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, its 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

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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 lenders 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.
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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