Presentation on theme: "Financial Leverage and Financing Alternatives"— Presentation transcript:
1 Financial Leverage and Financing Alternatives CHAPTER 12Financial Leverage and Financing Alternatives
2 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 investmentCan invest in other propertyMortgage interest tax benefitMagnify returns if the return on the property exceeds the cost of debt
3 Financial Leverage: Before-Tax Positive Financial LeverageReturns are higher with debtUnlevered BTIRRReturn with no debtIf unlevered BTIRR > interest rate on debtThe BTIRR on equity increases with debt.There is positive financial leverage.
4 Financial Leverage: Before-Tax Equation 1:BTIRRE= BTIRRP + (BTIRRP – BTIRRD)(D/E)BTIRRE = Before-Tax IRR on equity investedBTIRRP = Before-Tax IRR on total investment in the propertyBTIRRD = Before-Tax IRR on debt (effective cost including points)D/E =Debt/Equity ratio
5 Financial Leverage: Before-Tax Equation 1 shows that as long as:BTIRRP > BTIRRD, then BTIRRE > BTIRRPThis implies increasing D/E……But the use of debt is limitedDebt coverage ratio restrictionsHigher loan to value ratios are riskier to lenders…leading to higher interest ratesHigher debt levels increase risk to equity investor
6 Financial Leverage: Before-Tax Negative Financial LeverageIf BTIRRD > BTIRRP, then BTIRRE < BTIRRPThe use of debt reduces the return on equity.
7 Financial Leverage: After-Tax Equation 2:ATIRRE= ATIRRP + (ATIRRP – ATIRRD)(D/E)ATIRRE = After-Tax IRR on equity investedATIRRP = After-Tax IRR on total investment in the propertyATIRRD = BTIRRD (1-t)After-Tax IRR on debt (effective cost after taxes including points)D/E =Debt/Equity
8 Financial Leverage Example Building Value=$85,000, Land Value=$15,000, Total Value=$100,000Loan Assumptions:Loan Amount=$80,000Interest Rate=10%Term: Interest Only80% LTVIncome Assumptions:NOI=$12,000 per year (level)Income tax rate=28%Depreciation=31.5 years (straight line)Resale price= $100,000Holding period=5 years
15 Alternative Financing Structures Sale-Leaseback of Land and Ground LeasesOwn building and lease land from a different investorMotivations100% financing possibleLease payments are tax deductibleBuilding is depreciable; land is notPossible purchase option at end of lease