© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER TWELVE FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 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

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Financial Leverage The use of borrowed funds to complete an investment purchase.

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 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 Positive and negative leverage

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Positive Leverage- Before Tax When the unlevered BTIRR is greater than cost of debt BTIRR E = BTIRR on equity investment BTIRR P = BTIRR on total investment D/E= portion of debt to equity BTIRR D = BTIRR on debt BTIRR E = BTIRR P + (BTIRR P - BTIRR D ) (D/E)

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 Positive Leverage- After Tax ATIRR E = ATIRR on equity ATIRR P = ATIRR on total funds invested ATIRR D = ATIRR on debt D/E= ratio of debt to equity ATIRR E = ATIRR P + (ATIRR P - ATIRR D ) (D/E)

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Break-Even Interest Rate BTIRR D = ATIRR P 1-t

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 The Effect of Leverage Increased financial risk Increased variability of returns Effect on before and after tax cash flows Effect on before and after tax equity reversion Equity reversion is the lump-sum benefit that an investor receives or expects to receive at the termination of an investment.

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 The Effect of Leverage Initial LTVR0%60%80% NOI in yr.1$1,272,500 - Debt Service ,773857,038 =BTCF1,272,500588,727415,462 Initial Equity13,375,0005,350,0003,375,000 BTCF/ Initial Equity 9.51%11.00%12.31% Mean IRR10.68%14.58%17.84%

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Underwriting on Income Properties Loan application Property description and legal aspects Cash flows estimates Appraisal report and market or feasibility study

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 Loan Underwriting The property and borrower Property type, quality, and location Tenant quality and lease terms Environmental concerns Borrower experience and resources

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 The Maximum Loan Amount The loan to value ratio: LTV=V m /V o The debt service coverage ratio: DCR=NOI/ debt service Max debt service: NOI/Desired DCR

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 Chapter ends!