Week 05 Real Estate Leverage

Week 04
Real Estate Leverage

by Jonathan F. Caro, REB
Week 03: Real Estate Project Types
At the end of this module you are expected to :
1. Recognize the role of debt financing in real estate development
2. Identify and appreciate the benefits and costs in undertaking financial leverage
3. Be able to calculate allowable loanable amounts and the corresponding debt

repayments
Week 04: Real Estate Leverage
DIFFERENCE OF CAPITAL AND LIABILITIES

Difference of Capital and Liabilities

From a financial point of view, a business is made up of :
ASSETS = LIABILITIES + CAPITAL
ASSETS – summation of a company’s liabilities and capital.


CAPITAL – all financial resources provided by business owners made up of initial
and additional fund requirements of business along with any retained earnings.
Also known as capital financing by equity, sale of a percentage of business to an
investor, in exchange for capital or investible funds for business.
LIABILITIES – all loans extended to business by outside parties or 3rd party

financial institutions in return for share of ownership in company or payment of
interest, latter being more commonly known as borrowings or financing. Also
known as capital financing by sourcing debt, involves borrowing fixed sum from a
lender, which is then paid back with interest.

• Real estate development begins with investment of capital to purchase and construct
improvements on land and building structures on subject property. As stated above,
capital invested comes in form of equity and debt.
CAPITAL FINANCING BY
RAISING EQUITY
Capital Financing by Raising Equity

• Businesses fund or add capital into business by raising equity thru sale of shares.
Investors will infuse funds into company in exchange for company shares that allow
these investors to take part in the business’ operations (if owned shares allow) and
corresponding profitability.
• From the standpoint of a company raising capital by selling equity or shares, the
following are its advantages and disadvantages :
Capital Financing by Raising Equity

ADVANTAGES DISADVANTAGES
1. Company is not obligated to repay or be required to 1. Company loses certain level of ownership when
make regular payments to investor. Only thru dividends shares are sold to new investors. Investors buying into
company declares that such investors may earn from company is incentivized to invest with hope of sharing
its investment into company. Company has right not in company’s profits when company becomes
pay out dividends to its stockholders if company profitable.
encounters problems in profitability and cash flow
2. Company shares risk of business with its investors, 2. Company relinquishes certain level of control
in which company shares benefits of profitability with through sale of shares. The higher the level of company
its investors, or equally experiences no profitability shares sold, the more control buying investors have
during difficult times. over direction of company.
3. Funds which company receive in sale of shares are 3. From company’s standpoint, it may not pay out
not bound by any usage restrictions or stipulations dividends to its stockholders if company encounters
within overall company operations. Such capital usage problems in profitability and cash flow
shall be directly controlled by company.
CAPITAL FINANCING BY
RAISING DEBT
Capital Financing by Raising Debt

• Such financing arrangements secured from banks and similar financial entities are
backed by using real estate property as collateral – as security against non-payment of
loan. When debt is secured, creditor (or financing institution / source of the loan) has
claims against borrower and against identified assets of borrower – thereby need for
collateral to secure loan.
• There are exceptions, though, on creditors requiring collateral for financing borrower’s
needs. Such case occurs when debt is unsecured which lender has claim only against
borrower and not to any of borrower’s assets. These cases occur when :

1. Borrower established good repayment profile that shows minimal risk in non-
payment for additional loans
2. Borrower established business operations that has shown continuous profitability
thru years which are far more than enough to repay any obligation
3. Creditor charges significantly high interest rate for loan in return for not requiring
collateral as loan guarantee
From the standpoint of a company raising capital by securing debt financing, listed as
follows are its advantages and disadvantages :

ADVANTAGES DISADVANTAGES
1. Company maintains complete ownership when loan 1. Company has to guarantee repayment of debt regardless
from creditor is made. Benefit of maintaining ownership is of business conditions and changes in company’s
that management has complete control over decisions operations due to normal market cycle. From lender’s
made on behalf of company. Only obligation debtor has to a mind, debtor has considered all possibilities in securing
lender is to pay back principal and interest for loan. loan which allows business to allocate part of its cash flow
to repay such debt at pre-determined time frame.
2. Interest payments made to repay loans are allowed to be 2. The company has to prioritize debt repayment over its
deducted from taxable income. This allows business to cash flow for business operations to ensure timely
have incremental savings which in turn can be utilized to payment of the loan as pre-agreed.
grow business.
3. Period by which loan has an impact on business 3. Company must show first its capacity to operate and pay
operations are fixed based on agreed repayment schedule. off its financial obligations prior to being allowed to secure
As such, concrete plans can be made by company for its financing by its lenders. On other hand, capital investors
operations both during and after debt repayment. look only for potential of company to make profit for them
to provide capital in exchange for company ownership thru
shares.
DEBT CLASSIFICATION
Debt Classification
1. Marketable Debt
• This takes form of securities such as notes, bonds, or debentures, which are issued to
investors and can be traded in secondary market. Ownership of this kind of debt is
transferable – usually done thru banking institutions
Debt Classification
2. Non-Marketable Debt
• This takes form of loans arranged privately between two parties where lender is
usually bank or financial institution. For purposes of this module, this shall be the
focus of the discussion moving forward.
INTEREST RATE
Interest Rate
Interest – cost of borrowed capital, an amount charged on top of principal loan payable by lender to
creditor. Rate is pre-determined by both parties prior to lender’s receipt of loan. There are three
types of interest rates :
1. Nominal Interest Rate
2. Effective Interest Rate
3. Real Interest Rate
Interest Rate
a. Fixed Rate
• Unchanging rate charged on liability, such as loan or mortgage. It might apply during entire
term of loan or for just part of term, but it remains same throughout a set period.
• Fixed interest rate avoids risk that mortgage or loan payment can significantly increase over
time. Fixed interest rates can be higher than variable rates. Borrowers are more likely to opt
for fixed-rate loans during periods of low interest rates.
Interest Rate
a. Variable (Floating) Rate
• Unchanging Variable interest rates on adjustable-rate mortgages change periodically.
Borrower typically receives an introductory rate for a set period of time—often for one,
three, or five years. Rate adjusts on a periodic basis after that point
Interest Rate
• Compounding of interest over full term of loan. Often used to compare annual interest rates
with different compounding terms (daily, weekly, monthly, annual).
• As an example, a nominal interest rate of 6% compounded quarterly would equate to an
effective rate of 5.095%, compounded monthly at 5.116%, and daily at 5.127%.
Interest Rate
3. Real Interest Rate
• Used to include impact of inflation on nominal interest rates. Real interest rate deducts rate
of inflation from nominal interest rate to show impact of time and inflation on charged
interest rate. As an example, if nominal interest rate is 4% and inflation rate is also 4%, real
interest rate is effectively 0%.
DETERMINATION OF ALLOWABLE
LOANABLE FUND
Determination of Allowable Loanable Fund

• In general, term “loanable fund” is amount of funds that an entire banking sector of a
country has capacity to make available for funding loan requirements of both private
and public enterprise.
• “Investment spending is an important category of real GDP. Not only is it usually the
most volatile part of real GDP, but investment spending on physical capital is also an
important contributor to economic growth. So, if a firm wants to build a new factory,
where does it get the funds to build it? Usually, firms borrow that money.”
• “The market for loanable funds describes how that borrowing happens. The supply of
loanable funds is based on savings. The demand for loanable funds is based on
borrowing. The interaction between the supply of savings and the demand for loans
determines the real interest rate and how much is loaned out.”

• Such total loanable funds available in market are mostly sourced from banking and
financial institutions. For purposes of this module, the focus shall be the determination
of the amount of loanable fund can be given by a bank to a single borrower – either an
individual or corporate entity. Its two main parameters are :
1. Borrower’s Credit-Worthiness
2. Valuation of Collateral

• Loanable fund has certain limit placed by lending agency that an individual or
corporation is authorized to borrow thru bank loan (with or without mortgage), line
of credit, personal loan, or credit card.
• To determine loan applicant’s maximum loan amount, lenders consider the following :
a. Debt to Income Ratio
b. Credit History
c. Financial Profile
d. Credit Score

a. Debt to Income Ratio
• Equates loan applicant’s current monthly income to a computed monthly loan
payment based on requested loan amount for approval.
• In general, financial institutions consider loan applications with an applicant’s debt
to income ratio ranging from 30% to 35%.

b. Credit History
• Lenders want borrowers who will repay their debts, on time and as agreed upon in a
loan agreement. If lender feels they can rely on borrower to do that, they
acknowledge that such borrowers have "good credit," or considered low-risk
borrower.
• If, based on history of poor debt management, lender doubts a borrower will pay
back loan, they consider that borrower to have "bad credit," and to be high-risk
borrower.

b. Credit History
• As such, lending institutions usually undertake a due diligence of the loan
applicant’s prior loan repayment history if there have been instances of delayed or
outright non-payment of loan payments. Applicants with a prior record of non-
payment of a loan from any regulated financial institution will find it difficult to
possibly secure another loan.
• The credit history of borrowers are researched by internal groups of lending

institutions, or these institutions seek a government-owned and controlled agency
to provide such information. For the latter, having a central repository of credit
information is a common feature in many developed countries, as well as in
emerging markets.

b. Credit History
• Under Republic Act No. 9510, the Philippine government established in 2008 the
Credit Information Corporation “(CIC”) which has the powers and functions to
receive and consolidate basic credit data, to act as a central registry or central
repository of credit information, and to provide access to reliable, standardized
information on credit history and financial condition of borrowers. CIC’s main
mission is “To efficiently and effectively collect and provide accurate credit data
through a reliable and comprehensive centralized credit information system, using
state-of-the-art technology and facilities thereby contributing to improved access to
credit.”

b. Credit History
• The CIC is recognized as the Philippines’ central credit registry, which most lending
agencies collaborate with for their lending businesses with prior clearance from
their respective borrowers. In the process of obtaining a loan or service, loan
applicants may be asked by the lender or service provider to sign a waiver of access.
Their credit report supplied by the CIC will allow the lender or service provider to
assess the borrower’s application in a fair and objective manner. In general, people
with good track records of payment may receive lower interest rates or more
services than those with poor payment track records.

c. Financial Profile
• Loan applicants’ capacity to pay are prime determinant of amount of loan that they
can secure and if indeed applicant will be able to come up with a loan. Applicant’s
income source/s are diligently evaluated and reconfirmed by lending institution to
decide if applicant is credit-worthy enough to repay loan payment requirements to
secure loan proceeds.

d. Credit Score
• In the United States, lending institutions secure credit score of potential borrowers
to help understand individual borrowers’ level of credit risk. Credit scores are
calculated using computer programs known as scoring models. Scoring models
perform sophisticated statistical analysis on contents of a borrower’s credit
report—history of borrowing and repaying debts, as recorded by United States’
three (3) national credit bureaus: Experian, Equifax and TransUnion.

d. Credit Score
• Scoring models look for patterns in borrower’s credit report data that historically
have been associated with payment defaults among consumers. Based on
prevalence (or absence) of these patterns, scoring models assign score to borrower,
usually in form of three-digit number, reflecting their predicted riskiness relative to
other consumers

• Once the borrower’s credit-worthiness is determined and accepted by the lending
institution. The lending institution shall consider the valuation of the collateral
offered by the borrower for real estate loan purposes.
• Collateral is an asset or property that an individual or entity offers to a lender as

security for a loan. It is used as a way to obtain a loan, acting as a protection against
potential loss for the lender should the borrower default in his payments. In such an
event, the collateral becomes the property of the lender to compensate for the
unreturned borrowed money.

• In order to be able to take out loan successfully, every business owner or individual
should know the different types of collateral that can be used when borrowing.
These are :
a. Real Estate
• Most common type of collateral used by borrowers, such as one’s home or a parcel of
land. Such properties come with high value and low depreciation. However, it can also be
risky because if property is sequestered due to a default, it cannot any longer be taken
back.

b. Cash Secured Loan
• Cash is another common type of collateral because it works very simply. Individual
can take loan from bank where he maintains active accounts, and in event of default,
bank can liquidate his accounts in order to recoup borrowed money.
c. Inventory
• Involves inventory of business or individual borrower that serves as collateral for
loan. Should default happen, items listed in inventory can be sold by lender to recoup
its loss.

d. Blanket Liens
• Involves use of lien, which is legal claim allowing a lender to dispose of assets of
business that is in default on loan.

• Once collateral type is selected, then its corresponding value has to be determined in
order to compare this with targeted loan value. Collateral value is computed amount of
assets that have been put up to secure a loan. This value is often used by lenders to
estimate level of risk associated with a particular loan application.
• Various methods are used to estimate collateral value. These can include reviewing
comparable transactions, relying on tax assessments, and consulting with subject-
matter experts – most notably real estate appraisers for real estate – based collateral
assets.
• Typically, the size of loan provided by lender will range from 60% to 90% of its collateral
value. For instance, in case of mortgage loans, lenders have traditionally offered up to a
maximum of 80% financing for built up real estate assets, though land based assets may
only have a maximum of 60%.
CALCULATIONS OF DEBT REPAYMENTS

Calculation of Debt Repayments

• For simplicity, discussion below shall focus on a loan secured by borrower from a bank
for purchase of a real estate property back by a collateral represented by purchased
asset itself.
PURPOSE OF LOAN : Purchase of a House and Lot

PRICE OF HOUSE AND LOT : P5.0 MILLION
COLLATERAL : House and Lot subject of the Purchase
EST. COLLATERAL VALUE : 70% of List Price or P3.5 Million
LOAN PERIOD : Five (5) Years
LOAN INTEREST RATE : 7.0% - Fixed for 5 years

1. Computation of Required Monthly Payment
• Most commonly known as the mortgage calculator, the formula presented below
calculates the regular monthly payment to pay off the loan over a given period of time.
Regular Monthly Payment = Pmt

Loan Amount =A
Interest Charged =i
Total # of Monthly Payments =N
FORMULA : For Monthly Payment

Pmt = Ai
-N
(1 – (1 + i) )

Pmt = Ai = (P3.5 Million) x (7.0%/12) = P69,304.19 per month
(1 – (1 + i)-N) (1 – (1 + (0.07/12))-60)
To give a more detailed illustration to show the monthly payments are enough to pay off
the P3.5 Million loan in 5 years or 60 months, please refer to table below :
Monthly Payment
Excel Formula
PMT Function

2. Computation for the Outstanding Balance
• There is a need to know if loan can be refinanced at any point time during payment of
current loan. In event borrower would like to refinance or pay off outstanding loan,
there is a need to forecast balance outstanding at a point of time.
• Continuing example from above, borrower got financing for P3.5 Million over 5 years
at a fixed interest rate of 7% and am making monthly (minimum) repayments. After
three years, interest rates of banks have lowered due to positive market
developments. This gives rise to an opportunity for borrower to save on interest costs.
The question is : What is the outstanding balance at this point in time?

2. Computation for the Outstanding Balance
• The answer to this question is given by the formula:
Outstanding Balance =B
Regular Monthly Payment = Pmt
Loan Amount =A
Interest Charged = i (divide by 12 if period is monthly)
# of Monthly Payments Made = n (n <= N)
FORMULA : For Outstanding Balance

B = A ( 1 + i)n - Pmt (1 + i)n – 1)
i

B = A ( 1 + i)n - Pmt (1 + i)n – 1)
i
= P3.5 Million (1 + (0.07/12))36 – P69,304.19 (1 + (0.07/12))36 ) - 1

(0.07/12)
= P1,547,916.47 (refer to table below)
Excel Formula
CUMPRINC
Function
References:
Online Supplementary Reading Materials
1. The Market for Loanable Funds (The Khan Academy) :
https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-
sector/the-market-for-loanable-funds/a/the-market-for-loanable-funds
2. Credit Information Corporation : https://www.creditinfo.gov.ph/
3. What are the Different Credit Scoring Ranges? (Experian) :
https://www.experian.com/blogs/ask-experian/infographic-what-are-the-different-scoring-
ranges/#s1
4. How to use Excel for practical debt repayment calculations (Financial Management) :
https://www.fm-magazine.com/news/2018/jan/excel-debt-repayment-calculations-201718014.html
5. Financial Formulas : https://financeformulas.net/

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Week 04

Real Estate Leverage

At the end of this module you are expected to :

1. Recognize the role of debt financing in real estate development

3. Be able to calculate allowable loanable amounts and the corresponding debt

DIFFERENCE OF CAPITAL AND LIABILITIES

Difference of Capital and Liabilities

ASSETS – summation of a company’s liabilities and capital.

Difference of Capital and Liabilities

LIABILITIES – all loans extended to business by outside parties or 3rd party

Difference of Capital and Liabilities

Capital Financing by Raising Equity

Capital Financing by Raising Equity

Capital Financing by Raising Debt

Capital Financing by Raising Debt

Capital Financing by Raising Debt

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

• The credit history of borrowers are researched by internal groups of lending

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

• Collateral is an asset or property that an individual or entity offers to a lender as

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

Determination of Allowable Loanable Fund

CALCULATIONS OF DEBT REPAYMENTS

Calculation of Debt Repayments

PURPOSE OF LOAN : Purchase of a House and Lot

Calculation of Debt Repayments

Regular Monthly Payment = Pmt

Calculation of Debt Repayments

FORMULA : For Monthly Payment

Calculation of Debt Repayments

Calculation of Debt Repayments

Calculation of Debt Repayments

Calculation of Debt Repayments

Calculation of Debt Repayments

FORMULA : For Outstanding Balance

Calculation of Debt Repayments

= P3.5 Million (1 + (0.07/12))36 – P69,304.19 (1 + (0.07/12))36 ) - 1

Calculation of Debt Repayments

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