Financial Leverage and Financing Alternatives Chapter 12 Financial Leverage and Financing Alternatives

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

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 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 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 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

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

BTCF – No Leverage

ATCF – No Leverage

BTCF – $80,000 Loan

ATCF – $80,000 Loan

Break-Even Interest Rate Break-even interest rate: Maximum interest rate before negative financial leverage ATIRRD= ATIRRP ATIRRD= BTIRRD(1-t)

Underwriting Loans Market Study Borrower Financial Statements 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

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

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

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

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

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

Conventional Loan – BTIRR

Conventional Loan – ATIRR

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

Equity Participation Loan – BTIRR

Equity Participation Loan – ATIRR

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

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

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