1. use equity to buy other properties, reducing the risk of the overall portfolio
2. tax deductibility of mortgage interest
3. financial leverage

1. DCR may exceed the lender's limits
2. at higher loan to value ratios and declinging DCRs, the risk to the lender increases
3. additional risk for the equity investor

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. 

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 unlevered IRR is greater than the interest rate paid on the debt.  Negative leverage occurs when the unlevered 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.

            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.

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.  Participations 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.

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.

NOI_{Year 1}

_______________

Cap Rate

Cash Flow Mode

CF₀=0

CF₁=NOI₁

CF2=NOI2

CF3=NOI3

CF4=NOI4 + Net Sale Proceeds

Then solve for NPV using the Required Rate of Return

V_e

* Use BTCF for the CF's....no initial CF....and the Y_{e: the required return of the equity investor}