End of Chapter 16 Questions and Answers
1. What is the difference between the leverage ratio (LR) and the loan-to-value ratio
(LTV)? How much greater property value can be purchased with a 75% LTV than with a
50% LTV? What is the LR associated with each of those two LTVs?
Answer: Leverage ratio gives the ratio of property value to equity investment (LR=V/E)
Loan to Value ratio gives the ratio of debt to property value (LR=L/V)
Property value purchases with 75% LTV will be double the property value purchased
with 50% LTV.
LR will be 4 for LTV of 75% and 2 for LTV of 50%
2. What is meant by the “preferred” or “senior” lien of debt, and how does this affect the
relative risk of the debt, the equity, and the underlying property?
Answer: “Preferred” or “senior” lien of debt gives the holder the first right of return over
the cash flow of underlying property. The holder of preferred lien has the least risk. The
equity investor is left with the riskiest component of return from the underlying property.
3. How does the equity investor’s ability to control property management align the
interests and incentives of the debt and equity investors in normal circumstances, so as to
maximize total property value? [Hint: what are the implications of the fact that equity has
the “residual” claim on property value?]
Answer: Equity’s governance of the asset gives it the greater ability to influence the total
value of the underlying asset (e.g., by management actions), while its residual claim
causes any increment in this value to accrue to the value of the equity. If the equity
owner manages the property well, they will reap the benefit; if they manage it poorly they
will suffer the loss (at least up to a point). Thus, by giving the equity owner the primary
management control, it is likely that the value of the underlying asset (the property) will
be maximized.
3. What is wrong with the following statement: “Only a fool would invest in real estate
without financing most of the purchase with a mortgage: Borrowing allows you to
increase your expected return by using other people’s money!”
Answer: With increased debt the real estate equity holder increases the volatility of the
returns. The lender has the superior lien to the returns from the property hence its returns
are the least risky. The equity investor hence is left with the most risky components of
return. With increased leverage the risk also increases hence the given statement is
wrong.
5. What are the two types of risk that increase with leverage? Which of these two is the
more fundamental, and more directly relevant to the equity investor? How does the equity
investor indirectly pay for the lender’s risk?
Answer: “Default risk” and “volatility of returns” are the two risks that increase with
leverage. The higher the debt the higher will be the committed return (debt service) to the
lender. If the property does not give returns higher than the debt service there is risk of
default. However the default risk is more to lender than the borrower if debt is “nonrecourse”. The risk of volatility of returns is more fundamental and directly relevant to
the equity investor. Leverage increases the volatility of returns i.e. the range of possible
returns gets broadened, both on the upside and the downside. Leverage involves
allocating the lowest risk portion of the underlying property’s returns to the debt holder,
so the equity holder must be left with the higher-risk portion of the returns. Thus the
equity holder indirectly pays for the lender’s risk.
6. Why doesn’t the equity investor’s expected total return increase proportionately with
risk?
Answer: The expected total return includes the risk free rate as well as the risk premium.
Hence the expected total return does not increase in proportion with the risk. Only the
risk premium component of the total return increases with added risk brought by the
leverage.
7. That famous real estate investor, Bob, has $1,000,000 of his own equity capital
available to make a real estate investment. He finds a bargain, a property with a market
value of $1,100,000 that he can buy for $1,000,000. (a) By how much can Bob enhance
his net wealth by leveraging his purchase of this bargain property using borrowed money
to finance at least part of his investment? (b) Now suppose the bargain property is twice
as large, worth $2,200,000 and Bob can buy it for $2,000,000, but he still has only
$1,000,000 of his own capital available. In these circumstances how much more can Bob
increase his net wealth by using leverage, assuming he could borrow at least up to a 50%
LTV ratio?
Answer: a) As Bob has the money to buy the property he should go for 100% equity.
b) Considering Bob sells off the property after purchasing at a bargain price, he can then
increase his net wealth by $200,000 plus the cash flows during holding time minus the
cost of debt.
8.What is the relationship between the cap rate and the annual mortgage constant?
Answer: The mortgage constant reflects the return on and to debt capital. It is a
reflection of the cost of debt and as such the total return to equity should exceed the
mortgage constant. If the cap rate exceeds the mortgage constant then the cash flow
return to equity will also be higher than the mortgage constant and we have positive cash
flow leverage.
9. Suppose you want to increase the income component of your return from your real
estate equity portfolio, but you do not want to sacrifice the appreciation component.
What must you look for? (ie, What trade-off must you accept?)
Answer: To increase the income component of returns the leverage ratio should be low
(less debt, means lower debt service and increased income to equity holder). On other
hand, increased leverage can give higher returns on equity though leveraging the
appreciation component. By optimizing (trade off between higher and lower debt) both
these objectives can be met satisfactorily.
10. How does leverage enable the same underlying asset to serve the investment
objectives of different types of investors? What are the two different types of “investment
products” that result from the use of debt financing of real estate investment?
Answer: Partners investing in the same underlying asset can attain their individual
investment objectives through the use of mortgages (leverage). A partner requiring lowrisk return would become the lender to the partnership and hence ascertain a fixed income
on his/investment. The other partner with higher risk tolerance and low investment ability
will get the residual income from the property (lender has superior lien) however by
increasing the value of the property he/she can also get a higher return. Hence leverage
can be used to suit the investment requirements of different type of investors.
11. Quantitative problem: Suppose you expect that one year from now, a certain
property's before-tax cash flow (BTCF=NOI-debt service) will equal only $15,000 per
year under a plausible "pessimistic" scenario or as much as $25,000/yr under a plausible
"optimistic" scenario. If you borrow an amount such that the loan payments will be
$10,000 per year (for certain), then what is your range of expected income return
component (equity yield) under the "no leverage" and "leverage" alternatives, assuming
that the property price is $200,000 and the loan amount is $100,000?
Answer:
Equity Investment
Scenario
BTCF
Return on Equity
Leveraged
LR=2
$100,000
OPT
PESS
$25,000
$15,000
25%
15%
No levered
LR=1
$200,000
OPT
PESS
$35,000
$25,000
17.5%
12.5%