Chapter 12: Financial Leverage and Financing Alternatives

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Financial LeverageFinancial 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

investmentCan 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 TaxFinancial Leverage: Before Tax

Positive Financial Leverage– Returns are higher with debt

Unleveraged BTIRR– Return with no debt

If unleveraged BTIRR > interest rate on debt– The BTIRR on equity increases with debt– There is positive financial leverage

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Financial Leverage: Before TaxFinancial 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 (debt and equity)

– BTIRRD = Before-Tax IRR on debt (effective cost including points)

– D/E =Debt/Equity ratio

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Financial Leverage: Before TaxFinancial Leverage: Before Tax

Equation 1 shows that as long as:– BTIRRP > BTIRRD, then BTIRRE > BTIRRP

– This implies increasing D/E will yield positive results

But the use of debt is limited– Debt coverage ratio restrictions– Higher loan to value ratios are riskier to lenders. If the

LTV is too high, the interest rates will be higher. – Higher debt levels increase risk to equity investor

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Financial Leverage: Before TaxFinancial Leverage: Before Tax

Negative Financial Leverage– If BTIRRD > BTIRRP, then BTIRRE < BTIRRP

– The use of debt reduces the return on equity.

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Financial Leverage: After TaxFinancial 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

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Financial Leverage: After TaxFinancial 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 is not affected by LTV.

t1

ATIRRD

t1

ATIRR P

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Underwriting LoansUnderwriting Loans

Market Study and Appraisal Borrower Financial Statements

– Nonrecourse clause. If nonrecourse, it’s sort of like the loan has a built in put option for the borrower.

Loan to Value Ratio Debt Coverage Ratio

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Underwriting LoansUnderwriting Loans

Possible Mortgage Covenants– Approval of new leases by lender– Approval of lease modifications by lender– Approval of construction by lender– Borrower submits periodic updates of

financials

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Underwriting LoansUnderwriting Loans

Possible Mortgage Covenants– Annual property appraisal– Notify lender of legal problems– Notify lender when correcting property defects– Lender has right to visit

The lender’s goal is to insure that after the loan is closed, the value and income-producing ability of the asset is not impaired.

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Underwriting LoansUnderwriting 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

Sometimes the fee is fixed as a percentage of the outstanding balance. This percentage may also vary based on the remaining term of the mortgage.

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Alternative Financing StructuresAlternative Financing Structures

Mismatch between property income in the early years and constant payment loans

Income is expected to increase– Inflation effects– New building not fully leased when loan is

made– Leases may be below market

Results in different loan structures

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Equity Participation Loans– Lower interest rate from lender– Lender shares in property cash flow

Percent of PGI, NOI, or BTCF, etc.

– Lender motivationsGuaranteed minimum return and some protection

of real return

– Investor motivationsEasier to meet debt service requirements

Alternative Financing StructuresAlternative Financing Structures

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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. If option is

not present, the investor may not be able to buy back the land.

Alternative Financing StructuresAlternative Financing Structures

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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

– Accrual loans can be dangerous for a borrower as the amount owed becomes greater over time.

Alternative Financing StructuresAlternative Financing Structures

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Structuring the payment for a targeted debt coverage ratio– Not always fully amortizing– Balloon payment

Convertible Mortgage– Lender has an option to convert debt to equity

Mezzanine Loan Preferred Equity

Alternative Financing StructuresAlternative Financing Structures