Impact of Financial Leverage
I.
a.
b.
c.
d.
e.
A simple equation
Ko = Kd (L/V) + Ke (E/V)
Ke = Ko + (Ko - Kd) (L/E)
If Ko> Kd
Then, increase L will increase Ke
Increase leverage will increase the value of equity investment
II.
However, risk also increases by the use of debt.
Potential for bankruptcy
•
Higher variance
•
III.
An example
1. Use 100% equity
Equity = $500,000
State of the World NOI
Debt Service BTCF
Pessimistic
$55,000 $0
$55,000
Most likely
60,000
0
60,000
Optimistic
60,000
0
65,000
The equity dividend rate (EDR) for the pessimistic outcome is
EDR
EDR
11%
12
13
Probability
.2
.6
.2
= BTCF
Equity
$55,000
=$500,000
= 11%
The expected EDR is
S
E(EDR) = Σ pi (EDRi)
i=1
= .2(.11) + .6(.12) + .2(.13)
= 12%
2. Use 75% debt
Equity = $125,000
Debt = $375,000, at 10.908% interest rate
State of the world NOI
Debt Service
Pessimistic
$55,000 $40,905
Most likely
60,000
40,905
Optimistic
65,000
40,905
The expected equity dividend rate is
BTCF
$14,095
19,095
24,095
S
E(EDR) = Σ pi (EDRi)
i=1
= .2(.1128) + .6(.1528) + .2(.1928)
= 15.28%
EDR
11.28%
15.28
19.28
Probability
.2
.6
.2
3. Comparison
a.
b
Return:
Financing Option
Option 1
Option 2
E(EDR)
12.00%
15.28%
Risk:
Financing Option
1
2
Expected Return
12.00%
15.28%
Risk (σ)
0.63%
2.53%
Capital Decisions
I.
II.
Consideration
i. Tax advantages
• Interest payment is tax deductible
• There is an incentive to use debt
ii. Distress costs
• Bank will foreclosure on the property if borrower cannot pay debt service
• The more you borrow, the higher the likelihood that default will happen
• Foreclosure cost is high
• There is a cost to use high leverage ratio
Empirical result
1. Properties with larger depreciation base (newer property) use more debt
2. Properties with larger distress cost use less debt
3. Higher price properties use more debt because the difficult in raising equity capital
4. Entities with higher tax rate use more debt
5. Use less debt in the period with higher interest rates
Equation
Age: depreciation
Corporate * Price
1
0.0015
(3.6134)**
-0.0781
(1.9621)*
0.0198
(0.3812)
-0.0189
(0.3620)
0.0289
(0.5167)
0.1381
(2.9648)**
-0.0209
(0.2879)
-0.1872
(2.6780)**
0.0459
(4.2447)**
0.0274
(1.5088)
-0.0471
(7.9039)**
---
Constant
2
R
D.F.
0.4902
0.2041
747
1971: Tax law
Office
Retail
Mixed - distress cost
Apartment
Combination
Other
Price (ln)
Corporate - higher tax benefits
Interest rate
2
0.0016
(3.7497)**
-0.0683
(1.6960)
0.0226
(0.4346)
-0.0162
(0.3096)
0.0275
(0.4927)
0.1387
(2.9796)**
-0.0174
(0.2404)
-0.1838
(2.6307)**
0.0614
(4.1432)**
0.4067
(1.6332)
-0.0470
(7.8802)**
-0.0302
(1.5271)
0.2942
0.2066
746
What are Risks
I.
II.
Risk adjustment:
1. Conservative:
- Low estimates of cash flow
- High estimate of discount rate
2. Risk-adjusted discount rate
- Adjust discount rate higher for high-risk projects
3. Certainty-equivalent method
- Adjust cash flow lower for high-risk projects
Risk indicators
1. Variance (standard deviation)
2. Coefficient of variation
- Difficult to make comparison. For example
Payoff
$ 100
A
Probability
1.00
Mean = $100
Maximum = $100
σ=0
Payoff
$200
$400
B
Probability
0.5
0.5
Mean = $30
Minimum = $ 200
σ = $100
- Which is the preferred one?
- Coefficient of variation might give a wrong indication
3. CAPM
f. Mean-variance approach
g. Supported by theory
h. Difficult to implement due to data problem
i. Infrequent transactions
j. How to estimate holding period return?
k. Cannot use it without reliable database
4. Infer from REIT performance
5. Evidence from CREFs
III.
Information gathering
1. Publications
a. Associations
NAREIT
NCREIF
b. Brokerage houses
2. Adjustments – by survey (MAI) or by experience
c. Holding period
d. Type of property
Land
Office
Apartment
Hotel
Post office
e. Existing leases
f. Leverage
3. Comparable Property
a. Difficult to obtain information
b. For land lease contract (the 10% rule)
EXHIBIT 4-6. Ratio and Risk Analysis Techniques
Ratio Analysis in Investment Decision Making
Do you use ratio analysis?
Percentage
of 31 REITs
Percentage of
45 Insurance
Companies
Percentage
of 25
Real Estate
Corporations
47
53
Yes
72
78
No
28
22
Type of Ratios Used:
Leverage ratios
a
Mortgage debt to property value
47
34
20
b
Debt coverage
21
40
20
c
Default ratio
21
29
20
d
Total asset turnover
5
6
10
e
Operating expense ratio
26
23
10
Probability ratios
Profit margin
0
0
10
Return on total investment
5
20
20
Return on equity
11
43
30
Other ratios used
21
14
20
a
Mortgage debt to property value = mortgage outstanding/property value
b
Debt coverage = net operating income/debt service
c
Default ratio = operating expense + debt service/gross income
d
Total asset turnover = gross income/property value
e
Operating expense ratio = operating expenses/gross income
Percentage of
101
Respondents
70
30
36
44
25
6
22
2
16
31
17
Risk Adjustment Techniques
Percentage
of 31
REITs
Risk Adjustment Technique
Adjust upward the required rate of
return of the project
Adjust downward the cash flows
expected from the project
Use decision trees
Use sensitivity analysis
Use probability distributions
Other adjustments
No explicit adjustment for
uncertainty
Percentage of
25
Real Estate
Corporations
31
Percentage of
101
Respondents
33
Percentage
of 45
Insurance
Companies
26
33
40
44
39
4
26
0
0
19
0
20
5
8
30
0
13
19
0
13
1
20
6
4
23
30
EXHIBIT 4-5. Before and After-Tax Investment Criteria
Before Tax
Percentage
of 31
REITs
Percentage
of 45
Insurance
Companies
Percentage of
25 Real Estate
Corporations
Before-Tax Measure
Rules of thumb
Payback period
7
17
6
a
Net income multiplier
7
17
19
b
Gross income multiplier
0
5
13
c
BTCF multiplier
15
15
6
d
Overall capitalization rate
26
39
31
e
Equity dividend rate
26
39
31
Other
4
7
0
Discounted cash flow method
before tax IRR
48
66
50
No before tax measure used
4
3
13
a
Net income multiplier = total investment/net operating income
b
Gross income multiplier = total investment/gross income
c
Before-tax cash flow multiplier = equity investment/BTCF
d
Overall capitalization rate = net operating income/total investment
e
Equity dividend rate = BTCF/equity investment
Percentage of
101
Respondents
12
14
5
13
33
33
5
57
5
After Tax
After-Tax Measure
Rules of thumb
Payback period
a
After-tax rate
b
After-tax multiplier
Discounted-cash-flow techniques
Net present value
Internal rate of return
Financial management rate of
return
Profitability index
Tax shelter benefits
Other
No after-tax measure used
Percentage
of 31
REITs
Percentage
of 45
Insurance
Companies
Percentage of
25 Real Estate
Corporations
Percentage of
101
Respondents
6
0
17
13
29
11
7
0
14
11
17
14
6
22
18
61
36
43
20
50
0
0
11
6
50
16
3
11
3
13
7
7
0
7
21
11
3
9
5
26