Real Estate Finance and Investments: Lecture 5

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Real Estate Finance and Investments Lecture 5

• Financial Leverage and
• Credit Instruments

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Why Leverage is Popular

• Financial leverage using borrowed funds to
  amplify the outcome of equity investment
• Greater ratio of borrowed funds to equity,
  greater degree of financial leverage
• Leverage is favorable so long as the rate of
  return on assets exceeds the cost of borrowing

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Why Leverage is Popular

• Spread difference between rate of return on
  assets and cost of borrowing
• Favorable spread magnifies return on equity of
  highly leveraged investment
• When debt service constant is less than the rate
  of return on total assets, additional financial
  leverage increases cash flow to the equity
  position

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Why Leverage is Popular

• Federal income tax law creates major incentive to
  use financial leverage
• Interest payments generally tax deductible
• Depreciation allowance to recover costs
• Gains on disposal treated as capital gains

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Real Estate Finance and Investments Lecture 5

• Measuring Financial Leverage

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How to Measure Financial Leverage

• Debt/equity ratio ratio between borrowed funds
  and equity funds
• Loan/value ratio ratio between borrowed funds
  and market value of asset being financed

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How to Measure Financial Leverage

• Greater leverage increases risk that cash flow
  from investment will be insufficient to meet debt
  service obligation (financial risk)
• Debt coverage ratio degree to which actual net
  operating income can fall below expectations and
  still be sufficient to meet debt service
  obligation

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Optimal Amount of Financial Leverage

• Lenders frequently express maximum amount of loan
  in terms of minimum permissible debt coverage
  ratio
• Lenders specify maximum permissible loan-to-value
  ratio
• As more money is borrowed to finance an
  investment, the venture becomes increasingly
  risky
• Increasing amount of borrowed funds relative to
  equity funds drive up cost of borrowing

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Todays Lenders

• Commercial banks
• Life insurance companies
• Pension funds
• Commercial mortgage-backed securities (CMBs)
  Conduit Loans

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Real Estate Finance and Investments Lecture 5

• Credit Instruments and Borrowing Arrangements

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The Instruments for Credit

• Promissory notes
• Mortgages
• Purchase-money mortgages
• Blanket mortgages
• Open-ended mortgage
• Deed of trust

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Mortgage Restructuring

• Fully amortizing
• Partially amortizing
• Straight/term/bullet/interest-only (IO)
• Portion of interest deferred
• Fluctuating interest rates

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Alternative Financing Products

• Installment sales contracts
• Sale and leaseback
• Junior mortgages

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Government-Sponsored Credit

• Department of Housing and Urban Development
• State and local government private activity bonds
• Redevelopment bonds