net Chapter 12 Financial Leverage and Financing Alternatives In Chapter 6, we introduced a number of issues related to analyzing financing alternatives. Important concepts from that chapter include the effective cost of borrowing (before and after tax) and the incremental cost of borrowing additional funds. We also discussed how to evaluate whether a loan should be refinanced when interest rates decline. Although this discussion focused on residential property, all of the above concepts also apply to the analysis of income property.
The three preceding chapters have dealt with analyzing investment returns and risk on income property. In that analysis, we introduced financing and alluded to its effect on the before- and after-tax cash flow to the equity investor. The purpose of this chapter will be to extend the discussion of debt from the earlier chapters in three additional ways. First, we consider how the level of financing affects the investor’s before- and after-tax IRR.
Second, we consider important underwriting procedures used by lenders when financing is sought by investors. Third, we consider several different financing alternatives that are used with real estate income property. Since it is impossible to discuss all the varieties of loans that are used in practice, we will concentrate on the primary alternatives and focus our discussion on concepts and techniques that you can apply to any type of financing alternative that you might consider. Introduction to Financial Leverage Why should an investor use debt? One obvious reason is simply that the investor may not have enough equity capital to buy the property.
On the other hand, the investor may have enough equity capital but may choose to borrow anyway and use the excess equity to buy other properties. Because equity funds could be spread over several properties, the investor could reduce the overall risk of the portfolio. A second reason to borrow is to take advantage of the tax deductibility of mortgage interest, which amplifies tax benefits to the equity investor. The third reason usually given for using debt is to realize the potential benefit associated with financial leverage.
Financial leverage is defined as benefits that may result for an investor who borrows money at a rate of interest lower than the expected rate of return on total funds invested in a property. If the return on the total investment invested in a property is greater than the rate of interest on the debt, the return on equity is magnified. To examine the way financial leverage affects the investor’s rate of return, we consider investment in a small commercial property with the following assumptions: 393 www.net 394 Part 4 Income-Producing Properties Purchase price Building value $ 85,000 Land value 15,000 Total value $100,000 Loan assumptions Loan amount $ 80,000 Interest rate 10.00% Term Interest only Income assumptions NOI $12,000 per year (level) Income tax rate* 28.5 years (straight line)† Resale price $100,000 Holding period 5 years Used to illustrate this example only. Tax rates are subject to change.
* † Recall from Chapter 11 that the Tax Act of 1993 allows residential property to be depreciated over 27.5 years and nonresidential property to be depreciated over 39 years. These rates are subject to change, however, and we use 31.5 years in this example for illustration only. Using those assumptions, we obtain the cash flow estimates shown in Exhibit 12–1. Exhibit 12–2 shows the cash flow summary and IRR calculations for the cash flows in Exhibit 12–1.
From Exhibit 12–2 we see that the before-tax IRR (BTIRR) is 20 percent and the after-tax IRR (ATIRR) is 15.40 percent with an 80 percent loan. We now consider how these returns would be affected by a change in the amount of debt. Exhibits 12–3 and 12–4 show the cash flow and return calculations for the example assuming that no loan is used. From Exhibit 12–4 we see that both the BTIRR and ATIRR have fallen.
That is, both returns are higher with debt than without debt. When this occurs, we say that the investment has positive (favorable) financial leverage. We now examine the conditions that result in positive financial leverage more carefully. To do so, we first look at the conditions for positive leverage on a before-tax basis (the effect of leverage on BTIRR).
Later, we examine the relationship on an after-tax basis (the effect of leverage on ATIRR). Conditions for Positive Leverage—Before Tax In the example when no debt was used, the BTIRR was 12 percent. We will refer to this as the unleveraged BTIRR, since it equals the return when no debt is used. In the case where 80 percent debt was used, the BTIRR increased to 20 percent.
Why does this increase occur? It occurs because the unleveraged BTIRR is greater than the interest rate paid on the debt.1 The interest rate on the debt was 10 percent, which is less than the 12 percent unleveraged BTIRR. We could say that the return on investment (before debt) is greater than the rate that has to be paid on the debt. This differential (12% vs 10%) means that positive leverage exists that will magnify the BTIRR on equity. This relationship is formalized in a formula that estimates the return on equity, given the return on the property and the mortgage interest rate2: BTIRRE BTIRRP (BTIRRP BTIRRD) (D/E) 1 More precisely, the unleveraged IRR is greater than the effective cost of the loan.
Recall that the effective cost of a loan reflects points, prepayments, and other factors that affect the borrower. 2 This is an approximation when the ratio of debt to equity changes over time.net Chapter 12 Financial Leverage and Financing Alternatives 395 EXHIBIT 12–1 Cash Flow Estimates for Commercial Building Estimates of Cash Flow from Operations Year 1 2 3 4 5 A. Before-tax cash flow: Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 Less debt service (DS) 8,000 8,000 8,000 8,000 8,000 Before-tax cash flow $ 4,000 $ 4,000 $ 4,000 $ 4,000 $ 4,000 B. Taxable income or loss: Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 Less interest 8,000 8,000 8,000 8,000 8,000 Depreciation 2,698 2,698 2,698 2,698 2,698 Taxable income (loss) 1,302 1,302 1,302 1,302 1,302 Tax $ 364 $ 364 $ 364 $ 364 $ 364 C.
After-tax cash flow: Before-tax cash flow (BTCF ) $ 4,000 $ 4,000 $ 4,000 $ 4,000 $ 4,000 Less tax 364 364 364 364 364 After-tax cash flow (ATCF ) $ 3,636 $ 3,636 $ 3,636 $ 3,636 $ 3,636 Estimates of Cash Flows from Sale in Year 5 Sale price $100,000 Less mortgage balance 80,000 Before-tax cash flow (BTCFs ) $ 20,000 Taxes in year of sale Sale price $100,000 Original cost basis $100,000 Less accumulated depreciation 13,492 Adjusted basis 86,508 Capital gain $ 13,492 Tax from sale 3,778 After-tax cash flow from sale (ATCFs ) $ 16,222 where 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 of the loan considering points) D/E Ratio of debt to equity Using the numbers for our example, we have BTIRRE 12.00% This formula indicates that as long as BTIRRP is greater than BTIRRD, the BTIRRE will be greater than BTIRRP. This situation is referred to as favorable, or positive, leverage.net 396 Part 4 Income-Producing Properties EXHIBIT 12–2 End of Year Cash Flow Summary and IRR 0 1 2 3 4 5 Before-tax cash flow $20,000 $4,000 $4,000 $4,000 $4,000 24,000 After-tax cash flow 20,000 3,636 3,636 3,636 3,636 19,858 Before-tax IRR (BTIRR) 20.00% After-tax IRR (ATIRR) 15.40% EXHIBIT 12–3 Cash Flow Estimates (No Loan) Estimates of Cash Flow from Operations Year 1 2 3 4 5 A. Before-tax cash flow: Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 Less debt service (DS) 0 0 0 0 0 Before-tax cash flow $12,000 $12,000 $12,000 $12,000 $12,000 B. Taxable income or loss: Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000 Less interest 0 0 0 0 0 Depreciation 2,698 2,698 2,698 2,698 2,698 Taxable income (loss) 9,302 9,302 9,302 9,302 9,302 Tax $ 2,604 $ 2,604 $ 2,604 $ 2,604 $ 2,604 C.
After-tax cash flow: Before-tax cash flow (BTCF ) $12,000 $12,000 $12,000 $12,000 $12,000 Less tax 2,604 2,604 2,604 2,604 2,604 After-tax cash flow (ATCF ) $ 9,396 $ 9,396 $ 9,396 $ 9,396 $ 9,396 Estimates of Cash Flows from Sale in Year 5 Sale price $100,000 Less mortgage balance 0 Before-tax cash flow (BTCFs) $100,000 Taxes in year of sale Sale price $100,000 Original cost basis $100,000 Less accumulated depreciation 13,492 Adjusted basis 86,508 Capital gain $ 13,492 Tax from sale 3,778 After-tax cash flow from sale (ATCFs ) $ 96,222 Whenever leverage is positive, the greater the amount of debt, the higher the return to the equity investor. From this result many investors conclude that they should borrow as much as possible. (We will see later that this conclusion is not necessarily valid when risk is considered.) The graph in Exhibit 12–5 illustrates the effect of different loan-to-value ratios on the IRR for our example.net Chapter 12 Financial Leverage and Financing Alternatives 397 EXHIBIT 12–4 Cash Flow Summary Cash Flow Summary End of Year and IRR (No Loan) 0 1 2 3 4 5 Before-tax cash flow $100,000 $12,000 $12,000 $12,000 $12,000 $112,000 After-tax cash flow 100,000 9,396 9,396 9,396 9,396 105,618 Before-tax IRR (BTIRR) 12.00% After-tax IRR (ATIRR) 8.76% EXHIBIT 12–5 21 Before- and After- 20 Tax Positive Leverage 19 18 17 IRR on equity (%) Before tax 16 15 14 13 After tax 12 11 60 10 9 25.00 Loan-to-value ratio (%) While the relationships in Exhibit 12–5 are relatively straightforward, the amount of debt that may be used is limited. What are the limits? First, for various amounts of debt, the debt coverage ratio may exceed the lender’s limits, as discussed in Chapter 11.
Because the NOI does not change when more debt is used, increasing the amount of debt increases the debt service relative to the NOI. Second, at 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. Indeed, at some point BTIRRP may no longer exceed BTIRRD (leverage will no longer be positive).
Third, additional borrowing has additional risks for the equity investor. We will deal with the effect of leverage on risk more formally later in this chapter. However, we can point out now that leverage works both ways in the sense that it can magnify either returns or losses. That is, if the loan offers negative (unfavorable) financial leverage, or ATIRRD BTIRRP, the use of more debt will magnify losses on equity invested in the property.
We saw earlier that BTIRRP must exceed BTIRRD for the leverage to be favorable. Suppose that the interest rate is 14 percent instead of 10 percent. This results in negative leverage because the unlevered BTIRRE (12%) is now less than the 14 percent cost of debt. Exhibit 12–6 illustrates the effect that different loan-to-value ratios will have on the before- and after-tax IRRs.
Note that when BTIRRP is less than BTIRRD , the BTIRRE is also less than BTIRRD and declines even further as the amount borrowed (debt-to-equity ratio) increases. The next section develops this relationship more formally.net 398 Part 4 Income-Producing Properties EXHIBIT 12–6 12 Before- and After- 11 Tax Negative Leverage 10 9 Before tax 8 IRR on equity (%) 7 6 5 4 After tax 3 2 61 1 0 25.00 Loan-to-value ratio (%) Conditions for Positive Leverage—After Tax Looking at the after-tax IRR (ATIRR) in Exhibits 12–2 and 12–4, we see that ATIRRP (on total investment) is 8.76 percent and ATIRR on equity invested is 15. Thus, the investor has favorable, or positive, leverage on an after-tax basis.