FIN 460 FINAL EXAM

What are some of the types of risk that should be considered when analyzing real estate and other categories of investment?

Business Risk Financial Risk Liquidity Risk Inflation Risk Management Risk Interest Rate Risk Legislative Risk Environmental Risk

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.

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.

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 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 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. An investors 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 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.

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 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.

How can the effect of below-market rate loans on value be determined using investor criteria?

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.

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.

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.

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 or 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.

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.

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 and (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 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 is 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.