, if the extra cash offsets your costs up front, the yield is clearly positive At a higher interest rate, find the PV of the increase in payments at your minimum yield requirement Compare it to the cash you pull out of the deal

    9. Loan Refinancing Example – Part II Compare the effective cost of the new loan to the existing loan Loan B PV = (190,980.91 * .975) = $186,206.39 FV = 0 PMT = $1,442.53 N = 25 x 12 I = 8.04% Effective rate on Loan A is 8.5% (zero points) On an effective cost comparison, the refinance is a good deal

    10. Loan Refinancing Example – Part III In year 5, you are 5 years into an 8 year hold If you know you are going to sell in three more years, is this a good deal? Calculate the difference in outstanding balances under the old and the new loan Need to calculate the effective cost of the savings over the shorter time period What’s the issue? If there is a balance difference , the up front costs need to be reevaluated because the savings aren’t amortizing the costs fully over the shorter holding period

    11. Loan Refinancing Example – Part III Loan Balance of original loan in year 8 $183,423 Loan Balance of loan B in its 3rd year: $182,536 PV = -$4,774.52 PMT = $95.30 N = 3 x 12 FV = 0 (NOTE: no excess balance due on the new loan; if the balance on the new loan exceeds the balance on the old loan, the FV = added balance due) I = - 20.25% Knowing that you are going to sell early may sometimes make refinancing NOT a good deal

    12. Calculating Before and After Tax IRR IRR analysis Project level Return generated on total investment (price plus closing costs) by NOI and residual proceeds Equity level Before Tax IRR (BTIRR) Return generated by net cash flow after debt service and net residual value after repayment of debt balance After Tax IRR (ATIRR) Return generated by net cash flow after income tax and net residual after payment of capital gains tax

    13. Tax Benefits of Income Producing Property Mortgage Interest Deduction Actual annual interest expense NO deductibility of principal amortization Value of Improvements – not land – may be depreciated as follows 27.5 years for residential properties Only allowed for third party owned rental homes 39 years for commercial properties Varying terms for property improvements, systems, etc. Other, such as: Amortization of loan points

    14. Annual Cash Flow vs. Net Income from Real Estate Cash Flow: NOI - Debt Service - Cap Ex = NCF Before Tax - Income Tax Net Cash Flow Net Income NOI Interest on Debt Depreciation = Taxable Income - Tax (@ 36% marginal rate) = After Tax Income

    15. Calculating the Capital Gain on Sale Gain on a sale = price, less selling expenses and adjusted basis Tax due on a sale is based on determining: Difference between the original purchase price of the project and the project’s “adjusted basis” Breakdown of the gain between value appreciation and “recapture” of depreciation “Adjusted basis” = book value of the asset @ time of sale Original investment, less accumulated depreciation plus capital improvements (major ones, not TIs) The tax due on the gain is equal to: 15% on asset appreciation if held for more than 12 months 25% rate on depreciation “recapture” if any excess depreciation was claimed during the holding period Excess depreciation, if any, is taxed at ordinary income rates

    16. Before and After Tax Residual Values Before Tax NOI sale year +1 ÷ exit cap rate = gross sales price - 3% selling expense = net sales proceeds - debt balance = Before tax proceeds After Tax NOI (sale year +1) ÷ exit cap rate = gross sales price - 3% selling expense = net sales proceeds - Debt balance = Before tax proceeds - Capital Gain on Sale = Net After Tax Proceeds

    17. Putting it Together Same $13 million warehouse from last week’s lecture $12 million of improvements $1 million of land value $500K of TI expected after closing Project Economics: $1.2 million of NOI (cap rate = 9.23%) Assume NOI grows at 3% per annun 70% LTV loan, 2% discount points, 7% interest, 25 year amortization Total Equity Requirement of $5,232,000

    18. Closing Statement with Points

    19. Investment Cash Flow Pro Forma – Before Tax

    20. Investment Cash Flow Pro Forma – After Tax

    21. Calculating the After Tax Residual

    22. The ATIRR

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