CHAPTER TWELVE FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES

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

The Effects of Mortgage Financing on Cash Flows, Values, and Returns Effect on the initial investment Effect on the cash flows from operations Effect on the cash flow from sale

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 (leverage) Positive and negative leverage

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)

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)

Break-Even Interest Rate BTIRR D = ATIRR P I-T

The Effect of Leverage Increased financial risk Increased variability of returns –Effect in before and after tax cash flows –Effect on before and after tax equity reversion

The Effect of Leverage Initial LTVR0%60%80% NOI in yr.1$1,272,500 - Debt Service ,773857,038 =BTCF1,272,500584,727415,462 Initial Equity13,375,0005,350,0003,375,000 BTCF/ Initial Equity 9.51%10.93%12.31% Mean IRR10.68%14.58%17.84%

Underwriting on Income Properties Loan application Property description and legal aspects Cash flows estimates Appraisal report and market or feasibility study

Loan Underwriting The property and borrower –Property type, quality, and location –Tenant quality and lease terms –Environmental concerns –Borrower experience and resources

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/minimum DCR

Permanent Mortgages with Equity Participation Participation Mortgages –Income kickers –Equity kickers –Contingent interest

Other Equity Participation Arrangements Joint Ventures Sale Leasebacks

Financing Alternatives Participation loans –Lender gets percent of NOI and/ or resale –Borrower pays lower interest rate –Debt coverage ratio is higher –Participation is tax deductible (vs.only interest on loan) –May not be riskier for lender than fixed rate mortgage –E.g. interest rate is 10% on regular lean but 8% on participation loan with lender receiving 25% of NOI in excess of first year NOI and 25% increase in value when the property is sold. –Note that the participation payment is never negative Note: leverage will depend on effective cost of participation loan

Financing Alternatives Continued Convertible mortgage –Lender has option to convert loan balance to an ownership interest in the property –Borrower pays lower interest rate –Debt coverage ratio is higher –E.g. interest rate is 10% on regular loan but 8% on convertible loan with lender having the option in year 5 to convert the loan balance into an 80% ownership position –Note: if loan is non-recourse, lender gets the property if there is default

Financing Alternatives Continued Sale- leaseback of land –Owner of property sells land under building and leases it back, e.g. for 99 years –Owner can still get mortgage on building –Analogous to 100% financing on land –Land lease payment is tax deductible (vs. only interest on a mortgage) –Note that land not depreciable but building is