Chapter 12: Financial Leverage and Financing Alternatives McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

12-2 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 investment  Can invest in other property –Mortgage interest tax benefit –Magnify returns if the return on the property exceeds the cost of debt

12-3 Financial 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

12-4 Financial Leverage: Before Tax  Equation 1:  BTIRR E =BTIRR P + (BTIRR P – BTIRR D )(D/E) –BTIRR E = Before-Tax IRR on equity invested –BTIRR P = Before-Tax IRR on total investment in the property (debt and equity) –BTIRR D = Before-Tax IRR on debt (effective cost including points) –D/E =Debt/Equity ratio

12-5 Financial Leverage: Before Tax  Equation 1 shows that as long as: –BTIRR P > BTIRR D, then BTIRR E > BTIRR P –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

12-6 Financial Leverage: Before Tax  Negative Financial Leverage –If BTIRR D > BTIRR P, then BTIRR E < BTIRR P –The use of debt reduces the return on equity.

12-7 Financial Leverage: After Tax  Equation 2:  ATIRR E =ATIRR P + (ATIRR P – ATIRR D )(D/E) –ATIRR E = After-Tax IRR on equity invested –ATIRR P = After-Tax IRR on total investment in the property –ATIRR D = BTIRR D (1-t)  After-Tax IRR on debt (effective cost after taxes including points) –D/E =Debt/Equity

12-8 Financial Leverage: After Tax  Break-even interest rate –Maximum interest rate before negative financial leverage  ATIRR D = ATIRR P  ATIRR D = BTIRR D (1-t)  BTIRR D = =  Risk considerations  Break-even interest rate is not affected by LTV.

12-9 Underwriting 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

12-10 Underwriting 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

12-11 Underwriting 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.

12-12 Underwriting 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.

12-13 Alternative 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

12-14  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 Alternative Financing Structures

12-15  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 Structures

12-16  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 Structures

12-17  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 Structures