Chapter 12
Financial Leverage and Financing
Alternatives
1
Overview
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Financial Leverage
Financial Leverage: Before-Tax
Financial Leverage: After-Tax
Break-Even Interest Rate
Underwriting Loans
Alternative Financing Structures
Conventional Loan
Equity Participation Loan
2
Financial Leverage
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What is financial leverage?
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Benefit of borrowing at a lower interest rate than the
rate of return on the property.
Why use financial leverage?
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Diversification benefits of lower equity investment
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Can invest in other property
Mortgage interest tax benefit
Magnify returns if the return on the property exceeds
the cost of debt
3
Financial Leverage: BeforeTax
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Positive Financial Leverage
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Unlevered BTIRR
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Returns are higher with debt
Return with no debt
If unlevered BTIRR > interest rate on
debt
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The BTIRR on equity increases with debt
There is positive financial leverage
4
Financial Leverage: BeforeTax
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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
5
Financial Leverage: BeforeTax
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Equation shows that as long as:
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BTIRRP > BTIRRD, then BTIRRE > BTIRRP
This implies increasing D/E……
But the use of debt is limited
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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
6
Financial Leverage: BeforeTax
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Negative Financial Leverage
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If BTIRRD > BTIRRP, then BTIRRE < BTIRRP
The use of debt reduces the return on equity
7
Financial Leverage: After-Tax
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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)
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After-Tax IRR on debt (effective cost after taxes
including points)
D/E =Debt/Equity
8
Example
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Assumptions:
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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
9
BTCF – No Leverage
Year
0
Before Tax Cash Flow
= Net operating income (NOI)
- Debt service (DS)
= Before-tax cash flows (BTCF)
1
2
3
4
5
$12,000
$0
$12,000
$12,000
$0
$12,000
$12,000
$0
$12,000
$12,000
$0
$12,000
$12,000
$0
$12,000
= Net operating income (NOI)
$12,000
- Debt service (DS)
$0
= Net sales price (NSP)
- Unpaid mortgage balance (UMB)
= Before-tax cash flows($100,000)
(BTCF)
$12,000
$12,000
$0
$12,000
$0
$12,000
$0
$12,000
$12,000
$12,000
$12,000
$0
$100,000
$0
$112,000
BTIRR on Equity
12.00%
10
ATCF – No Leverage
Year
0
1
Net operating income (NOI)
$12,000
- Interest (INT)
$0
- Amortized Financing Cost
$0
- Depreciation (DEP)
$2,698
= Taxable income from operations (TI)$9,302
- Loss carry forward
- Net carry forward
= Net taxable income
$9,302
x Marginal tax rate (t)
28%
= Taxes (savings) from operations (TXS)
$2,604
2
$12,000
$0
$0
$2,698
$9,302
3
$12,000
$0
$0
$2,698
$9,302
4
$12,000
$0
$0
$2,698
$9,302
5
$12,000
$0
$0
$2,698
$9,302
$9,302
28%
$2,604
$9,302
28%
$2,604
$9,302
28%
$2,604
$9,302
28%
$2,604
Year
0
1
= Net operating income (NOI)
$12,000
- Debt service (DS)
$0
= Taxes (savings) from operations (TXS)
$2,604
= After-tax equity reversion (ATER)
= After-tax cash flows (ATCF)
($100,000)
$9,396
2
$12,000
$0
$2,604
3
$12,000
$0
$2,604
4
$12,000
$0
$2,604
$9,396
$9,396
$9,396
5
$12,000
$0
$2,604
$96,222
$105,618
ATIRR on Equity
8.76%
11
BTCF – $80,000 Loan
Year
0
Before Tax Cash Flow
= Net operating income (NOI)
- Debt service (DS)
= Before-tax cash flows (BTCF)
1
2
3
4
5
$12,000
$8,000
$4,000
$12,000
$8,000
$4,000
$12,000
$8,000
$4,000
$12,000
$8,000
$4,000
$12,000
$8,000
$4,000
= Net operating income (NOI)
$12,000
- Debt service (DS)
$8,000
= Net sales price (NSP)
- Unpaid mortgage balance (UMB)
= Before-tax cash flows ($20,000)
(BTCF)
$4,000
$12,000
$8,000
$12,000
$8,000
$12,000
$8,000
$4,000
$4,000
$4,000
$12,000
$8,000
$100,000
$80,000
$24,000
BTIRR on Equity
20.00%
12
ATCF – $80,000 Loan
Year
0
1
Net operating income (NOI)
$12,000
- Interest (INT)
$8,000
- Amortized Financing Cost
$0
- Depreciation (DEP)
$2,698
= Taxable income from operations (TI)$1,302
- Loss carry forward
- Net carry forward
= Net taxable income
$1,302
x Marginal tax rate (t)
28%
= Taxes (savings) from operations (TXS)$364
2
$12,000
$8,000
$0
$2,698
$1,302
3
$12,000
$8,000
$0
$2,698
$1,302
4
$12,000
$8,000
$0
$2,698
$1,302
5
$12,000
$8,000
$0
$2,698
$1,302
$1,302
28%
$364
$1,302
28%
$364
$1,302
28%
$364
$1,302
28%
$364
Year
0
1
= Net operating income (NOI)
$12,000
- Debt service (DS)
$8,000
= Taxes (savings) from operations (TXS)$364
= After-tax equity reversion (ATER)
= After-tax cash flows (ATCF)
($20,000)
$3,636
2
$12,000
$8,000
$364
3
$12,000
$8,000
$364
4
$12,000
$8,000
$364
$3,636
$3,636
$3,636
5
$12,000
$8,000
$364
$16,222
$19,858
ATIRR on Equity
15.40%
13
Break-Even Interest Rate
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Break-even interest rate: Maximum
interest rate before negative financial
leverage
ATIRRD= ATIRRP
ATIRRD= BTIRRD(1-t)
ATIRR D ATIRR p
BTIRR D 

1 t
1 t
8.76%
 12.17%
1  0.28
14
Underwriting Loans
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Market Study
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Borrower Financial Statements
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Economic base
Submarkets
Appraisal
Nonrecourse clause may be included
Loan to Value Ratio
Debt Coverage Ratio
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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
15
Underwriting Loans
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Additional Considerations:
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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
16
Underwriting Loans
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Lockout Clause
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Prohibits prepayment of loan for a specified
period of time
Yield Maintenance Fee
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Guarantees a yield to the lender after a
lockout period expires
17
Alternative Financing
Structures
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Mismatch between early year property
income and constant payment loans
Income is expected to increase
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Inflation effects
New building not fully leased
Leases may be below market
Results in different loan structures
18
Alternative Financing Structures
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Equity Participation Loans
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Lower interest rate from lender
Lender shares in property cash flow
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Lender motivations
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Percent of PGI, NOI or BTCF, etc.
Guaranteed minimum return and some protection
of real return
Investor motivations
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Easier to meet debt service requirements
19
Conventional Loan
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Assumptions:
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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
20
Conventional Loan – BTIRR
Year
0
Beginning Period
Ending Period
Before Tax Cash Flow
= Net operating income (NOI)
- Debt service (DS)
= Cash flow before participation
- Participation
= Before-tax cash flows (BTCF)
1
1
12
2
13
24
3
25
36
4
37
48
5
49
60
$100,000 $103,000 $106,090 $109,273
$90,267 $90,267 $90,267 $90,267
$9,733 $12,733 $15,823 $19,006
$0
$0
$0
$0
$9,733 $12,733 $15,823 $19,006
$112,551
$90,267
$22,284
$0
$22,284
= Net operating income (NOI)
$100,000 $103,000 $106,090 $109,273
- Debt service (DS)
$90,267 $90,267 $90,267 $90,267
- Participation
$0
$0
$0
$0
= Net sales price (NSP)
- Unpaid mortgage balance (UMB)
- Participation
= Before-tax cash flows($300,000)
(BTCF)
$9,733 $12,733 $15,823 $19,006
$112,551
$90,267
$0
$1,159,274
$569,216
$0
$612,342
BTIRR on Equity
18.37%
21
Conventional Loan – ATIRR
Year
0
1
2
3
4
Net operating income (NOI)
$100,000 $103,000 $106,090 $109,273
- Interest (INT)
$69,045 $66,823 $64,368 $61,656
- Depreciation (DEP)
$31,364 $32,727 $32,727 $32,727
- Participation
$0
$0
$0
$0
= Taxable income from operations (TI) ($408)
$3,450
$8,995 $14,890
- Loss carry forward
$0
$0
$0
$0
- Net carry forward
$0
$0
$0
$0
= Net taxable income
($408)
$3,450
$8,995 $14,890
x Marginal tax rate (t)
28%
28%
28%
28%
= Taxes (savings) from operations (TXS)($114)
$966
$2,519
$4,169
5
$112,551
$58,660
$31,364
$0
$22,528
$0
$0
$22,528
28%
$6,308
Year
0
1
2
3
4
= Net operating income (NOI)
$100,000 $103,000 $106,090 $109,273
- Debt service (DS)
$90,267 $90,267 $90,267 $90,267
- Participation
$0
$0
$0
$0
= Taxes (savings) from operations (TXS)($114)
$966
$2,519
$4,169
= After-tax equity reversion (ATER)
= After-tax cash flows (ATCF)
($300,000)
$9,848 $11,767 $13,305 $14,837
5
$112,551
$90,267
$0
$6,308
$500,406
$516,383
ATIRR on Equity
14.29%
22
Equity Participation Loan
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Assumptions:
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Total value: $1,000,000 (Building: $900,000, Land: $100,000)
Participation loan information:
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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
23
Equity Participation Loan –
BTIRR
Year
0
Beginning Period
Ending Period
Before Tax Cash Flow
= Net operating income (NOI)
- Debt service (DS)
= Cash flow before participation
- Participation
= Before-tax cash flows (BTCF)
1
1
12
2
13
24
3
25
36
4
37
48
5
49
60
$100,000 $103,000 $106,090 $109,273
$80,275 $80,275 $80,275 $80,275
$19,725 $22,725 $25,815 $28,998
$0
$1,500
$3,045
$4,636
$19,725 $21,225 $22,770 $24,362
$112,551
$80,275
$32,276
$6,275
$26,001
= Net operating income (NOI)
$100,000 $103,000 $106,090 $109,273
- Debt service (DS)
$80,275 $80,275 $80,275 $80,275
- Participation
$0
$1,500
$3,045
$4,636
= Net sales price (NSP)
- Unpaid mortgage balance (UMB)
- Participation
= Before-tax cash flows($300,000)
(BTCF)
$19,725 $21,225 $22,770 $24,362
$112,551
$80,275
$6,275
$1,159,274
$551,364
$71,673
$562,238
BTIRR on Equity
18.36%
24
Equity Participation Loan –
ATIRR
Year
0
1
2
3
4
Net operating income (NOI)
$100,000 $103,000 $106,090 $109,273
- Interest (INT)
$55,090 $53,000 $50,736 $48,284
- Depreciation (DEP)
$31,364 $32,727 $32,727 $32,727
- Participation
$0
$1,500
$3,045
$4,636
= Taxable income from operations (TI)$13,547 $15,773 $19,582 $23,625
- Loss carry forward
$0
$0
$0
$0
- Net carry forward
$0
$0
$0
$0
= Net taxable income
$13,547 $15,773 $19,582 $23,625
x Marginal tax rate (t)
28%
28%
28%
28%
= Taxes (savings) from operations (TXS)
$3,793
$4,417
$5,483
$6,615
5
$112,551
$45,629
$31,364
$6,275
$29,283
$0
$0
$29,283
28%
$8,199
Year
0
1
2
3
4
= Net operating income (NOI)
$100,000 $103,000 $106,090 $109,273
- Debt service (DS)
$80,275 $80,275 $80,275 $80,275
- Participation
$0
$1,500
$3,045
$4,636
= Taxes (savings) from operations (TXS)
$3,793
$4,417
$5,483
$6,615
= After-tax equity reversion (ATER)
= After-tax cash flows (ATCF)
($300,000)
$15,932 $16,809 $17,287 $17,747
5
$112,551
$80,275
$6,275
$8,199
$466,654
$484,456
ATIRR on Equity
14.06%
25
Alternative Financing Structures
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Sale-Leaseback of Land
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Own building and lease land from a
different investor
Motivations
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100% financing possible
Lease payments are tax deductible
Building is depreciable; land is not
Possible purchase option at end of lease
26
Alternative Financing Structures
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Interest Only Loans: “Bullet Loans”
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No amortization for a specified period
Balloon payment or amortization afterward
Accrual Loans
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Negative amortization
Pay Rate
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Interest rate used to calculate loan payment
Accrual Rate
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Interest rate used to calculate the interest
charged
27
Alternative Financing Structures
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Structuring the payment for a targeted
debt coverage ratio
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Convertible Mortgage
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Not always fully amortizing
Balloon payment
Lender has an equity investment option
Mezzanine Loan
Preferred Equity
28