1. Financial Leverage and Financing Alternatives
Chapter 12
Financial Leverage and Financing Alternatives

2. Overview Financial Leverage Financial Leverage: Before-Tax
Financial Leverage: After-Tax
Break-Even Interest Rate
Underwriting Loans
Alternative Financing Structures
Conventional Loan
Equity Participation Loan

3. 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

4. Financial Leverage: Before-Tax
Positive Financial Leverage
Returns are higher with debt
Unlevered BTIRR
Return with no debt
If unlevered BTIRR > interest rate on debt
The BTIRR on equity increases with debt
There is positive financial leverage

5. Financial Leverage: Before-Tax
BTIRRE= BTIRRP + (BTIRRP – BTIRRD)(D/E)
BTIRRE = Before-Tax IRR on equity invested
BTIRRP = Before-Tax IRR on total investment in the property
BTIRRD = Before-Tax IRR on debt (effective cost including points)
D/E =Debt/Equity ratio

6. Financial Leverage: Before-Tax
Equation shows that as long as:
BTIRRP > BTIRRD, then BTIRRE > BTIRRP
This implies increasing D/E……
But the use of debt is limited
Debt coverage ratio restrictions
Higher loan to value ratios are riskier to lenders…leading to higher interest rates
Higher debt levels increase risk to equity investor

7. Financial Leverage: Before-Tax
Negative Financial Leverage
If BTIRRD > BTIRRP, then BTIRRE < BTIRRP
The use of debt reduces the return on equity

8. Financial Leverage: After-Tax
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

9. Example
Assumptions:
Total value: $100,000 (Building: $80,000, Land: $15,000)
Loan amount: vary for demonstrations
Loan interest rate: 10.00% at moderate levels of debt
Loan term is same as holding period: 5 years
NOI: $12,000 constant
All tax rates: 28.00%
Depreciation: 31.5 years
Sale price: $100,000

10. BTCF – No Leverage

11. ATCF – No Leverage

12. BTCF – $80,000 Loan

13. ATCF – $80,000 Loan

14. Break-Even Interest Rate
Break-even interest rate: Maximum interest rate before negative financial leverage
ATIRRD= ATIRRP
ATIRRD= BTIRRD(1-t)

15. Underwriting Loans Market Study Borrower Financial Statements
Economic base
Submarkets
Appraisal
Borrower Financial Statements
Nonrecourse clause may be included
Loan to Value Ratio
Debt Coverage Ratio
DCR = NOI / Debt Service
Lenders prefer DCR to be at least 1.2
Using a desired DCR we can determine maximum debt service = NOI / Desired DCR

16. Underwriting Loans Additional Considerations:
Approval of new leases by lender
Approval of lease modifications by lender
Approval of construction by lender
Borrower submits period financials
Annual property appraisal
Notify lender of legal problems
Notify lender when correcting property defects
Lender has right to visit

17. Underwriting Loans Lockout Clause Yield Maintenance Fee
Prohibits prepayment of loan for a specified period of time
Yield Maintenance Fee
Guarantees a yield to the lender after a lockout period expires

18. Alternative Financing Structures
Mismatch between early year property income and constant payment loans
Income is expected to increase
Inflation effects
New building not fully leased
Leases may be below market
Results in different loan structures

19. Alternative Financing Structures
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

20. Conventional Loan Assumptions:
Total value: $1,000,000 (Building: $900,000, Land: $100,000)
Loan amount: $700,000
Loan interest rate: 10.00%
Loan term: 15 years
Holding period: 5 years
NOI: $100,000 first year growing at 3.00% per year
All tax rates: 28.00%
Depreciation: 27.5 years
Sale price: Growing at 3.00% per year

21. Conventional Loan – BTIRR

22. Conventional Loan – ATIRR

23. Equity Participation Loan
Assumptions:
Total value: $1,000,000 (Building: $900,000, Land: $100,000)
Participation loan information:
Loan amount: $700,000
Loan interest rate: 8.00%
Loan term: 15 years
Participation in 50.00% of any NOI in excess of $100,000
Participation in 45.00% of gain in property value
Holding period: 5 years
NOI: $100,000 first year growing at 3.00% per year
All tax rates: 28.00%
Depreciation: 27.5 years
Sale price: Growing at 3.00% per year

24. Equity Participation Loan – BTIRR

25. Equity Participation Loan – ATIRR

26. Alternative Financing Structures
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

27. Alternative Financing Structures
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

28. Alternative Financing Structures
Structuring the payment for a targeted debt coverage ratio
Not always fully amortizing
Balloon payment
Convertible Mortgage
Lender has an equity investment option
Mezzanine Loan
Preferred Equity