1. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER TWELVE FINANCIAL LEVERAGE AND FINANCING ALTERNATIVES

2. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 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

3. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 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

4. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 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

5. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 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)

6. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 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)

7. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Break-Even Interest Rate BTIRR D = ATIRR P I-T

8. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 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

9. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 The Effect of Leverage Initial LTVR0%60%80% NOI in yr.1$1,272,500 - Debt Service ------683,773857,038 =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%

10. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Underwriting on Income Properties Loan application Property description and legal aspects Cash flows estimates Appraisal report and market or feasibility study

11. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 Loan Underwriting The property and borrower –Property type, quality, and location –Tenant quality and lease terms –Environmental concerns –Borrower experience and resources

12. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 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

13. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 Permanent Mortgages with Equity Participation Participation Mortgages –Income kickers –Equity kickers –Contingent interest

14. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 14 Other Equity Participation Arrangements Joint Ventures Sale Leasebacks

15. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 15 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

16. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 16 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

17. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 17 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