Financial Leverage and Financing Alternatives

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Chapter 12

• Financial Leverage and Financing Alternatives

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Overview

• Financial Leverage
• Financial Leverage Before-Tax
• Financial Leverage After-Tax
• Break-Even Interest Rate
• Underwriting Loans
• Alternative Financing Structures
• Conventional Loan
• Equity Participation Loan

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Financial Leverage

• What is financial leverage?
• Benefit of borrowing at a lower interest rate
  than the rate of return on the property.
• Why use financial leverage?
• Diversification benefits of lower equity
  investment
• Can invest in other property
• Mortgage interest tax benefit
• Magnify returns if the return on the property
  exceeds the cost of debt

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Financial Leverage Before-Tax

• Positive Financial Leverage
• Returns are higher with debt
• Unlevered BTIRR
• Return with no debt
• If unlevered BTIRR gt interest rate on debt
• The BTIRR on equity increases with debt
• There is positive financial leverage

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Financial Leverage Before-Tax

• BTIRRE BTIRRP (BTIRRP BTIRRD)(D/E)
• BTIRRE Before-Tax IRR on equity invested
• BTIRRP Before-Tax IRR on total investment in
  the property
• BTIRRD Before-Tax IRR on debt (effective cost
  including points)
• D/E Debt/Equity ratio

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Financial Leverage Before-Tax

• Equation shows that as long as
• BTIRRP gt BTIRRD, then BTIRRE gt BTIRRP
• This implies increasing D/E
• But the use of debt is limited
• Debt coverage ratio restrictions
• Higher loan to value ratios are riskier to
  lendersleading to higher interest rates
• Higher debt levels increase risk to equity
  investor

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Financial Leverage Before-Tax

• Negative Financial Leverage
• If BTIRRD gt BTIRRP, then BTIRRE lt BTIRRP
• The use of debt reduces the return on equity

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Financial Leverage After-Tax

• ATIRRE ATIRRP (ATIRRP ATIRRD)(D/E)
• ATIRRE After-Tax IRR on equity invested
• ATIRRP After-Tax IRR on total investment in the
  property
• ATIRRD BTIRRD (1-t)
• After-Tax IRR on debt (effective cost after taxes
  including points)
• D/E Debt/Equity

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Example

• Assumptions
• Total value 100,000 (Building 80,000, Land
  15,000)
• Loan amount vary for demonstrations
• Loan interest rate 10.00 at moderate levels of
  debt
• Loan term is same as holding period 5 years
• NOI 12,000 constant
• All tax rates 28.00
• Depreciation 31.5 years
• Sale price 100,000

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BTCF No Leverage
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ATCF No Leverage
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BTCF 80,000 Loan
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ATCF 80,000 Loan
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Break-Even Interest Rate

• Break-even interest rate Maximum interest rate
  before negative financial leverage
• ATIRRD ATIRRP
• ATIRRD BTIRRD(1-t)

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Underwriting Loans

• Market Study
• Economic base
• Submarkets
• Appraisal
• Borrower Financial Statements
• Nonrecourse clause may be included
• Loan to Value Ratio
• Debt Coverage Ratio
• DCR NOI / Debt Service
• Lenders prefer DCR to be at least 1.2
• Using a desired DCR we can determine maximum debt
  service NOI / Desired DCR

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Underwriting Loans

• Additional Considerations
• Approval of new leases by lender
• Approval of lease modifications by lender
• Approval of construction by lender
• Borrower submits period financials
• Annual property appraisal
• Notify lender of legal problems
• Notify lender when correcting property defects
• Lender has right to visit

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Underwriting Loans

• Lockout Clause
• Prohibits prepayment of loan for a specified
  period of time
• Yield Maintenance Fee
• Guarantees a yield to the lender after a lockout
  period expires

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Alternative Financing Structures

• Mismatch between early year property income and
  constant payment loans
• Income is expected to increase
• Inflation effects
• New building not fully leased
• Leases may be below market
• Results in different loan structures

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Alternative Financing Structures

• Equity Participation Loans
• Lower interest rate from lender
• Lender shares in property cash flow
• Percent of PGI, NOI or BTCF, etc.
• Lender motivations
• Guaranteed minimum return and some protection of
  real return
• Investor motivations
• Easier to meet debt service requirements

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Conventional Loan

• Assumptions
• Total value 1,000,000 (Building 900,000,
  Land 100,000)
• Loan amount 700,000
• Loan interest rate 10.00
• Loan term 15 years
• Holding period 5 years
• NOI 100,000 first year growing at 3.00 per
  year
• All tax rates 28.00
• Depreciation 27.5 years
• Sale price Growing at 3.00 per year

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Conventional Loan BTIRR
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Conventional Loan ATIRR
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Equity Participation Loan

• Assumptions
• Total value 1,000,000 (Building 900,000,
  Land 100,000)
• Participation loan information
• Loan amount 700,000
• Loan interest rate 8.00
• Loan term 15 years
• Participation in 50.00 of any NOI in excess of
  100,000
• Participation in 45.00 of gain in property value
• Holding period 5 years
• NOI 100,000 first year growing at 3.00 per
  year
• All tax rates 28.00
• Depreciation 27.5 years
• Sale price Growing at 3.00 per year

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Equity Participation Loan BTIRR
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Equity Participation Loan ATIRR
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Alternative Financing Structures

• Sale-Leaseback of Land
• Own building and lease land from a different
  investor
• Motivations
• 100 financing possible
• Lease payments are tax deductible
• Building is depreciable land is not
• Possible purchase option at end of lease

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Alternative Financing Structures

• Interest Only Loans Bullet Loans
• No amortization for a specified period
• Balloon payment or amortization afterward
• Accrual Loans
• Negative amortization
• Pay Rate
• Interest rate used to calculate loan payment
• Accrual Rate
• Interest rate used to calculate the interest
  charged

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Alternative Financing Structures

• Structuring the payment for a targeted debt
  coverage ratio
• Not always fully amortizing
• Balloon payment
• Convertible Mortgage
• Lender has an equity investment option
• Mezzanine Loan
• Preferred Equity