CH.7

Most significant source of lending

Commercial banks, then insurance industry

When financial leverage is used, what is the potential impact on before-tax cash flow and the current before-tax yield to the equity position?

Increases cash flow to the equity position as a percentage of the equity investment

financial leverage and the cost of borrowing

Increasing financial leverage increases the cost of borrowing

How do income tax laws create an incentive to borrow money?

Interest payments are generally deductible from taxable income and investors are allowed an annual tax deduction

How can the debt-coverage ratio be used to determine the amount of available financing for a project?

Measure of the extent to which NOI can fall below expectations before it becomes insufficient to service the debt ( NOI/Annual debt service0

Explain the meaning of the loan-to-value ratio from a mortgage lender's perspective and from the viewpoint of an investor.

Measure of the mortgage lender's safety in the event of default. Measure of the dollar amount of real estate that can be controlled with a given amount of equity funds.

Why is financial leverage so popular?

Spread, amplifying the tax shelter, amplifying the gain on disposal

How is financial leverage measured?

The relationship between an equity investment and the total market value of assets acquired

Describe financial risk in real estate investment and explain a useful method of measuring financial risk.

The relationship between an equity investment and the total market value of the assets acquired. Debt-to-equity ratio, Loan-to-value ratio, debt-coverage ratio

Why do investors borrow?

To enhance the expected yield on equity resources

Amplifying the gain on disposal

When market values are increasing, favorable financial leverage will multiply the gain from appreciation

Leveraging out

buying entirely with borrowed funds, increased risk

What are the most frequent sources of lending

commercial banks, insurance companies, pension funds, and conduits

conduit loans

commercial mortgage-backed securities (CMBS)

What is the right amount of financial leverage?

debt-coverage ratios and available financing, Loan-to-value ratios and available financing, financial leverage and risk, financial leverage and the cost of borrowing

Spread

difference between the rate of return on assets and the cost of borrowing, as long as the debt-service constant ( the annual debt service expressed as a percentage of the amount borrowed) is less than the rate of return on total assets, additional financial leverage increases cash flow to the equity position as a percentage of the equity investment

debt-coverage ratios and available financing

how much leverage is available, minimum acceptable debt-coverage ratios

negative consequences from increasing dependence on borrowed funds

increased risk, cost of borrowing escalates

Amplifying the tax shelter

interest payments are generally deductible form taxable income on a dollar-for-dollar basis, annual tax deduction called allowance for depreciation/cost recovery even when properties are purchased with borrowed money, amplifies the amount of tax-deductible expenses with the dame level of equity investment

When the rate of return on assets exceeds borrowing costs

leverage is favorable/positive

If the cost of borrowing is greater than the return on assets

leverage is unfavorable/negative

Loan-to-value ratios and available financing

maximum acceptable loan-to-value ratios

loan-to-value

more commonly used, ratio between borrowed funds and the market value of the asset being financed, measure of the mortgage lender's margin of safety in the event of default

financial leverage and risk

negative consequences from increasing dependence on borrowed funds

debt-coverage ratio/debt-service ratio

ratio between NOI and the annual debt-service obligation, measure of the extent to which NOI can fall below expectations before it becomes insufficient to service the debt

Debt-to-equity ratio

ratio between borrowed funds and equity funds

Higher the ratio of borrowing to equity...

the greater the degree of leverage