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CHAPTER

Financial Leverage and Financing Alternatives

Financial LeverageFinancial 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

Financial Leverage: Before-TaxFinancial 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.

• 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

BTIRRD = Before-Tax IRR on debt (effective cost including points)

D/E =Debt/Equity ratio

• Equation 1 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

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

The use of debt reduces the return on equity.

Financial Leverage: After-TaxFinancial 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

Financial Leverage ExampleFinancial Leverage Example

• Building Value=$85,000, Land Value=$15,000, Total Value=$100,000

• Loan Assumptions: Loan Amount=$80,000 Interest Rate=10% Term: Interest Only 80% LTV

• Income Assumptions: NOI=$12,000 per year (level) Income tax rate=28% Depreciation=31.5 years (straight line) Resale price= $100,000 Holding period=5 years

Cash Flow Summary and IRR With Cash Flow Summary and IRR With LeverageLeverage

Cash Flow Summary and IRR Cash Flow Summary and IRR Without LeverageWithout Leverage

Financial Leverage: After-TaxFinancial Leverage: After-Tax

• Break-even interest rate Maximum interest rate before negative

financial leverage

• ATIRRD= ATIRRP

• ATIRRD= BTIRRD(1-t)

• BTIRRD= =

• Risk considerations

ATIRRD

ATIRR P

Break-even Interest RateBreak-even Interest Rate

Alternative Financing StructuresAlternative Financing Structures

• Sale-Leaseback of Land and Ground Leases 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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