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FINANCIAL
LEVERAGE AND
FINANCING Chapter 12
ALTERNATIVES
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Members

1920003 MD. SHADUL ALAM SHAD

1920004 MD MAHFUZ ISLAM
1920005 MD. AZIZUL HAQUE
1920006 MAHMUD AL FAISAL
1920032 MAHMUD KYSAR RAKA
1920044 SHAKIL MIA
1920061 MD. RUBEL MIA
1920062 MD. RIFAT HASSAN
1920015 MD. MONSUR ALI
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Financial Leverage

Financial
Equity
Leverage: Before-
Participation Loan
Tax

Conventional Loan
Financial
Leverage: After-
Overview
Tax

Alternative
Break-Even
Financing
Interest Rate
Structures

Underwriting
Loans
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What is financial leverage?

• Benefit of borrowing at a lower interest

rate than the rate of return on the property.

Financial
Why use financial leverage?
Leverage
• Diversification benefits of lower equity
investment
• Can invest in other property
• Mortgage interest tax benefit
• Magnify returns if the return on the
property exceeds the cost of debt
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Financial Leverage: Before-Tax

Positive Financial Leverage

• Returns are higher with debt

Unlevered BTIRR

• Return with no debt

If unlevered BTIRR > interest rate on debt

• The BTIRR on equity increases with debt

• There is positive financial leverage
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 BTIRRE= BTIRRP + (BTIRRP – BTIRRD)

(D/E)
BTIRRE = Before-Tax IRR on equity
Financial 
invested
Leverage:  BTIRRP = Before-Tax IRR on total
Before-Tax investment in the property
 BTIRRD = Before-Tax IRR on debt
(effective cost including points)
 D/E =Debt/Equity ratio
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Equation shows that as long as:

• BTIRRP > BTIRRD, then BTIRRE >

BTIRRP
Financial • This implies increasing D/E……

Leverage: But the use of debt is limited

Before-Tax • Debt coverage ratio restrictions
• Higher loan to value ratios are riskier to
lenders…leading to higher interest rates
• Higher debt levels increase risk to equity
investor
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Negative Financial Leverage

Financial
Leverage:  If BTIRRD > BTIRRP, then BTIRRE <
Before-Tax BTIRRP
 The use of debt reduces the return on
equity
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 ATIRRE= ATIRRP + (ATIRRP –

ATIRRD)(D/E)
 ATIRRE = After-Tax IRR on equity
invested
Financial  ATIRRP = After-Tax IRR on total
Leverage: investment in the property

After-Tax  ATIRRD = BTIRRD (1-t)

 After-Tax IRR on debt (effective cost
after taxes including points)
 D/E =Debt/Equity
Example 10

 Assumptions:
 Total value: $100,000 (Building: $80,000, Land: $15,000)
 Loan amount: vary for demonstrations
 Loan interest rate: 10.00% at moderate levels of debt
 Loan term is same as holding period: 5 years
 NOI: $12,000 constant
 All tax rates: 28.00%
 Depreciation: 31.5 years
 Sale price: $100,000
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BTCF – No Leverage

Year 0 1 2 3 4 5
Before Tax Cash Flow
= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000
- Debt service (DS) $0 $0 $0 $0 $0
= Before-tax cash flows (BTCF) $12,000 $12,000 $12,000 $12,000 $12,000

= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000

- Debt service (DS) $0 $0 $0 $0 $0
= Net sales price (NSP) $100,000
- Unpaid mortgage balance (UMB) $0
= Before-tax cash flows($100,000)
(BTCF) $12,000 $12,000 $12,000 $12,000 $112,000

BTIRR on Equity 12.00%

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ATCF – No Leverage

Year 0 1 2 3 4 5
Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000
- Interest (INT) $0 $0 $0 $0 $0
- Amortized Financing Cost $0 $0 $0 $0 $0
- Depreciation (DEP) $2,698 $2,698 $2,698 $2,698 $2,698
= Taxable income from operations (TI)$9,302 $9,302 $9,302 $9,302 $9,302
- Loss carry forward
- Net carry forward
= Net taxable income $9,302 $9,302 $9,302 $9,302 $9,302
x Marginal tax rate (t) 28% 28% 28% 28% 28%
= Taxes (savings) from operations (TXS)
$2,604 $2,604 $2,604 $2,604 $2,604

Year 0 1 2 3 4 5
= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000
- Debt service (DS) $0 $0 $0 $0 $0
= Taxes (savings) from operations (TXS)
$2,604 $2,604 $2,604 $2,604 $2,604
= After-tax equity reversion (ATER) $96,222
= After-tax cash flows (ATCF)
($100,000) $9,396 $9,396 $9,396 $9,396 $105,618

ATIRR on Equity 8.76%

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BTCF – $80,000 Loan

Year 0 1 2 3 4 5
Before Tax Cash Flow
= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000
- Debt service (DS) $8,000 $8,000 $8,000 $8,000 $8,000
= Before-tax cash flows (BTCF) $4,000 $4,000 $4,000 $4,000 $4,000

= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000

- Debt service (DS) $8,000 $8,000 $8,000 $8,000 $8,000
= Net sales price (NSP) $100,000
- Unpaid mortgage balance (UMB) $80,000
= Before-tax cash flows ($20,000)
(BTCF) $4,000 $4,000 $4,000 $4,000 $24,000

BTIRR on Equity 20.00%

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ATCF – $80,000 Loan

Year 0 1 2 3 4 5
Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000
- Interest (INT) $8,000 $8,000 $8,000 $8,000 $8,000
- Amortized Financing Cost $0 $0 $0 $0 $0
- Depreciation (DEP) $2,698 $2,698 $2,698 $2,698 $2,698
= Taxable income from operations (TI)$1,302 $1,302 $1,302 $1,302 $1,302
- Loss carry forward
- Net carry forward
= Net taxable income $1,302 $1,302 $1,302 $1,302 $1,302
x Marginal tax rate (t) 28% 28% 28% 28% 28%
= Taxes (savings) from operations (TXS)$364 $364 $364 $364 $364

Year 0 1 2 3 4 5
= Net operating income (NOI) $12,000 $12,000 $12,000 $12,000 $12,000
- Debt service (DS) $8,000 $8,000 $8,000 $8,000 $8,000
= Taxes (savings) from operations (TXS)$364 $364 $364 $364 $364
= After-tax equity reversion (ATER) $16,222
= After-tax cash flows (ATCF)
($20,000) $3,636 $3,636 $3,636 $3,636 $19,858

ATIRR on Equity 15.40%

 Break-Even Interest Rate

 Break-even interest rate: Maximum interest rate before negative financial

leverage
 ATIRRD= ATIRRP
 ATIRRD= BTIRRD(1-t)

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Underwriting Loans

Market Study
 Economic base
 Submarkets
 Appraisal

Borrower Financial Statements

 Nonrecourse clause may be included

Loan to Value Ratio

Debt Coverage Ratio

 DCR = NOI / Debt Service
 Lenders prefer DCR to be at least 1.2
 Using a desired DCR we can determine maximum debt service = NOI / Desired DCR
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Underwriting Loans

Additional Considerations:
 Approval of new leases by lender
 Approval of lease modifications by lender
 Approval of construction by lender
 Borrower submits period financials
 Annual property appraisal
 Notify lender of legal problems
 Notify lender when correcting property defects
 Lender has right to visit
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Underwriting Loans

Lockout Clause Yield Maintenance Fee

Prohibits prepayment of loan for a Guarantees a yield to the lender after
specified period of time a lockout period expires
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Alternative Financing Structures

Mismatch between early

year property income and Inflation effects
constant payment loans

Income is expected to New building not fully

increase leased

Results in different loan Leases may be below

structures market
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Participation Loans

Equity Participation Loans

 Lower interest rate from lender
Alternative  Lender shares in property cash flow
Financing  Percent of PGI, NOI or BTCF, etc.
Structures Lender motivations
 Guaranteed minimum return and some protection of
real return

Investor motivations
 Easier to meet debt service requirements
Conventional Loan 21

 Assumptions:
 Total value: $1,000,000 (Building: $900,000, Land: $100,000)
 Loan amount: $700,000
 Loan interest rate: 10.00%
 Loan term: 15 years
 Holding period: 5 years
 NOI: $100,000 first year. growing at 3.00% per year
 All tax rates: 28.00%
 Depreciation: 27.5 years
 Sale price: Growing at 3.00% per year
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Conventional Loan – BTIRR

Year 0 1 2 3 4 5
Beginning Period 1 13 25 37 49
Ending Period 12 24 36 48 60
Before Tax Cash Flow
= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551
- Debt service (DS) $90,267 $90,267 $90,267 $90,267 $90,267
= Cash flow before participation $9,733 $12,733 $15,823 $19,006 $22,284
- Participation $0 $0 $0 $0 $0
= Before-tax cash flows (BTCF) $9,733 $12,733 $15,823 $19,006 $22,284

= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551

- Debt service (DS) $90,267 $90,267 $90,267 $90,267 $90,267
- Participation $0 $0 $0 $0 $0
= Net sales price (NSP) $1,159,274
- Unpaid mortgage balance (UMB) $569,216
- Participation $0
= Before-tax cash flows($300,000)
(BTCF) $9,733 $12,733 $15,823 $19,006 $612,342

BTIRR on Equity 18.37%

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Conventional Loan – ATIRR

Year 0 1 2 3 4 5
Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551
- Interest (INT) $69,045 $66,823 $64,368 $61,656 $58,660
- Depreciation (DEP) $31,364 $32,727 $32,727 $32,727 $31,364
- Participation $0 $0 $0 $0 $0
= Taxable income from operations (TI) ($408) $3,450 $8,995 $14,890 $22,528
- Loss carry forward $0 $0 $0 $0 $0
- Net carry forward $0 $0 $0 $0 $0
= Net taxable income ($408) $3,450 $8,995 $14,890 $22,528
x Marginal tax rate (t) 28% 28% 28% 28% 28%
= Taxes (savings) from operations (TXS)($114) $966 $2,519 $4,169 $6,308

Year 0 1 2 3 4 5
= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551
- Debt service (DS) $90,267 $90,267 $90,267 $90,267 $90,267
- Participation $0 $0 $0 $0 $0
= Taxes (savings) from operations (TXS)($114) $966 $2,519 $4,169 $6,308
= After-tax equity reversion (ATER) $500,406
= After-tax cash flows (ATCF)
($300,000) $9,848 $11,767 $13,305 $14,837 $516,383

ATIRR on Equity 14.29%

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Equity Participation Loan

 Assumptions:
 Total value: $1,000,000 (Building: $900,000, Land: $100,000)
 Participation loan information:
 Loan amount: $700,000
 Loan interest rate: 8.00%
 Loan term: 15 years
 Participation in 50.00% of any NOI in excess of $100,000
 Participation in 45.00% of gain in property value
 Holding period: 5 years
 NOI: $100,000 first year. growing at 3.00% per year
 All tax rates: 28.00%
 Depreciation: 27.5 years
 Sale price: Growing at 3.00% per year
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Equity Participation Loan – BTIRR

Year 0 1 2 3 4 5
Beginning Period 1 13 25 37 49
Ending Period 12 24 36 48 60
Before Tax Cash Flow
= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551
- Debt service (DS) $80,275 $80,275 $80,275 $80,275 $80,275
= Cash flow before participation $19,725 $22,725 $25,815 $28,998 $32,276
- Participation $0 $1,500 $3,045 $4,636 $6,275
= Before-tax cash flows (BTCF) $19,725 $21,225 $22,770 $24,362 $26,001

= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551

- Debt service (DS) $80,275 $80,275 $80,275 $80,275 $80,275
- Participation $0 $1,500 $3,045 $4,636 $6,275
= Net sales price (NSP) $1,159,274
- Unpaid mortgage balance (UMB) $551,364
- Participation $71,673
= Before-tax cash flows($300,000)
(BTCF) $19,725 $21,225 $22,770 $24,362 $562,238

BTIRR on Equity 18.36%

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Equity Participation Loan – ATIRR

Year 0 1 2 3 4 5
Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551
- Interest (INT) $55,090 $53,000 $50,736 $48,284 $45,629
- Depreciation (DEP) $31,364 $32,727 $32,727 $32,727 $31,364
- Participation $0 $1,500 $3,045 $4,636 $6,275
= Taxable income from operations (TI)$13,547 $15,773 $19,582 $23,625 $29,283
- Loss carry forward $0 $0 $0 $0 $0
- Net carry forward $0 $0 $0 $0 $0
= Net taxable income $13,547 $15,773 $19,582 $23,625 $29,283
x Marginal tax rate (t) 28% 28% 28% 28% 28%
= Taxes (savings) from operations (TXS)
$3,793 $4,417 $5,483 $6,615 $8,199

Year 0 1 2 3 4 5
= Net operating income (NOI) $100,000 $103,000 $106,090 $109,273 $112,551
- Debt service (DS) $80,275 $80,275 $80,275 $80,275 $80,275
- Participation $0 $1,500 $3,045 $4,636 $6,275
= Taxes (savings) from operations (TXS)
$3,793 $4,417 $5,483 $6,615 $8,199
= After-tax equity reversion (ATER) $466,654
= After-tax cash flows (ATCF)
($300,000) $15,932 $16,809 $17,287 $17,747 $484,456

ATIRR on Equity 14.06%


Alternative Financing Structures
Sale-Leaseback of Land
Own building and lease land from a different
investor
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Why is it attractive to investor?
100% financing possible
Lease payments are tax deductible
Building is depreciable; land is not
Possible purchase option at end of lease
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Interest Only Loans: “Bullet Loans”
 No amortization for a specified period
 Balloon payment or amortization
afterward

Alternative Accrual Loans

Financing  Negative amortization

Structures  Pay Rate

 Interest rate used to calculate loan
payment
 Accrual Rate
 Interest rate used to calculate the
interest charged
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Structuring the payment for a targeted debt

coverage ratio

Alternative
Not always fully amortizing
Financing 

 Balloon payment
Structures
Convertible Mortgage
 Lender has an equity investment option
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