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Real Estate Finance.ppt

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This document discusses financial leverage and various financing alternatives for real estate investments. It defines financial leverage as the relationship between investment return and amount of debt financing. Total leverage compares returns with and without debt, while marginal leverage looks at small amounts of additional debt. The document provides an example analyzing total and marginal leverage for the Willow Brook Apartments project. It then discusses various financing structures like participation loans, sale-leasebacks, interest-only loans, accrual loans, and convertible mortgages. Examples are provided to illustrate how these alternatives could impact investment returns.

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Real Estate Finance Financial Leverage Financial Leverage describes the relationship between the return on an investment and the amount of debt used to finance the acquisition. The investment return can be measured on either a before tax or on an after tax basis. (Total) leverage is positive if the investment return increases with debt financing (Total) leverage is negative if the investment return decreases with debt financing (Total) leverage is neutral if the investment return does not change with debt financing
Real Estate Finance Financial Leverage On a before tax basis, the influence that leverage has on the investment return is (approximately) given by: BTIRRE = BTIRRP + (BTIRRP – BTIRRD)  (D/E), where: BTIRRE = before tax IRR on the equity cash flows BTIRRP = before tax IRR on the property cash flows BTIRRD = before tax IRR on the debt cash flows, or the effective borrowing cost D = the loan amount E = equity
Real Estate Finance Financial Leverage Interpretation: Before tax financial leverage will be positive (or the before tax IRR on equity will exceed the before tax IRR on the property) when the before tax IRR on the property exceeds the before tax cost of debt, BTIRRP - BTIRRD > 0, or BTIRRP > BTIRRD.
Real Estate Finance Financial Leverage Example: Willow Brook Apartments BTIRRP = 11.1% BTIRRE = 16.2% BTIRRD = ????? D/E = 11,600,000/3,132,000 = 3.704
Real Estate Finance Financial Leverage Example: Willow Brook Apartments BTIRRD = ????? Net Loan Amount = $11,600,000 - $232,000 = $11,368,000 Monthly Pmt = $89,193.96, for 60 months Future Value = $11,076,871 + $332,306 = $11,409,177 BTIRRD = 9.47%
Real Estate Finance Financial Leverage Example: Willow Brook Apartments On a before tax basis, the influence that leverage has on the investment return is (approximately) given by: BTIRRE = 16.2%  (approximately equal to) BTIRRP + (BTIRRP – BTIRRD)  (D/E) = 11.1% + (11.1% - 9.5%)  3.7 = 11.1% + 1.6%  3.7 = 11.1% + 5.9% = 17.0%
Real Estate Finance Financial Leverage On an after tax basis, the influence that leverage has on the investment return is (approximately) given by: ATIRRE = ATIRRP + (ATIRRP – ATIRRD)  (D/E), where: ATIRRE = after tax IRR on the equity cash flows ATIRRP = after tax IRR on the property cash flows ATIRRD = after tax IRR on the debt cash flows, = (1 – tax rate)  BTIRRD D = the loan amount E = equity
Real Estate Finance Financial Leverage Interpretation: After tax financial leverage will be positive (or the after tax IRR on equity will exceed the after tax IRR on the property) when the after tax IRR on the property exceeds the after tax cost of debt,  ATIRRP - ATIRRD > 0, or  ATIRRP > ATIRRD.
Real Estate Finance Financial Leverage Example: Willow Brook Apartments ATIRRP = 8.0% ATIRRE = 14.3% ATIRRD = (1 – 0.36)  9.47% = 6.06% D/E = 11,600,000/3,132,000 = 3.704
Real Estate Finance Financial Leverage Example: Willow Brook Apartments On a after tax basis, the influence that leverage has on the investment return is (approximately) given by: ATIRRE = 14.3%  ATIRRP + (ATIRRP – ATIRRD)  (D/E) = 8.0% + (8.0% - 6.1%)  3.7 = 8.0% + 1.9%  3.7 = 8.0% + 7.0% = 15.0%
Real Estate Finance Financial Leverage Marginal Leverage The above discussion refers to the influence that using any amount of debt has on the (before or after tax) return on investment. That is, total leverage compares the investment return of a debt-financed acquisition to the investment return of an all cash purchase. The numerical example for Willow Brook illustrated that, in this example, financial leverage is positive on both a before and an after tax basis. Marginal leverage refers to the influence that small amounts of additional debt have on (either the before or after tax) investment return.
Real Estate Finance Financial Leverage Example: Willow Brook Apartments Required Yields: Property Returns: Property: 12.0% IRR NPV Before Tax: 15.0% BT 11.1% - $488,276 After Tax: 13.5% AT 8.0% - $2,814,264
Real Estate Finance Financial Leverage Example: Willow Brook Apartments Before Tax After Tax Financing Alternative IRR NPV IRR NPV All Cash 11.1% -448,276 8.0% -2,814,264 80% L/V; 8.5%i; 2% fee 16.2% +147,865 14.3% +98,290 85% L/V; 9.0%i; 3% fee 14.5% -45,300 14.0% +50,317 75% L/V; 8.25%i; 2% fee 15.7% +104,812 13.3% -25,965
Real Estate Finance Financial Leverage Example: Willow Brook Apartments 1. Total leverage is positive for both the 75% and 85% L/V 2. Relative to the 80% L/V, marginal leverage is negative for both the 75% and 85% L/V. 3. The 85% L/V is a negative BTNPV deal even though before tax total leverage is positive. 4. The 75% L/V is a negative ATNPV deal even though after tax total leverage is positive.
Real Estate Finance Financial Leverage Break Even Interest Rate (BEIR) The break even interest rate is the (before tax) interest rate at which (total) leverage is neutral. P ATIRR BEIR = 1-tax rate For Willow Brook Apartments, the break even interest rate is: P ATIRR 8.0% BEIR = 12.5% 1-tax rate 1 0.36   
Real Estate Finance Financing Alternatives There are numerous alternatives to fixed rate loans, including: Lender participations Sale-lease back of the land Interest only loans Accrual loans Convertible mortgages
Real Estate Finance Financing Alternatives Participation Loans With a participation loan, the lender offers the borrower a below market interest rate in exchange for a portion of the property’s cash flows. The lender may participate in cash flows from 1. operations (e.g. NOI, BTCFO), or 2. reversion (e.g. sales proceeds, BTCFR, capital gain)
Real Estate Finance Financing Alternatives Participation Loan The participation may be tiered, or have different participation percentages for different amounts of cash flow. For example, the lender may receive: 1. 50% of any BTCFO if 0 < BTCFO < $25,000 PLUS 2. 40% of any BTCFO if $25,000 < BTCFO < $50,000 PLUS 3. 25% of any BTCFO if BTCFO > $50,000
Real Estate Finance Financing Alternatives Participation Loan Example Suppose the lender in the Willow Brook Apartments example offered the investor a 7.5% interest rate (instead of the 8.5% rate) with monthly payments for 30 years in exchange for twenty five percent of the before tax cash flows from operations and ten percent of the before tax cash flow from reversion. 1. Should the investor accept the offer? 2. What is the lender’s expected yield?
Real Estate Finance Financing Alternatives Willow Brook Participation Cash Flows from Operations Year: 1 2 3 NOI 1,323,365 1,363,066 1,403,958 - DS -973,307 -973,307 -973,307 BTCF before 350,058 389,759 430,651 - Participation -87,515 -97,440 -107,663 BTCF after 262,544 292,319 322,988 Participation CF to lender 1,060,822 1,070,747 1,080,970
Real Estate Finance Financing Alternatives Willow Brook Participation Cash Flow from Reversion Year: 5 Net Sales Proceeds 15,825,893 - MB -10,975,623 - PP -329,269 BTCFR before 4,521,001 - Participation -452,100 BTCFR after 4,068,901 Participation
Real Estate Finance Financing Alternatives Go to Willow_Brook.Participation Spreadsheet
Real Estate Finance Financing Alternatives Willow Brook Participation Equity Investor’s Return: ATIRR = 13.12% ATNPV = -44,273 (no deal) Lender’s Return: BTIRR = 10.05% How might the equity investor respond?
Real Estate Finance Financing Alternatives Sales-Leaseback of the Land Property owner sells land in exchange for long-term lease. Contract frequently contains an option to repurchase land at the end of the lease (at prevailing market value) Advantages 1. no equity tied up in land cost (100% land financing) 2. entire (land) lease payment deductible for tax purposes
Real Estate Finance Financing Alternatives Interest Only Borrower pays only interest over loan term Entire loan amount repaid at maturity Like a corporate bond with monthly rather than semi- annual payments
Real Estate Finance Financing Alternatives Interest Only  Advantages (compared to conventional financing) 1. Higher BTCFO (no principal repayment) 2. Same interest deduction 3. Higher ATCFO 4. Higher ATIRR compared to comparable conventional loan  Disadvantage: higher risk of default
Real Estate Finance Financing Alternatives Accrual Loan This loan has two interest rates: 1. Pay rate: used to determine periodic (e.g. monthly) mortgage payment 2. Accrual rate: used to determine interest charged  Pay rate < accrual rate, so 1. lower periodic debt service payment 2. lower debt service coverage (DSC) ratio
Real Estate Finance Financing Alternatives Accrual Loan  Advantages (compared to conventional financing) 1. lower debt service payment with higher interest deduction 2. higher ATCFO (for two reasons) higher BTCFO higher interest deduction; lower taxable income  Disadvantage: higher risk of default
Real Estate Finance Financing Alternatives Convertible Loan  The lender offers the borrower a below market rate on the loan in exchange for the option to purchase an interest in the property at some specified period of time (in lieu of the outstanding mortgage balance).  Conversion option ratio = percent of property price that reverts to lender  IRS requires that L/V > conversion option ratio
Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments  Suppose the lender offered the borrower a 7.5% interest rate (rather than the 8.5% market rate) in exchange for 75% of the sales price at the end of year 5. 1. Would the lender exercise the option? 2. What is the lender’s expected yield? 3. What is the investor’s expected ATIRR?
Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments Expected sales price $16,148,878 75% of expected sales price $12,111,659 85% conventional 75% convertible Net loan 11,368,000.00 11,368,000.00 Monthly Pmt 89,193.96 81,108.88 Outstanding Balance 11,076,870.85 n.a. Prepayment Penalty 332,306.13 n.a. Purchase Option n.a. 12,111,659.00 Total FV 11,409,176.98 12,111,659.00
Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments Lender’s Yield:     60 60 1 1 12,111,653 11,368,000 81,108.88 ; d 9.59% d d 1 1 12 12 t t      
Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments Investor’s Yield Sales Price 16,148,878 -Selling cost -322,978 -Lender proceeds -12,111,659 BTCFR 3,714,242 -Capital gain tax -713,362 +Ordinary Income Credit 69,600 ATCFO 3,070,480 ATIRR 12.15% ATNPV -147,597

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Real Estate Finance.ppt

  • 1. Real Estate Finance Financial Leverage Financial Leverage describes the relationship between the return on an investment and the amount of debt used to finance the acquisition. The investment return can be measured on either a before tax or on an after tax basis. (Total) leverage is positive if the investment return increases with debt financing (Total) leverage is negative if the investment return decreases with debt financing (Total) leverage is neutral if the investment return does not change with debt financing
  • 2. Real Estate Finance Financial Leverage On a before tax basis, the influence that leverage has on the investment return is (approximately) given by: BTIRRE = BTIRRP + (BTIRRP – BTIRRD) ï‚´ (D/E), where: BTIRRE = before tax IRR on the equity cash flows BTIRRP = before tax IRR on the property cash flows BTIRRD = before tax IRR on the debt cash flows, or the effective borrowing cost D = the loan amount E = equity
  • 3. Real Estate Finance Financial Leverage Interpretation: Before tax financial leverage will be positive (or the before tax IRR on equity will exceed the before tax IRR on the property) when the before tax IRR on the property exceeds the before tax cost of debt, BTIRRP - BTIRRD > 0, or BTIRRP > BTIRRD.
  • 4. Real Estate Finance Financial Leverage Example: Willow Brook Apartments BTIRRP = 11.1% BTIRRE = 16.2% BTIRRD = ????? D/E = 11,600,000/3,132,000 = 3.704
  • 5. Real Estate Finance Financial Leverage Example: Willow Brook Apartments BTIRRD = ????? Net Loan Amount = $11,600,000 - $232,000 = $11,368,000 Monthly Pmt = $89,193.96, for 60 months Future Value = $11,076,871 + $332,306 = $11,409,177 BTIRRD = 9.47%
  • 6. Real Estate Finance Financial Leverage Example: Willow Brook Apartments On a before tax basis, the influence that leverage has on the investment return is (approximately) given by: BTIRRE = 16.2% ï‚» (approximately equal to) BTIRRP + (BTIRRP – BTIRRD) ï‚´ (D/E) = 11.1% + (11.1% - 9.5%) ï‚´ 3.7 = 11.1% + 1.6% ï‚´ 3.7 = 11.1% + 5.9% = 17.0%
  • 7. Real Estate Finance Financial Leverage On an after tax basis, the influence that leverage has on the investment return is (approximately) given by: ATIRRE = ATIRRP + (ATIRRP – ATIRRD) ï‚´ (D/E), where: ATIRRE = after tax IRR on the equity cash flows ATIRRP = after tax IRR on the property cash flows ATIRRD = after tax IRR on the debt cash flows, = (1 – tax rate) ï‚´ BTIRRD D = the loan amount E = equity
  • 8. Real Estate Finance Financial Leverage Interpretation: After tax financial leverage will be positive (or the after tax IRR on equity will exceed the after tax IRR on the property) when the after tax IRR on the property exceeds the after tax cost of debt,  ATIRRP - ATIRRD > 0, or  ATIRRP > ATIRRD.
  • 9. Real Estate Finance Financial Leverage Example: Willow Brook Apartments ATIRRP = 8.0% ATIRRE = 14.3% ATIRRD = (1 – 0.36) ï‚´ 9.47% = 6.06% D/E = 11,600,000/3,132,000 = 3.704
  • 10. Real Estate Finance Financial Leverage Example: Willow Brook Apartments On a after tax basis, the influence that leverage has on the investment return is (approximately) given by: ATIRRE = 14.3% ï‚» ATIRRP + (ATIRRP – ATIRRD) ï‚´ (D/E) = 8.0% + (8.0% - 6.1%) ï‚´ 3.7 = 8.0% + 1.9% ï‚´ 3.7 = 8.0% + 7.0% = 15.0%
  • 11. Real Estate Finance Financial Leverage Marginal Leverage The above discussion refers to the influence that using any amount of debt has on the (before or after tax) return on investment. That is, total leverage compares the investment return of a debt-financed acquisition to the investment return of an all cash purchase. The numerical example for Willow Brook illustrated that, in this example, financial leverage is positive on both a before and an after tax basis. Marginal leverage refers to the influence that small amounts of additional debt have on (either the before or after tax) investment return.
  • 12. Real Estate Finance Financial Leverage Example: Willow Brook Apartments Required Yields: Property Returns: Property: 12.0% IRR NPV Before Tax: 15.0% BT 11.1% - $488,276 After Tax: 13.5% AT 8.0% - $2,814,264
  • 13. Real Estate Finance Financial Leverage Example: Willow Brook Apartments Before Tax After Tax Financing Alternative IRR NPV IRR NPV All Cash 11.1% -448,276 8.0% -2,814,264 80% L/V; 8.5%i; 2% fee 16.2% +147,865 14.3% +98,290 85% L/V; 9.0%i; 3% fee 14.5% -45,300 14.0% +50,317 75% L/V; 8.25%i; 2% fee 15.7% +104,812 13.3% -25,965
  • 14. Real Estate Finance Financial Leverage Example: Willow Brook Apartments 1. Total leverage is positive for both the 75% and 85% L/V 2. Relative to the 80% L/V, marginal leverage is negative for both the 75% and 85% L/V. 3. The 85% L/V is a negative BTNPV deal even though before tax total leverage is positive. 4. The 75% L/V is a negative ATNPV deal even though after tax total leverage is positive.
  • 15. Real Estate Finance Financial Leverage Break Even Interest Rate (BEIR) The break even interest rate is the (before tax) interest rate at which (total) leverage is neutral. P ATIRR BEIR = 1-tax rate For Willow Brook Apartments, the break even interest rate is: P ATIRR 8.0% BEIR = 12.5% 1-tax rate 1 0.36   
  • 16. Real Estate Finance Financing Alternatives There are numerous alternatives to fixed rate loans, including: Lender participations Sale-lease back of the land Interest only loans Accrual loans Convertible mortgages
  • 17. Real Estate Finance Financing Alternatives Participation Loans With a participation loan, the lender offers the borrower a below market interest rate in exchange for a portion of the property’s cash flows. The lender may participate in cash flows from 1. operations (e.g. NOI, BTCFO), or 2. reversion (e.g. sales proceeds, BTCFR, capital gain)
  • 18. Real Estate Finance Financing Alternatives Participation Loan The participation may be tiered, or have different participation percentages for different amounts of cash flow. For example, the lender may receive: 1. 50% of any BTCFO if 0 < BTCFO < $25,000 PLUS 2. 40% of any BTCFO if $25,000 < BTCFO < $50,000 PLUS 3. 25% of any BTCFO if BTCFO > $50,000
  • 19. Real Estate Finance Financing Alternatives Participation Loan Example Suppose the lender in the Willow Brook Apartments example offered the investor a 7.5% interest rate (instead of the 8.5% rate) with monthly payments for 30 years in exchange for twenty five percent of the before tax cash flows from operations and ten percent of the before tax cash flow from reversion. 1. Should the investor accept the offer? 2. What is the lender’s expected yield?
  • 20. Real Estate Finance Financing Alternatives Willow Brook Participation Cash Flows from Operations Year: 1 2 3 NOI 1,323,365 1,363,066 1,403,958 - DS -973,307 -973,307 -973,307 BTCF before 350,058 389,759 430,651 - Participation -87,515 -97,440 -107,663 BTCF after 262,544 292,319 322,988 Participation CF to lender 1,060,822 1,070,747 1,080,970
  • 21. Real Estate Finance Financing Alternatives Willow Brook Participation Cash Flow from Reversion Year: 5 Net Sales Proceeds 15,825,893 - MB -10,975,623 - PP -329,269 BTCFR before 4,521,001 - Participation -452,100 BTCFR after 4,068,901 Participation
  • 22. Real Estate Finance Financing Alternatives Go to Willow_Brook.Participation Spreadsheet
  • 23. Real Estate Finance Financing Alternatives Willow Brook Participation Equity Investor’s Return: ATIRR = 13.12% ATNPV = -44,273 (no deal) Lender’s Return: BTIRR = 10.05% How might the equity investor respond?
  • 24. Real Estate Finance Financing Alternatives Sales-Leaseback of the Land Property owner sells land in exchange for long-term lease. Contract frequently contains an option to repurchase land at the end of the lease (at prevailing market value) Advantages 1. no equity tied up in land cost (100% land financing) 2. entire (land) lease payment deductible for tax purposes
  • 25. Real Estate Finance Financing Alternatives Interest Only Borrower pays only interest over loan term Entire loan amount repaid at maturity Like a corporate bond with monthly rather than semi- annual payments
  • 26. Real Estate Finance Financing Alternatives Interest Only  Advantages (compared to conventional financing) 1. Higher BTCFO (no principal repayment) 2. Same interest deduction 3. Higher ATCFO 4. Higher ATIRR compared to comparable conventional loan  Disadvantage: higher risk of default
  • 27. Real Estate Finance Financing Alternatives Accrual Loan This loan has two interest rates: 1. Pay rate: used to determine periodic (e.g. monthly) mortgage payment 2. Accrual rate: used to determine interest charged  Pay rate < accrual rate, so 1. lower periodic debt service payment 2. lower debt service coverage (DSC) ratio
  • 28. Real Estate Finance Financing Alternatives Accrual Loan  Advantages (compared to conventional financing) 1. lower debt service payment with higher interest deduction 2. higher ATCFO (for two reasons) higher BTCFO higher interest deduction; lower taxable income  Disadvantage: higher risk of default
  • 29. Real Estate Finance Financing Alternatives Convertible Loan  The lender offers the borrower a below market rate on the loan in exchange for the option to purchase an interest in the property at some specified period of time (in lieu of the outstanding mortgage balance).  Conversion option ratio = percent of property price that reverts to lender  IRS requires that L/V > conversion option ratio
  • 30. Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments  Suppose the lender offered the borrower a 7.5% interest rate (rather than the 8.5% market rate) in exchange for 75% of the sales price at the end of year 5. 1. Would the lender exercise the option? 2. What is the lender’s expected yield? 3. What is the investor’s expected ATIRR?
  • 31. Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments Expected sales price $16,148,878 75% of expected sales price $12,111,659 85% conventional 75% convertible Net loan 11,368,000.00 11,368,000.00 Monthly Pmt 89,193.96 81,108.88 Outstanding Balance 11,076,870.85 n.a. Prepayment Penalty 332,306.13 n.a. Purchase Option n.a. 12,111,659.00 Total FV 11,409,176.98 12,111,659.00
  • 32. Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments Lender’s Yield:     60 60 1 1 12,111,653 11,368,000 81,108.88 ; d 9.59% d d 1 1 12 12 t t      
  • 33. Real Estate Finance Financing Alternatives Convertible Loan Example Willow Brook Apartments Investor’s Yield Sales Price 16,148,878 -Selling cost -322,978 -Lender proceeds -12,111,659 BTCFR 3,714,242 -Capital gain tax -713,362 +Ordinary Income Credit 69,600 ATCFO 3,070,480 ATIRR 12.15% ATNPV -147,597