Financial Leverage and Financing Alternatives Question and Answer (FN-444)

Financial Leverage and Financing Alternatives Question and Answer (FN-444)

FN-444-Chapter12: Financial Leverage and Financing Alternatives

Question 12-1: What is financial leverage?  Why is a one-year measure of return on investment inadequate in determining whether positive or negative financial leverage exists?

  • Financial leverage is defined as benefits that may result to an investor by borrowing money at a rate of interest that is lower than the expected rate of return on total funds invested in a property.
  • To determine whether leverage is positive (favorable) or negative (unfavorable), the investor needs to determine whether the IRR (calculated over the entire holding period) is greater than the cost of  borrowed funds.  A first-year measure of return such as the overall capitalization rate can not be used because it does not explicitly consider the benefits that accrue to the investor over time from changes in income and value that do not affect the cost of debt.

Question 12-2: What is the break-even mortgage interest rate (BEIR)  in the context of financial leverage?  Would you ever expect an investor to pay a break-even interest rate when financing a property?  Why or why not?

  • The BEIR is the maximum interest rate that could be paid on the debt before the leverage becomes unfavorable.  It represents the interest rate where the leverage is neutral (neither favorable or unfavorable).
  • The BEIR remains constant regardless of the amount borrowed (that is 60, 70, or 80 percent of the property value).
  • An equity investor probably would not pay a break-even interest rate when financing a property because the investor just earns the same after-tax rate of return as a lender on the same project.  Borrowing at the BEIR      provides no risk premium to the investor.  Normally, a risk premium is required because the equity investor bears the risk of variations in the performance of the property.

Question 12-3: What is positive and negative financial leverage?  How are returns or losses magnified as the degree of leverage increases?  How does leverage on a before-tax basis differ from leverage on an after-tax basis?

  • When the before-tax or after-tax IRR are higher with debt than without debt, we say that the investment has  positive or favorable financial leverage.  When returns are lower with debt than without debt we say that the investment has negative or unfavorable financial leverage.
  • Positive leverage occurs when the unlettered IRR is greater than the interest rate paid on the debt.  Negative leverage occurs when the unlettered IRR is less than the interest rate paid on the debt. Returns and losses are magnified by the greater the amount of debt, the greater the return or loss to the equity investor.
  • Leverage on a before-tax basis differs from leverage on an after-tax basis because interest is tax deductible. Therefore, we must consider the after-tax cost of debt which is different than the before-tax cost of debt.

Financial Leverage and Financing Alternatives Question and Answer (FN-444)

Question 12-4: In what way does leverage increase the riskiness of a loan?

  • Leverage increases the standard deviation of return regardless of whether it is positive or negative.  This means the investment is clearly riskier when leverage is used. Because the NOI does not change when more debt is used, increasing the amount of debt increases the debt service relative to NOI.  Therefore, the debt coverage ratio (DCR) may exceed the lender’s limits.  With higher loan-to-value ratios and declining debt coverage ratios, risk to the lender increases.  As a result, the interest rate on additional debt will also increase.

Question 12-5: What is meant by a participation loan?  What does the lender participate in?  Why would a lender want to make a participation loan?  Why would an investor want to obtain a participation loan?

  • A participation loan is where in return for a lower stated interest rate on the loan, the lender participates in some        way in the income or cash flow from the property.  The lender’s rate of return depends, in part, on the performance of the property.  Participation are highly negotiable and there is no standard way of structuring them.
  • A lender’s motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults).  Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result   of inflation.  To some extent this protects the lender’s real rate of return.
  • An investors motivation is that the participation may be very little or zero for one or more years.  This is because the loan is often structured so that the participation is based on income or cash flow above some specified break-even point.  During this time period, the borrower will be paying less than would have been paid with a straight loan.  This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.

Question 12-6: What is meant by a sale-leaseback?  Why would a building investor want to do a sale-leaseback of the land?  What is the benefit to the party that purchases the land under a sale-leaseback?

  • When land is already owned and is then sold to an investor with a simultaneous agreement to lease the land from  the party it is sold to, this is called a sale-leaseback of the land. One motivation for the sale-leaseback of the land is that it is a way of obtaining 100 percent financing on the land.
  • A second benefit is that lease payments are 100 percent tax deductible.  With a mortgage, only the interest is tax deductible.  The investor may deduct the same depreciation charges whether or not the land is owned, since land cannot be depreciated.  This results in the same depreciation for a smaller equity investment. The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so.

Question 12-7: Why might an investor prefer a loan with a lower interest rate and a participation?

  • An investor’s motivation is that the participation may be very little or zero for one or more years.  This is because     the loan is often structured so that the participation is based on income or cash flow above some specified break-even point.  During this time period, the borrower will be paying less than would have been paid with a straight loan.  This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.

 Question 12-8: Why might a lender prefer a loan with a lower interest rate and a participation?

  • A lender’s motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan.  The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults).  Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result   of inflation.  To some extent this protects the lender’s real rate of return.

Question 12-9: How do you think participation affect the riskiness of a loan?

  • There is clearly some uncertainty associated with the receipt of a participation since it depends on the performance of the property.  The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults).  Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of      inflation.  To some extent this protects the lender’s real rate of return.

Question 12-10: What is the motivation for a sale-leaseback of the land?

  • One motivation for the sale-and-leaseback of the land is that it is a way of obtaining 100 percent financing on the    land.  A second benefit is that lease payments are 100 percent tax deductible.  With a mortgage, only the interest is tax deductible.  The investor may deduct the same depreciation charges whether or not the land is owned, since land cannot be depreciated.  This results in the same depreciation for a smaller equity investment. The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so.

Question 12-11:What criteria should be used to choose between two financing alternatives?

  • Assuming the two financing alternatives are for roughly the same amount of funds (so financial risk due to leverage is the same), the alternative with the lowest effective interest cost should be chosen.  This alternative should also result in the highest IRR on equity.

Question 12-12: What is the traditional cash equivalency approach to determine how below-market rate loans affect value?

  • Cash equivalency was introduced in Chapter 9 where it was demonstrated that a buyer would be willing to pay more for a property with a below market interest rate loan.  In that chapter, the present value of interest savings was used to indicate the additional amount which might be paid for a property.  This same approach could be used to determine the additional amount that might be paid for income producing properties as analyzed in this chapter.

Question 12-13: How can the effect of below-market rate loans on value be determined using investor criteria?

  • Note: This question is not explicitly covered in the chapter.  It requires students to think about how concepts from earlier chapters dealing with valuation and cash equivalency might be applied to evaluate a below-market rate loan on income property.
  • Evaluating a below-market rate loan is like comparing two financing alternatives where one is at the market rate and one has a below-market rate.  All else being equal, the below market interest rate loan should result in a higher IRRE for the property than would result with a market rate loan.  The investor might therefore be willing to pay more for the property, as long as the IRRE  is at least as much as it would be with the market interest rate loan.

FN-444-Chapter12 Financial Leverage and Financing Alternatives

Credit: academia.edu