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Why might a lender prefer a loan with a lower interest rate and a participation?
A lender's motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of inflation. To some extent this protects the lender's real rate of return.
What is a mortgage REIT?
A mortgage REIT is a REIT that primarily invests in mortgages rather than equity ownership.
What is meant by a participation loan? What does the lender participate in? Why would a lender want to make a participation loan? Why would an investor want to obtain a participation loan?
A participation loan is where in return for a lower stated interest rate on the loan, the lender participates in some way in the income or cash flow from the property. The lender's rate of return depends, in part, on the performance of the property. Participations are highly negotiable and there is no standard way of structuring them. A lender's motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge
What is meant by a "real option"?
A real option is an option related to investment in tangible assets like real estate that involves the option to wait to decide whether to invest additional capital based on future economic conditions. Land can be viewed as having the option to invest additional capital in the future to construct a building.
What is a risk premium? Why does such a premium exist between interest rates on mortgages and rates of return earned on equity invested in real estate?
A risk premium is a higher expected rate of return paid to an investor as compensation for incurring additional risk on a higher risk investment. In general, investors are considered risk averse and must be compensated more for the higher risk of some investments. This premium exists between mortgage interest rates and returns on equity invested in real estate because the equity investor is assuming more risk than the mortgage lender. The lender assumes less risk because a lender would have first claim on the property should there be a default. If this were not the case, the investor would be better off lending on real estate than investing in it.
What are some of the types of risk that should be considered when analyzing real estate?
Business Risk Financial Risk Liquidity Risk Inflation Risk Management Risk Interest Rate Risk Legislative Risk Environmental Risk
What is the difference between business risk and financial risk?
Business risk is the risk of loss due to fluctuations in economic activity that affect the variability of income produced by a property. Financial risk (or debt financing referred to as financial leverage) magnifies the business risk. Financial risk increases as the amount of debt increases.
What is the traditional cash equivalency approach to determine how below-market-rate loans affect value?
Cash equivalency was introduced in Chapter 9 where it was demonstrated that a buyer would be willing to pay more for a property with a below market interest rate loan. In that chapter, the present value of interest savings was used to indicate the additional amount which might be paid for a property. This same approach could be used to determine the additional amount that might be paid for income producing properties as analyzed in this chapter.
Why is the variance (or standard deviation) used as a measure of risk? What are the advantages and disadvantages of this risk measure?
Lower variability in returns is considered by many analysts to be associated with lower risk and vice versa. Therefore, by using a statistical measure of variance, one has an indication of the extent risk is present in an investment. The standard deviation gives us a specific range over which we can expect the actual return for each investment to fall in relation to its expected return. It has the advantage of being relatively easy to calculate. It has the disadvantage of treating the both higher than expected returns and lower than expected returns the same. It could be argued, however, that investors should be more concerned about returns being lower than expected or lower than some threshold return.
What is the motivation for a sale-leaseback of the land?
One motivation for the sale-and-leaseback of the land is that it is a way of obtaining 100 percent financing on the land. A second benefit is that lease payments are 100 percent tax deductible. With a mortgage, only the interest is tax deductible. The investor may deduct the same depreciation charges whether or not the land is owned, since land cannot be depreciated. This results in the same depreciation for a smaller equity investment. The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so.
What is meant by the term "overage" for retail space?
Overage refers to the rent that is paid above the minimum rent in the lease where the rent is based on a percentage of the tenant's sales once sales exceeds a specified breakpoint. The total rent is the minimum rent plus the overage rent.
Explain how an investor in an equity REIT may receive a current dividend, part of which may be tax-deferred.
Part of the dividend paid by a REIT may represent "return of capital." This can occur when the dividends per share exceeds earnings per share.
How does the use of scenarios differ from sensitivity analysis?
Sensitivity analysis involves changing one variable at ta time such as the market rent or the vacancy rate. Scenarious involves changing several variables at once for each scenario, e.g., a pessimistic, most likely, and optimistic scenario. For each scenario there might be a different assumption about market rents, vacancy rates, and the resale price because they are interrelated.
What is the break-even mortgage interest rate (BEIR) in the context of financial leverage? Would you ever expect an investor to pay a break-even interest rate when financing a property? Why or why not?
The BEIR is the maximum interest rate that could be paid on the debt before the leverage becomes unfavorable. It represents the interest rate where the leverage is neutral (neither favorable nor unfavorable). The BEIR remains constant regardless of the amount borrowed (that is 60, 70, or 80 percent of the property value). An equity investor probably would not pay a break-even interest rate when financing a property because the investor just earns the same after-tax rate of return as a lender on the same project. Borrowing at the BEIR provides no risk premium to the investor. Normally, a risk premium is required because the equity investor bears the risk of variations in the performance of the property.
Why might the market value of a loan differ from its outstanding balance?
The balance of a loan depends on the original contract rate, whereas the market value of the loan depends on the current market interest rate.
What are the primary considerations that should be made when refinancing?
The borrower must determine whether to present value of the savings in monthly payments is greater than the refinancing costs (points, origination fees, costs of (1) appraisal, (2) credit reports, (3) survey, (4) title insurance, (5) closing fees, etc.
Under what conditions might a home with an assumable loan sell for more than comparable homes with no assumable loans available?
The home with an assumable loan might be expected to sell for more than comparable homes with no assumable loans available when the contract interest rate on the assumable loan is significantly less than the current market rate on a loan with similar maturity and similar loan-to-value ratio. Note that if the dollar amount of the assumable loan is significantly less than that which could be obtained with a market rate loan, the benefit of the assumable loan is diminished because the borrower may need to make up the difference with a second mortgage.
Is the incremental cost of borrowing additional funds affected significantly by early repayment of the loan?
The incremental cost of borrowing additional funds can be affected significantly by early repayment of the loan, especially if additional points were paid to obtain the additional funds. Thus, the borrower should consider how long he or she expects to have the loan when calculating the incremental cost of the additional funds.
What is meant by the incremental cost of borrowing additional funds?
The incremental cost of borrowing funds is a measure of what it really costs to obtain additional funds by getting a loan with a higher loan-to-value ratio that has a higher interest rate. This measure is important because the contract rate on the loan with the higher loan-to-value ratio does not take into consideration the fact that this higher rate must be paid on the entire loan - not just the additional funds borrowed. Thus, the borrower should consider the incremental cost of the additional funds to know what it is really costing to borrow the additional funds.
What factors must be considered when deciding whether to refinance a loan after interest rates have declined?
The payment savings resulting from the lower interest rate must be weighed against the costs associated with refinancing such as points on the new loan or prepayment penalties on the loan being refinanced.
What are the three principal types of REITs?
The three principal types of REITs are mortgage, equity, and hybrid.
How do you think participations affect the riskiness of a loan?
There is clearly some uncertainty associated with the receipt of a participation since it depends on the performance of the property. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of inflation. To some extent this protects the lender's real rate of return.
How can the effect of below-market-rate loans on value be determined using investor criteria?
This question is not explicitly covered in the chapter. It requires students to think about how concepts from earlier chapters dealing with valuation and cash equivalency might be applied to evaluate a below-market rate loan on income property. Evaluating a below-market rate loan is like comparing two financing alternatives where one is at the market rate and one has a below-market rate. All else being equal, the below market interest rate loan should result in a higher IRRE for the property than would result with a market rate loan. The investor might therefore be willing to pay more for the property, as long as the IRRE is at least as much as it would be with the market interest rate loan.
What are some important lease provisions which investors should be aware of when analyzing the financial statements of REITs?
When analyzing the financial statements of REITs, investors should consider the effect of lease provisions such as provisions for tenant improvements and free rents, leasing commissions and lease guarantees. The accounting treatment of these provisions can affect the reported FFO for one REIT versus another REIT.
What is meant by a sale-leaseback? Why would a building investor want to do a sale-leaseback of the land? What is the benefit to the party that purchases the land under a sale-leaseback?
When land is already owned and is then sold to an investor with a simultaneous agreement to lease the land from the party it is sold to, this is called a sale-leaseback of the land. One motivation for the sale-leaseback of the land is that it is a way of obtaining 100 percent financing on the land. A second benefit is that lease payments are 100 percent tax deductible. With a mortgage, only the interest is tax deductible. The investor may deduct the same depreciation charges whether or not the land is owned, since land cannot be depreciated. This results in the same depreciation for a smaller equity investment. The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so.
What are positive and negative financial leverage? How are returns or losses magnified as the degree of leverage increases? How does leverage on a before-tax basis differ from leverage on an after-tax basis?
When the before-tax or after-tax IRR are higher with debt than without debt, we say that the investment has positive or favorable financial leverage. When returns are lower with debt than without debt we say that the investment has negative or unfavorable financial leverage. Positive leverage occurs when the unlevered IRR is greater than the interest rate paid on the debt. Negative leverage occurs when the unlevered IRR is less than the interest rate paid on the debt. Returns and losses are magnified by the greater the amount of debt, the greater the return or loss to the equity investor. Leverage on a before-tax basis differs from leverage on an after-tax basis because interest is tax deductible. Therefore, we must consider the after-tax cost of debt which is different than the before-tax cost of debt.
List and characterize equity REITs based on their property types. Equity trusts may be broken down into the following categories:
1. Blank or "blind pool" check trusts. 2. Purchasing, or Specified Trusts. 3. Mixed Trusts. 4. Leveraged REITs versus Unleveraged REITs. 5. Finite-Life versus NonFinite-Life REITs. 6. Closed-end versus Open-end REITs. 7. Exchange trusts. 8. Developmental-Joint Venture Equity REITs. 9. Health-Care REITs.
What is meant by partitioning the internal rate of return? Why is this procedure meaningful? To illustrate what is meant by partitioning the IRR, remember that the IRR is made up of two components of cash flow:
1. cash flow from operations 2. cash flow from the sale of the investment Partitioning is done to obtain some idea of the relative weights of these components of return and to get an idea of the timing of the receipt of the largest portion of that return. Partitioning is meaningful because it helps the investor to determine how much of the return is from annual operating cash flow and how much is from the projected resale cash flow. Operating cash flow is generally more certain than projected resale cash flow. Therefore, the greater the proportion of resale cash flow versus operating cash flow, the greater the risk facing the investor. This could be useful in comparing multiple investments.
What is a buydown loan? What parties are usually involved in this kind of loan?
A buydown loan is a loan that has lower payments than a loan that would be made at the current interest rate. The payments are usually lowered for the first one or two years of the loan term. The payments are "bought down" by giving the lender funds in advance that equal the present value of the amount by which the payments have been reduced.
Why might a wraparound lender provide a wraparound loan at a lower rate than a new first mortgage?
Although the wraparound loan is technically a "second mortgage," the wraparound lender is only required to make payments on the existing mortgage if the borrower makes payments on the wraparound loan. Furthermore, the wraparound lender is typically taking over an existing mortgage that has a below market interest rate. Thus, the wraparound lender is benefiting from the spread between the rate being earned on the wraparound loan and that being paid on the existing loan. This allows the wraparound lender to earn a higher return on the incremental funds being advanced even if the rate on the wraparound loan is less than the rate on a new first mortgage.
Why might a borrower be willing to pay a higher price for a home with an assumable loan?
An assumable loan allows the borrower to save interest costs if the interest rate is lower than the current market interest rate. The investor may be willing to pay a higher price for the home if the additional price paid is less than the present value of the expected interest savings from the assumable loan.
Why might an investor prefer a loan with a lower interest rate and a participation?
An investor's motivation is that the participation may be very little or zero for one or more years. This is because the loan is often structured so that the participation is based on income or cash flow above some specified break- even point. During this time period, the borrower will be paying less than would have been paid with a straight loan. This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.
What criteria should be used to choose between two financing alternatives?
Assuming the two financing alternatives are for roughly the same amount of funds (so financial risk due to leverage is the same), the alternative with the lowest effective interest cost should be chosen. This alternative should also result in the highest IRR on equity.
What is the difference between earnings per share (EPS), funds from operations (FFO), adjusted funds from operations (AFFO), and dividends per share?
Earnings per share (EPS) is based on accounting income which is reduced by any depreciation and amortization which are non-cash deductions. FFO is calculated by adding back depreciation and amortization and other non-cash deductions to earnings. Dividends per share is what the REIT actually distributes to shareholders.
What is financial leverage? Why is a one-year measure of return on investment inadequate in determining whether positive or negative financial leverage exists?
Financial leverage is defined as benefits that may result to an investor by borrowing money at a rate of interest that is lower than the expected rate of return on total funds invested in a property. To determine whether leverage is positive (favorable) or negative (unfavorable), the investor needs to determine whether the IRR (calculated over the entire holding period) is greater than the cost of borrowed funds. A first-year measure of return such as the overall capitalization rate can not be used because it does not explicitly consider the benefits that accrue to the investor over time from changes in income and value that do not affect the cost of debt.
Assuming the borrower is in no danger of default, under what conditions might a lender be willing to accept a lesser amount from a borrower than the outstanding balance of a loan and still consider the loan paid in full?
If interest rates have risen significantly, the market value of the loan will be less. Thus, the lender may be willing to accept less than the outstanding balance of the loan, especially if the lender still receives more than the market value of the loan. The lender can then make a new loan at the higher market interest rate.
What are the general requirements regarding income, investments, and dividends with which a REIT must comply to maintain its qualification to be taxed as a REIT?
In general, at least 95 percent of a REITs gross income must be from dividends, interest, rents, or gains from the sale of certain assets. At least 75 percent of gross income must be from rents, interest on obligations secured by mortgages, gains from the sale of certain assets, or income attributable to investments in other REITs. At least 75 percent of the value of a REIT's assets must consist of real estate assets, cash, and government securities. A REIT must distribute 95 percent of its taxable income to shareholders as a dividend.
In what way does leverage increase the riskiness of a loan?
Leverage increases the standard deviation of return regardless of whether it is positive or negative. This means the investment is clearly riskier when leverage is used. Because the NOI does not change when more debt is used, increasing the amount of debt increases the debt service relative to NOI. Therefore, the debt coverage ratio (DCR) may exceed the lender's limits. With higher loan-to- value ratios and declining debt coverage ratios, risk to the lender increases. As a result, the interest rate on additional debt will also increase.
