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Chapter 12

Financial Leverage and Financing Alternatives

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Overview Financial Leverage Financial Leverage: Before-Tax Financial Leverage: After-Tax Break-Even Interest Rate Underwriting Loans Alternative Financing Structures Conventional Loan Equity Participation Loan

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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

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Financial Leverage: Before-Tax Positive Financial Leverage

Returns are higher with debt Unlevered BTIRR

Return with no debt If unlevered BTIRR > interest rate

on debt The BTIRR on equity increases with

debt There is positive financial leverage

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Financial Leverage: Before-Tax

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

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Financial Leverage: Before-Tax Equation shows that as long as:

BTIRRP > BTIRRD, then BTIRRE > BTIRRP

This implies increasing D/E…… But the use of debt is limited

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

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Financial Leverage: Before-Tax

Negative Financial Leverage If BTIRRD > BTIRRP, then BTIRRE < BTIRRP

The use of debt reduces the return on equity

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Financial Leverage: After-Tax

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

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Example Assumptions:

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

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BTCF – No Leverage

Year 0 1 2 3 4 5Before Tax Cash Flow = Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Debt service (DS) $0 $0 $0 $0 $0 = Before-tax cash flows (BTCF) $12,000 $12,000 $12,000 $12,000 $12,000

= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Debt service (DS) $0 $0 $0 $0 $0 = Net sales price (NSP) $100,000 - Unpaid mortgage balance (UMB) $0 = Before-tax cash flows (BTCF)($100,000) $12,000 $12,000 $12,000 $12,000 $112,000

BTIRR on Equity 12.00%

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ATCF – No LeverageYear 0 1 2 3 4 5 Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Interest (INT) $0 $0 $0 $0 $0 - Amortized Financing Cost $0 $0 $0 $0 $0 - Depreciation (DEP) $2,698 $2,698 $2,698 $2,698 $2,698 = Taxable income from operations (TI)$9,302 $9,302 $9,302 $9,302 $9,302 - Loss carry forward - Net carry forward = Net taxable income $9,302 $9,302 $9,302 $9,302 $9,302 x Marginal tax rate (t) 28% 28% 28% 28% 28% = Taxes (savings) from operations (TXS)$2,604 $2,604 $2,604 $2,604 $2,604

Year 0 1 2 3 4 5 = Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Debt service (DS) $0 $0 $0 $0 $0 = Taxes (savings) from operations (TXS)$2,604 $2,604 $2,604 $2,604 $2,604 = After-tax equity reversion (ATER) $96,222 = After-tax cash flows (ATCF)($100,000) $9,396 $9,396 $9,396 $9,396 $105,618

ATIRR on Equity 8.76%

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BTCF – $80,000 LoanYear 0 1 2 3 4 5Before Tax Cash Flow = Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Debt service (DS) $8,000 $8,000 $8,000 $8,000 $8,000 = Before-tax cash flows (BTCF) $4,000 $4,000 $4,000 $4,000 $4,000

= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Debt service (DS) $8,000 $8,000 $8,000 $8,000 $8,000 = Net sales price (NSP) $100,000 - Unpaid mortgage balance (UMB) $80,000 = Before-tax cash flows (BTCF)($20,000) $4,000 $4,000 $4,000 $4,000 $24,000

BTIRR on Equity 20.00%

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ATCF – $80,000 LoanYear 0 1 2 3 4 5 Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Interest (INT) $8,000 $8,000 $8,000 $8,000 $8,000 - Amortized Financing Cost $0 $0 $0 $0 $0 - Depreciation (DEP) $2,698 $2,698 $2,698 $2,698 $2,698 = Taxable income from operations (TI)$1,302 $1,302 $1,302 $1,302 $1,302 - Loss carry forward - Net carry forward = Net taxable income $1,302 $1,302 $1,302 $1,302 $1,302 x Marginal tax rate (t) 28% 28% 28% 28% 28% = Taxes (savings) from operations (TXS)$364 $364 $364 $364 $364

Year 0 1 2 3 4 5 = Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 - Debt service (DS) $8,000 $8,000 $8,000 $8,000 $8,000 = Taxes (savings) from operations (TXS)$364 $364 $364 $364 $364 = After-tax equity reversion (ATER) $16,222 = After-tax cash flows (ATCF)($20,000) $3,636 $3,636 $3,636 $3,636 $19,858

ATIRR on Equity 15.40%

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Break-Even Interest Rate

Break-even interest rate: Maximum interest rate before negative financial leverage

ATIRRD= ATIRRP

ATIRRD= BTIRRD(1-t)

%17.1228.01

%76.811

t

ATIRR

t

ATIRRBTIRR pD

D

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Underwriting Loans Market Study

Economic base Submarkets Appraisal

Borrower Financial Statements Nonrecourse clause may be included

Loan to Value Ratio Debt Coverage Ratio

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

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Underwriting Loans Additional Considerations:

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

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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

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Alternative Financing Structures

Mismatch between early year property income and constant payment loans

Income is expected to increase Inflation effects New building not fully leased Leases may be below market

Results in different loan structures

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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

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Conventional Loan Assumptions:

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

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Conventional Loan – BTIRR Year 0 1 2 3 4 5Beginning Period 1 13 25 37 49Ending Period 12 24 36 48 60Before Tax Cash Flow = Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Debt service (DS) $90,267 $90,267 $90,267 $90,267 $90,267 = Cash flow before participation $9,733 $12,733 $15,823 $19,006 $22,284 - Participation $0 $0 $0 $0 $0 = Before-tax cash flows (BTCF) $9,733 $12,733 $15,823 $19,006 $22,284

= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Debt service (DS) $90,267 $90,267 $90,267 $90,267 $90,267 - Participation $0 $0 $0 $0 $0 = Net sales price (NSP) $1,159,274 - Unpaid mortgage balance (UMB) $569,216 - Participation $0 = Before-tax cash flows (BTCF)($300,000) $9,733 $12,733 $15,823 $19,006 $612,342

BTIRR on Equity 18.37%

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Conventional Loan – ATIRR Year 0 1 2 3 4 5 Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Interest (INT) $69,045 $66,823 $64,368 $61,656 $58,660 - Depreciation (DEP) $31,364 $32,727 $32,727 $32,727 $31,364 - Participation $0 $0 $0 $0 $0 = Taxable income from operations (TI) ($408) $3,450 $8,995 $14,890 $22,528 - Loss carry forward $0 $0 $0 $0 $0 - Net carry forward $0 $0 $0 $0 $0 = Net taxable income ($408) $3,450 $8,995 $14,890 $22,528 x Marginal tax rate (t) 28% 28% 28% 28% 28% = Taxes (savings) from operations (TXS)($114) $966 $2,519 $4,169 $6,308

Year 0 1 2 3 4 5 = Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Debt service (DS) $90,267 $90,267 $90,267 $90,267 $90,267 - Participation $0 $0 $0 $0 $0 = Taxes (savings) from operations (TXS)($114) $966 $2,519 $4,169 $6,308 = After-tax equity reversion (ATER) $500,406 = After-tax cash flows (ATCF)($300,000) $9,848 $11,767 $13,305 $14,837 $516,383

ATIRR on Equity 14.29%

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Equity Participation Loan Assumptions:

Total value: $1,000,000 (Building: $900,000, Land: $100,000)

Participation loan information: 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

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Equity Participation Loan – BTIRR

Year 0 1 2 3 4 5Beginning Period 1 13 25 37 49Ending Period 12 24 36 48 60Before Tax Cash Flow = Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Debt service (DS) $80,275 $80,275 $80,275 $80,275 $80,275 = Cash flow before participation $19,725 $22,725 $25,815 $28,998 $32,276 - Participation $0 $1,500 $3,045 $4,636 $6,275 = Before-tax cash flows (BTCF) $19,725 $21,225 $22,770 $24,362 $26,001

= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Debt service (DS) $80,275 $80,275 $80,275 $80,275 $80,275 - Participation $0 $1,500 $3,045 $4,636 $6,275 = Net sales price (NSP) $1,159,274 - Unpaid mortgage balance (UMB) $551,364 - Participation $71,673 = Before-tax cash flows (BTCF)($300,000) $19,725 $21,225 $22,770 $24,362 $562,238

BTIRR on Equity 18.36%

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Equity Participation Loan – ATIRRYear 0 1 2 3 4 5 Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Interest (INT) $55,090 $53,000 $50,736 $48,284 $45,629 - Depreciation (DEP) $31,364 $32,727 $32,727 $32,727 $31,364 - Participation $0 $1,500 $3,045 $4,636 $6,275 = Taxable income from operations (TI)$13,547 $15,773 $19,582 $23,625 $29,283 - Loss carry forward $0 $0 $0 $0 $0 - Net carry forward $0 $0 $0 $0 $0 = Net taxable income $13,547 $15,773 $19,582 $23,625 $29,283 x Marginal tax rate (t) 28% 28% 28% 28% 28% = Taxes (savings) from operations (TXS)$3,793 $4,417 $5,483 $6,615 $8,199

Year 0 1 2 3 4 5 = Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551 - Debt service (DS) $80,275 $80,275 $80,275 $80,275 $80,275 - Participation $0 $1,500 $3,045 $4,636 $6,275 = Taxes (savings) from operations (TXS)$3,793 $4,417 $5,483 $6,615 $8,199 = After-tax equity reversion (ATER) $466,654 = After-tax cash flows (ATCF)($300,000) $15,932 $16,809 $17,287 $17,747 $484,456

ATIRR on Equity 14.06%

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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

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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

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Alternative Financing Structures

Structuring the payment for a targeted debt coverage ratio Not always fully amortizing Balloon payment

Convertible Mortgage Lender has an equity investment option

Mezzanine Loan Preferred Equity