Financial Leverage and Financing Alternatives

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Presentation transcript:

Financial Leverage and Financing Alternatives CHAPTER 12 Financial Leverage and Financing Alternatives

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

Financial Leverage: Before-Tax Positive Financial Leverage Returns are higher with debt Unlevered BTIRR Return with no debt If unlevered BTIRR > interest rate on debt The BTIRR on equity increases with debt. There is positive financial leverage.

Financial Leverage: Before-Tax Equation 1: 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

Financial Leverage: Before-Tax Equation 1 shows that as long as: BTIRRP > BTIRRD, then BTIRRE > 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 lenders…leading to higher interest rates Higher debt levels increase risk to equity investor

Financial Leverage: Before-Tax Negative Financial Leverage If BTIRRD > BTIRRP, then BTIRRE < BTIRRP The use of debt reduces the return on equity.

Financial Leverage: After-Tax Equation 2: 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

Financial Leverage Example Building Value=$85,000, Land Value=$15,000, Total Value=$100,000 Loan Assumptions: Loan Amount=$80,000 Interest Rate=10% Term: Interest Only 80% LTV Income Assumptions: NOI=$12,000 per year (level) Income tax rate=28% Depreciation=31.5 years (straight line) Resale price= $100,000 Holding period=5 years

Cash Flow Summary and IRR With Leverage

Cash Flow Summary and IRR Without Leverage

Financial Leverage: After-Tax Break-even interest rate Maximum interest rate before negative financial leverage ATIRRD= ATIRRP ATIRRD= BTIRRD(1-t) BTIRRD= = Risk considerations

Break-even Interest Rate

Alternative Financing Structures Sale-Leaseback of Land and Ground Leases 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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