CHAPTER TWELVECHAPTER TWELVE

FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES

Chapter ObjectivesChapter 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

The Effects of Mortgage The Effects of Mortgage Financing on Cash Flows, Financing on Cash Flows,

Values, and ReturnsValues, and Returns

• Effect on the initial investment

• Effect on the cash flows from operations

• Effect on the cash flow from sale

The Borrower’s The Borrower’s Decision Making ProcessDecision 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

Positive Leverage- Before TaxPositive 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)

Positive Leverage- After TaxPositive 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)

Break-Even Interest RateBreak-Even Interest Rate

• BTIRRD=

ATIRRP

I-T

The Effect of LeverageThe 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

The Effect of LeverageThe Effect of LeverageInitial LTVR 0% 60% 80%

NOI in yr.1 $1,272,500 $1,272,500 $1,272,500

- Debt Service

------ 683,773 857,038

=BTCF 1,272,500 584,727 415,462

Initial Equity 13,375,000 5,350,000 3,375,000

BTCF/ Initial Equity

9.51% 10.93% 12.31%

Mean IRR 10.68% 14.58% 17.84%

Underwriting on Income Underwriting on Income PropertiesProperties

• Loan application

• Property description and legal aspects

• Cash flows estimates

• Appraisal report and market or feasibility study

Loan UnderwritingLoan Underwriting

• The property and borrower– Property type, quality, and location– Tenant quality and lease terms– Environmental concerns– Borrower experience and resources

The Maximum Loan AmountThe 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

Permanent Mortgages with Permanent Mortgages with Equity ParticipationEquity Participation

• Participation Mortgages– Income kickers– Equity kickers– Contingent interest

Other Equity Participation Other Equity Participation ArrangementsArrangements

• Joint Ventures

• Sale Leasebacks

Financing AlternativesFinancing 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

Financing Alternatives Financing Alternatives ContinuedContinued

• 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

Financing Alternatives Financing Alternatives ContinuedContinued

• 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