1. Real Estate Finance
Financial Leverage
Financial Leverage describes the relationship between
the return on an investment and the amount of debt used
to finance the acquisition. The investment return can be
measured on either a before tax or on an after tax basis.
(Total) leverage is positive if the investment return
increases with debt financing
(Total) leverage is negative if the investment return
decreases with debt financing
(Total) leverage is neutral if the investment return
does not change with debt financing
2. Real Estate Finance
Financial Leverage
On a before tax basis, the influence that leverage has on the
investment return is (approximately) given by:
BTIRRE = BTIRRP + (BTIRRP – BTIRRD) (D/E),
where: BTIRRE = before tax IRR on the equity cash flows
BTIRRP = before tax IRR on the property cash flows
BTIRRD = before tax IRR on the debt cash flows, or
the effective borrowing cost
D = the loan amount
E = equity
3. Real Estate Finance
Financial Leverage
Interpretation:
Before tax financial leverage will be positive (or the before tax
IRR on equity will exceed the before tax IRR on the property)
when the before tax IRR on the property exceeds the before tax
cost of debt,
BTIRRP - BTIRRD > 0, or
BTIRRP > BTIRRD.
5. Real Estate Finance
Financial Leverage
Example: Willow Brook Apartments
BTIRRD = ?????
Net Loan Amount = $11,600,000 - $232,000
= $11,368,000
Monthly Pmt = $89,193.96, for 60 months
Future Value = $11,076,871 + $332,306
= $11,409,177
BTIRRD = 9.47%
6. Real Estate Finance
Financial Leverage
Example: Willow Brook Apartments
On a before tax basis, the influence that leverage has on the
investment return is (approximately) given by:
BTIRRE = 16.2% (approximately equal to)
BTIRRP + (BTIRRP – BTIRRD) (D/E) =
11.1% + (11.1% - 9.5%) 3.7 =
11.1% + 1.6% 3.7 = 11.1% + 5.9% = 17.0%
7. Real Estate Finance
Financial Leverage
On an after tax basis, the influence that leverage has on the
investment return is (approximately) given by:
ATIRRE = ATIRRP + (ATIRRP – ATIRRD) (D/E),
where: ATIRRE = after tax IRR on the equity cash flows
ATIRRP = after tax IRR on the property cash flows
ATIRRD = after tax IRR on the debt cash flows,
= (1 – tax rate) BTIRRD
D = the loan amount
E = equity
8. Real Estate Finance
Financial Leverage
Interpretation:
After tax financial leverage will be positive (or the after tax
IRR on equity will exceed the after tax IRR on the property)
when the after tax IRR on the property exceeds the after tax
cost of debt,
ATIRRP - ATIRRD > 0, or
ATIRRP > ATIRRD.
10. Real Estate Finance
Financial Leverage
Example: Willow Brook Apartments
On a after tax basis, the influence that leverage has on
the investment return is (approximately) given by:
ATIRRE = 14.3%
ATIRRP + (ATIRRP – ATIRRD) (D/E) =
8.0% + (8.0% - 6.1%) 3.7 =
8.0% + 1.9% 3.7 = 8.0% + 7.0% = 15.0%
11. Real Estate Finance
Financial Leverage
Marginal Leverage
The above discussion refers to the influence that using any
amount of debt has on the (before or after tax) return on
investment. That is, total leverage compares the investment
return of a debt-financed acquisition to the investment return of
an all cash purchase.
The numerical example for Willow Brook illustrated that, in
this example, financial leverage is positive on both a before
and an after tax basis.
Marginal leverage refers to the influence that small amounts of
additional debt have on (either the before or after tax)
investment return.
12. Real Estate Finance
Financial Leverage
Example: Willow Brook Apartments
Required Yields: Property Returns:
Property: 12.0% IRR NPV
Before Tax: 15.0% BT 11.1% - $488,276
After Tax: 13.5% AT 8.0% - $2,814,264
14. Real Estate Finance
Financial Leverage
Example: Willow Brook Apartments
1. Total leverage is positive for both the 75% and 85% L/V
2. Relative to the 80% L/V, marginal leverage is negative
for both the 75% and 85% L/V.
3. The 85% L/V is a negative BTNPV deal even though
before tax total leverage is positive.
4. The 75% L/V is a negative ATNPV deal even though
after tax total leverage is positive.
15. Real Estate Finance
Financial Leverage
Break Even Interest Rate (BEIR)
The break even interest rate is the (before tax) interest rate at
which (total) leverage is neutral.
P
ATIRR
BEIR =
1-tax rate
For Willow Brook Apartments, the break even interest rate is:
P
ATIRR 8.0%
BEIR = 12.5%
1-tax rate 1 0.36
16. Real Estate Finance
Financing Alternatives
There are numerous alternatives to fixed rate loans, including:
Lender participations
Sale-lease back of the land
Interest only loans
Accrual loans
Convertible mortgages
17. Real Estate Finance
Financing Alternatives
Participation Loans
With a participation loan, the lender offers the borrower a
below market interest rate in exchange for a portion of the
property’s cash flows.
The lender may participate in cash flows from
1. operations (e.g. NOI, BTCFO), or
2. reversion (e.g. sales proceeds, BTCFR, capital gain)
18. Real Estate Finance
Financing Alternatives
Participation Loan
The participation may be tiered, or have different participation
percentages for different amounts of cash flow.
For example, the lender may receive:
1. 50% of any BTCFO if 0 < BTCFO < $25,000 PLUS
2. 40% of any BTCFO if $25,000 < BTCFO < $50,000 PLUS
3. 25% of any BTCFO if BTCFO > $50,000
19. Real Estate Finance
Financing Alternatives
Participation Loan
Example
Suppose the lender in the Willow Brook Apartments example
offered the investor a 7.5% interest rate (instead of the 8.5%
rate) with monthly payments for 30 years in exchange for
twenty five percent of the before tax cash flows from
operations and ten percent of the before tax cash flow from
reversion.
1. Should the investor accept the offer?
2. What is the lender’s expected yield?
20. Real Estate Finance
Financing Alternatives
Willow Brook Participation
Cash Flows from Operations
Year: 1 2 3
NOI 1,323,365 1,363,066 1,403,958
- DS -973,307 -973,307 -973,307
BTCF before 350,058 389,759 430,651
- Participation -87,515 -97,440 -107,663
BTCF after 262,544 292,319 322,988
Participation
CF to lender 1,060,822 1,070,747 1,080,970
21. Real Estate Finance
Financing Alternatives
Willow Brook Participation
Cash Flow from Reversion
Year: 5
Net Sales Proceeds 15,825,893
- MB -10,975,623
- PP -329,269
BTCFR before 4,521,001
- Participation -452,100
BTCFR after 4,068,901
Participation
23. Real Estate Finance
Financing Alternatives
Willow Brook Participation
Equity Investor’s Return:
ATIRR = 13.12%
ATNPV = -44,273 (no deal)
Lender’s Return:
BTIRR = 10.05%
How might the equity investor respond?
24. Real Estate Finance
Financing Alternatives
Sales-Leaseback of the Land
Property owner sells land in exchange for long-term lease.
Contract frequently contains an option to repurchase land
at the end of the lease (at prevailing market value)
Advantages
1. no equity tied up in land cost (100% land financing)
2. entire (land) lease payment deductible for tax purposes
25. Real Estate Finance
Financing Alternatives
Interest Only
Borrower pays only interest over loan term
Entire loan amount repaid at maturity
Like a corporate bond with monthly rather than semi-
annual payments
26. Real Estate Finance
Financing Alternatives
Interest Only
Advantages (compared to conventional financing)
1. Higher BTCFO (no principal repayment)
2. Same interest deduction
3. Higher ATCFO
4. Higher ATIRR compared to comparable conventional
loan
Disadvantage: higher risk of default
27. Real Estate Finance
Financing Alternatives
Accrual Loan
This loan has two interest rates:
1. Pay rate: used to determine periodic (e.g. monthly)
mortgage payment
2. Accrual rate: used to determine interest charged
Pay rate < accrual rate, so
1. lower periodic debt service payment
2. lower debt service coverage (DSC) ratio
28. Real Estate Finance
Financing Alternatives
Accrual Loan
Advantages (compared to conventional financing)
1. lower debt service payment with higher interest deduction
2. higher ATCFO (for two reasons)
higher BTCFO
higher interest deduction; lower taxable income
Disadvantage: higher risk of default
29. Real Estate Finance
Financing Alternatives
Convertible Loan
The lender offers the borrower a below market rate
on the loan in exchange for the option to purchase
an interest in the property at some specified period
of time (in lieu of the outstanding mortgage
balance).
Conversion option ratio = percent of property price
that reverts to lender
IRS requires that L/V > conversion option ratio
30. Real Estate Finance
Financing Alternatives
Convertible Loan Example
Willow Brook Apartments
Suppose the lender offered the borrower a 7.5% interest
rate (rather than the 8.5% market rate) in exchange for
75% of the sales price at the end of year 5.
1. Would the lender exercise the option?
2. What is the lender’s expected yield?
3. What is the investor’s expected ATIRR?
31. Real Estate Finance
Financing Alternatives
Convertible Loan Example
Willow Brook Apartments
Expected sales price $16,148,878
75% of expected sales price $12,111,659
85% conventional 75% convertible
Net loan 11,368,000.00 11,368,000.00
Monthly Pmt 89,193.96 81,108.88
Outstanding Balance 11,076,870.85 n.a.
Prepayment Penalty 332,306.13 n.a.
Purchase Option n.a. 12,111,659.00
Total FV 11,409,176.98 12,111,659.00
32. Real Estate Finance
Financing Alternatives
Convertible Loan Example
Willow Brook Apartments
Lender’s Yield:
60
60
1
1 12,111,653
11,368,000 81,108.88 ; d 9.59%
d d
1 1
12 12
t
t
33. Real Estate Finance
Financing Alternatives
Convertible Loan Example
Willow Brook Apartments
Investor’s Yield
Sales Price 16,148,878
-Selling cost -322,978
-Lender proceeds -12,111,659
BTCFR 3,714,242
-Capital gain tax -713,362
+Ordinary Income Credit 69,600
ATCFO 3,070,480
ATIRR 12.15%
ATNPV -147,597
