CHAPTER TWELVE

1
CHAPTER TWELVE

• FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES

2
Chapter Objectives

• The effects of financial leverage (both positive
  and negative) on a propertys 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 Borrowers 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
• LTVVm/Vo
• The debt service coverage ratio
• DCRNOI/ 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