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.