Chapter 12 Financial Leverage and Debt Structure

Purpose The purpose of this chapter will be to extend the discussion of debt from the earlier chapters in two main ways. First, we consider how the level of financing affects the investor’s before- and after –tax IRR. Second, we consider several different financing alternatives that are used with real estate income property.

Financial Leverage Financial leverage is the concept of using debt in financing an investment project. The two primary sources of capital for financing any project are debt and equity. Real Estate projects are most often financed with a mix of these two.

Why should an investor use debt? The investor may not have enough equity capital to buy the property outright. The investor may have money, but wishes to use the excess equity to buy other properties. There are tax advantages- mortgage interest is tax deductible, this amplifies tax benefits to the equity investor. Using financial leverage can magnify the return on equity (ROE).

If the return on the total investment invested in a property (ROA) is greater than the rate of interest on the debt (K), the return on equity (ROE) is magnified. If ROA > K, then ROE > ROA -----Positive Financial Leverage Whenever leverage is positive, the greater the amount of debt, the higher the return to the equity investor.

Should investors conclude that they should borrow as much as possible??? No!!!!! Why???? Lenders often enforce maximum loan-to- value ratios. Higher amounts of debt mean lower debt service coverage ratios -----Lenders have maximum limits.

As debt increases, the debt service relative to the NOI increases also. As a result, the interest rate on additional debt will also increase. Additional borrowing has additional risks for the equity investor. Leverage works both ways in the sense that it can magnify either returns or losses.

Conditions for Positive Leverage- After Tax Using Previous Example – How can leverage be favorable if the unlevered ATIRR (8.76 percent) is less than the cost of debt (10 percent)? The reason is because interest is tax deductible hence we must consider the after-tax cost of debt. The after-tax cost of debt is equal to the before- tax cost times (1-t), where t is the tax rate. Example: 10(1-.28) = 7.2%

Break-Even Interest Rate What is the maximum interest rate that could be paid on the debt before the leverage becomes unfavorable? Example: BTIRR D = ATIRR P 1 – t = = 12.17% Therefore, regardless of the amount borrowed or degree of leverage desired, the maximum rate of interest that may be paid on debt and not reduce the return on equity is percent.