1 / 17

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

ltucker
Download Presentation

CHAPTER TWELVE

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  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

More Related