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8.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.
5.What is meant by 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.
11.What is meant by an effective tax rate? What does it matter?
•A tax rate that takes into account the effects of depreciation and time value of money. It measures the actual difference between BTIRR and ATIRR. This difference is the effective tax rate and can be less than the actual marginal tax rate. It is also due to the fact that the interest on the mortgage loan is deductible.
9.What is meant by a tax shelter?
•An investment that allows a taxpayer to reduce taxable income. Although most of the tax shelter benefits of real estate were removed by the Tax Reform Act of 1986, depreciation deductions still provide some "shelter" in that they are non-cash deductions that reduce taxable income. Interest deductions on the mortgage also serve to reduce an in a sense shelter taxable income.
7.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.
11. 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.
1.What is financial leverage? Why is a one-year measure of return on investment inadequate in determining whether positive or negative financial leverage exists?
•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 if leverage is positive or negative, the investor needs to determine whether the IRR 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.
12. What is the traditional cash equivalency approach to determine how below-market rate loans affect value?
•Cash equivalency was demonstrated that a buyer would be willing to pay more for a property with a below market interest rate loan. 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.
13.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 IRR 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 IRR is at least as much as it would be with the market interest rate loan.
5.Why should investors be concerned about market rents if they are purchasing a property subject to leases?
•Even if the investment is an existing building that has already been leased, the income can be affected when the existing leases expire and are renewed at the market rent at the time
2.What factors affect a property's projected NOI?
•Expected market rents and vacancy rates, expenses associated with operating the property, and nature of any leases on the property
3.What factors would result in a property increasing in value over a holding period?
•Inflation- this causes rents as well as the final sale to be higher •Demand- increased demand for space many increase value if the supply of space doesn't increase as well
8.What is the significance of a debt coverage ratio?
•It is a ratio of the NOI to the mortgage payment that indicates the riskiness of a loan. It is the degree to which the NOI from the property is expected to exceed the mortgage payment. Lenders typically want a debt coverage ratio to be at least 1.2.
4.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.
1.What are the primary benefits from investing in real estate income property?
•Net Income- dollars left over after collecting rent and parking expenses but before considering taxes and financing costs •Property sale- expecting a price increase over a specified holding period increases investor return •Diversification- reduces overall risk to hold many types of investments •Taxes- preferential tax benefits. Taxable income is often less than before-tax cash flow
10.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.
2.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.
13.What is the significance of the passive activity loss limitation (PAL) rules for real estate investors?
•The PALL rules are important because passive losses cannot be used to offset income from another category. Because any tax loss from real estate is usually considered a passive loss, it can be used to offset income from other sources such as active income from salaries and wages or portfolio income from interest or dividends.
7.What are the similarities and differences between an overall rate and an equity dividend rate?
•The difference is that the overall rate relates the entire NOI to the value of the property. The equity dividend rate relates the BTCF in the first year to the initial equity investment. The similarity is that neither one of these is a measure of investment yield because they do not take into account future income from operations or resale of the property at the end of the holding period. Both are based on a single year
10.How is the gain from the sale of real estate taxed?
•The entire taxable gain from sale of real estate is taxed at the same rate as ordinary income. It's important to keep track of capital gains and losses and ordinary income gains/losses. This is due to TRA rules for passive investors and properties acquired prior to 1986.
6.What is meant by equity?
•The investor's initial equity in the project is equal to the purchase price less the amount borrowed. The amount of equity an investor has in a property may change over time if the property value and loan balance changes. If the property value increases and the loan balance is reduced through amortization, the investor's equity increases
9.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.
4.How do you think expense stops and CPI adjustments in leases affect the riskiness of the lease from the lessor's point of view?
•There is less risk for the lessor with expense stops and CPI adjustments in leases •CPI adjustments- the risk of unexpected inflation is shifted to the lessee •Expense stops- the risk of increases in expenses is shifted to the lessee while allowing the lessor to retain the benefit of any decrease in expenses
6.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.
3.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.
12.Do you think taxes affect the value of real estate versus other investments?
•Yes. Not all investments are treated alike when it comes to federal income taxes. So taxes must be considered when comparing returns for investments which are not taxed in the same manner. Investments that have the same before-tax return may have different after-tax returns.
