REE 4313 Exam 1 Chapter 12

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 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.

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.

balloon payment

At the end of the interest-only period, the loan is either amortized over the remaining loan term or the balance of the loan is due as a balloon payment

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 IRREfor 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 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.

put option

If default occurs and the value of the property is lower than the outstanding loan balance, the investor may "put," or give, the property security to the lender.

sale leaseback of the land

If the investor already owns the land, she can sell it with an agreement to lease the land back from the purchaser

bullet loans

Lenders for income-producing properties refer to these loans as bullet loans because they are short term and require little or no amortization

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.

How does leverage on a before-tax basis differ from leverage on an after-tax basis?

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.

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 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.

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.

loan to value ratio =

Vm / Vo

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.

financial leverage

benefits that may result for an investor who borrows money at a rate of interest lower than the expected rate of return on total funds invested in a property.

mezzanine loan

bridges the gap between the first mortgage debt on the property and the equity investment. It differs from a second mortgage in that it is not secured as a mortgage on the property. Rather, it is secured by the investor's equity in the property.

incremental cost of debt

determining the actual cost of additional financing

lockout period

during which the property cannot be sold or refinanced without a prepayment penalty to compensate the lender

preferred equity

equity interest in the property but it has debtlike characteristics because preferred equity investors have a claim on cash flows from the property that comes before that of the regular (common) equity investors

convertible mortgage

gives the lender an option to purchase a full or a partial interest in the property at the end of some specified period of time

equity participation loans

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.

negative amortization

increase in the principal balance of a loan caused by a failure to make payments that cover the interest due. The remaining amount of interest owed is added to the loan's principal.

covenants

lender will require notification of any material changes that may affect the value of the property aka covenants

accrual loans

loans are structured so the payments for a specified number of years are lower than the amount that would be required to cover the monthly interest charge. These loans, when made on income properties, are referred to as accrual loans and they have negative amortization.

break even interest rate

maximum interest rate that could be paid on the debt before the leverage becomes unfavorable

interest only loan

monthly payment is just sufficient to cover the interest charges

lockout clause

prohibits the borrower from prepaying the loan within a specified period of time (usually 7 to 10 years)

yield maintenance fee

protection against prepayment after the lockout period but before the loan matures, while still providing the borrower with an option to prepay

pay rate

rate to calculate the loan payment that is different than the interest rate

accrual rate

rate used to calculate interest charged

nonrecourse clause

releases the borrower from personal liability and makes the property the sole source of security for the loan

positive financial leverage

returns are higher with debt than without debt

negative financial leverage

returns are lower with debt than without debt

interest rate swaps

used to achieve the equivalent of a fixed interest rate, very large and involves many participants