Chapter 12: Financial Leverage and Financing Alternatives McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 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 12-2 Financial Leverage: Before Tax Positive Financial Leverage – Returns are higher with debt Unleveraged BTIRR – Return with no debt If unleveraged BTIRR > interest rate on debt – The BTIRR on equity increases with debt – There is positive financial leverage 12-3 Financial Leverage: Before Tax Equation 1: BTIRRE= BTIRRP + (BTIRRP – BTIRRD)(D/E) – BTIRRE = Before-Tax IRR on equity invested – BTIRRP = Before-Tax IRR on total investment in the property (debt and equity) – BTIRRD = Before-Tax IRR on debt (effective cost including points) – D/E =Debt/Equity ratio 12-4 Financial Leverage: Before Tax Equation 1 shows that as long as: – BTIRRP > BTIRRD, then BTIRRE > BTIRRP – This implies increasing D/E will yield positive results But the use of debt is limited – Debt coverage ratio restrictions – Higher loan to value ratios are riskier to lenders. If the LTV is too high, the interest rates will be higher. – Higher debt levels increase risk to equity investor 12-5 Financial Leverage: Before Tax Negative Financial Leverage – If BTIRRD > BTIRRP, then BTIRRE < BTIRRP – The use of debt reduces the return on equity. 12-6 Financial Leverage: After Tax Equation 2: 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 12-7 Financial Leverage: After Tax Break-even interest rate – Maximum interest rate before negative financial leverage ATIRRD= ATIRRP ATIRRD= BTIRRD(1-t) BTIRRD= ATIRR D = 1 t ATIRR P 1 t Risk considerations Break-even interest rate is not affected by LTV. 12-8 Underwriting Loans Market Study and Appraisal Borrower Financial Statements – Nonrecourse clause. If nonrecourse, it’s sort of like the loan has a built in put option for the borrower. Loan to Value Ratio Debt Coverage Ratio 12-9 Underwriting Loans Possible Mortgage Covenants – Approval of new leases by lender – Approval of lease modifications by lender – Approval of construction by lender – Borrower submits periodic updates of financials 12-10 Underwriting Loans Possible Mortgage Covenants – Annual property appraisal – Notify lender of legal problems – Notify lender when correcting property defects – Lender has right to visit The lender’s goal is to insure that after the loan is closed, the value and incomeproducing ability of the asset is not impaired. 12-11 Underwriting Loans Lockout Clause – Prohibits prepayment of loan for a specified period of time Yield Maintenance Fee – Guarantees a yield to the lender after a lockout period expires Sometimes the fee is fixed as a percentage of the outstanding balance. This percentage may also vary based on the remaining term of the mortgage. 12-12 Alternative Financing Structures Mismatch between property income in the early years and constant payment loans Income is expected to increase – Inflation effects – New building not fully leased when loan is made – Leases may be below market Results in different loan structures 12-13 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 12-14 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. If option is not present, the investor may not be able to buy back the land. 12-15 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 – Accrual loans can be dangerous for a borrower as the amount owed becomes greater over time. 12-16 Alternative Financing Structures Structuring the payment for a targeted debt coverage ratio – Not always fully amortizing – Balloon payment Convertible Mortgage – Lender has an option to convert debt to equity Mezzanine Loan Preferred Equity 12-17