Debt Financing for Real Estate

1
Debt Financing for Real Estate

• Lecture Map
• The benefits of positive leverage
• Debt underwriting from the lenders perspective
• Alternative Structures
• Fixed and floating rate loans
• Interest only loans
• Participating loans
• Land sale-leasebacks
• Accruals
• Convertible loans

2
Positive Leverage

• Benefits of borrowing
• Decreasing equity exposure to the asset
• Tax deductibility of interest expense
• Positive leverage
• Before and after tax returns to equity are
  greater with than without debt
• As long as debt costs less than equity, it takes
  less than its proportionate share of cash flow
• Annual cash flow and PV of cash flow

3
Positive Leverage

• From an IRR perspective
• As long as the unlevered BTIRR gt effective cost
  of debt, leverage is positive
• I.e., as long as theres a positive spread
  between the WACC as represented by cap and
  discount rates, and the interest cost of debt
• Even if the unlevered ATIRR lteffective cost of
  debt, leverage can still be favorable because of
  the tax deductibility of the interest

4
Underwriting from the Lenders Perspective

• Steps in Lender analysis
• Market study
• Appraisal
• Analysis of borrower financial condition
• Financial analysis of asset
• Loan to value
• DCR test

5
Setting the Loan Terms

• Determination of Loan Amount
• Based on ratio tests, risk assessment
• Other provisions designed to address risk
• Prepayment provisions
• Reps and warranties
• Loan covenants

6
Alternative Loan Structures

• Loan Structures reflect a trade off of risk and
  return between the parties
• Lender evaluates looser underwriting conditions
  for greater return
• Borrower evaluates more or less debt proceeds
  versus
• Timing of cash flows
• Cost of incremental debt vs. outside equity

7
Fixed, Floating and Interest Only Loans

• Fixed rate loans are the standard
• Floating rate loans
• Construction and mini-perms
• Acquisition lines of credit
• Interest only loans
• balloon or bullet payment at maturity
• Used for
• Construction
• Acquisition lines of credit
• Structured finance transactions

8
Participating Loans

• Lender trades risk for higher potential returns
• Reduces LTV, DCR coverage
• ? Increases loan amount
• Takes a percentage of after debt service cash
  flows
• Structured as additional interest
• Total of fixed payment and percentage interest
  creates higher total yield on loan dollars
  invested

9
More on Participating Loans

• Borrower benefits
• Greater loan proceeds
• Often cheaper than equity which might have to be
  raised from outside sources
• Lower fixed debt payments
• Less pressure on short term NOI
• Borrowers decision
• What is the incremental cost of borrowing the
  extra loan amount, vs. cost of equity?
• If the deal IRR is weighted toward the residual,
  the lenders participation in the residual is
  probably less than an equity investors would be

10
More Alternatives

• Land Sale Leaseback
• Financing land separately from improvements
• Higher total loan proceeds
• Finances 100 of land value, vs. LTV if included
  in typical loan calculation
• 100 of payments are tax deductible
• Vs. only interest portion if financed by loan
• Risk is in subordination provision

11
More Alternatives (cont.)

• Accrual Loans
• Pay rate lt stated interest rate
• Negative amortization situation
• An ARM with a payment cap is effectively an
  accrual loan
• Tax benefits
• Creates greater tax shield ? deductible interest
  is based on the accrued rate, not the pay rate
• More risk to the lender ? WHY?

12
One More.

• Convertible Loans
• Lender has an option to convert ie, swap loan
  proceeds for partial equity ownership
• Would convert if the equity value of the interest
  exceeds the mortgage balance at conversion date
• Borrower benefits
• Lower interest rate, greater current cash flow in
  exchange for potential loss of equity value in
  the future