Thus far, our focus has been on analyzing a property without considering whether there would be debt financing on the property or it would be purchased on an all- cash basis. This is because the way a property is financed should not affect the property’s value. This does not mean that the overall level of interest rates and availability of debt in the market do not affect values. It means that, for a given property, the investor paying all cash should be paying the same price as one who decides to use some debt financing. Of course, investors who do use debt financing will normally expect to earn a higher rate of return on their equity investment. This is because they expect to earn a greater return on the property than what they will be paying the lender. Thus, there will be positive financial leverage. By borrowing money, the investor is taking
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on more risk in anticipation of a higher return on equity invested. The risk is higher because with debt there will be more uncertainty as to what return the investor will actually earn on equity because the investor gets what is left over after paying the lender. A small drop in property value can result in a large decrease in the investor’s return if a high amount of debt was used to finance the property. When a property is valued without explicitly considering financing, the discount rate can be thought of as a weighted average of the rate of return an equity investor would want and the interest rate on the debt.
The maximum amount of debt that an investor can obtain on commercial real estate is usually limited by either the ratio of the loan to the appraised value of the property (loan to value or LTV) or the debt service coverage ratio (DSCR), depending on which measure results in the lowest loan amount. The debt service coverage ratio is the ratio of the first- year NOI to the loan payment (referred to as debt service for commercial real estate). That is,
DSCR = NOI/Debt service
The debt service includes both interest and principal payments on the mortgage. The principal payments are the portion of the loan payment that amortizes the loan over the loan term. An “interest- only” loan would be one that has no principal payments, so the loan balance would remain constant over time. Interest- only loans typically either revert to amortizing loans at some point or have a specified maturity date.
For example, an interest- only loan might be made that requires the entire balance of the loan to be repaid after 7–10 years (referred to as a “balloon payment”). Lenders typically require a DSCR of 1.2 or greater to provide a margin of safety that the NOI from the property can cover the debt service.
EXAMPLE 30
Loans on Real Estate
A property has been appraised for $5 million and is expected to have NOI of
$400,000 in the first year. The lender is willing to make an interest- only loan at an 8 percent interest rate as long as the loan- to- value ratio does not exceed 80 percent and the DSCR is at least 1.25. The balance of the loan will be due after seven years. How much of a loan can be obtained?
Solution:
Based on the loan- to- value ratio, the loan would be 80 percent of $5 million or $4 million. With a DSCR of 1.25, the maximum debt service would be
$400,000/1.25 = $320,000. This amount is the mortgage payment that would result in a 1.25 DSCR for an interest- only loan.
If the loan is interest only, then we can obtain the loan amount by simply dividing the mortgage payment by the interest rate. Therefore, the loan amount would be $320,000/0.08 = $4,000,000.
In this case, we obtain the same loan amount based on either the LTV or DSCR requirements of the lender. If one ratio had resulted in a lower loan amount, that would normally be the maximum that could be borrowed.
When financing is used on a property, equity investors often look at their first- year return on equity or “equity dividend rate” as a measure of how much cash flow they are getting as a percentage of their equity investment. This is sometimes referred to as a “cash- on- cash” return because it measures how much cash they are receiving as a percentage of the cash equity they put into the investment.
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EXAMPLE 31
Equity Dividend Rate
Using the information in Example 30, what is the equity dividend rate or cash- on- cash return assuming the property is purchased at its appraised value?
Solution:
The first- year cash flow is the NOI less the mortgage payment.
NOI $400,000
DS $320,000
Cash flow $80,000
The amount of equity is the purchase price less the loan amount.
Price $5,000,000
Mortgage $4,000,000
Equity $1,000,000
The equity yield rate is the Cash flow/Equity = $80,000/$1,000,000 = 8%.
Keep in mind that this is not an IRR that would be earned over a holding period until the property is sold. The equity investor does not share any of the price appreciation in the value of the property with the lender.
For loans called “participation” loans, the lender might receive some of the price appreciation, but it would be in exchange for a lower interest rate on the loan.
EXAMPLE 32
Leveraged IRR
Refer to the previous examples 30 and 31. Suppose the property is sold for
$6 million after five years. What IRR will the equity investor receive on his or her investment?
Solution:
The cash flow received by the equity investor from the sale will be the sale price less the mortgage balance, or $6 million – $4 million = $2 million. Using a financial calculator,
PV = −$1,000,000 (using a calculator, this is input as a negative to indicate the negative cash flow at the beginning of the investment)
PMT = $80,000 n = 5
FV = $2,000,000 Solve for i = 21.14%
This is an IRR based on the equity invested in the property.
EXAMPLE 33
Unleveraged IRR
Refer to the previous examples 30, 31, and 32. What would the IRR be if the property were purchased on an all- cash basis (no loan)?
Solution:
Now the equity investor will receive all the cash flow from sale ($6 million) and the NOI ($400,000). The initial investment will be $5 million. Using a financial calculator,
PV = −$5,000,000 PMT = $400,000
n = 5
FV = $6,000,000 Solve for i = 11.20%
This is an IRR based on an unleveraged (all- cash) investment in the property.
The difference between this IRR (11.20 percent) and the IRR the equity investor receives with a loan calculated in Example 32 of 21.14 percent reflects positive financial leverage. The property earns 11.20 percent before adding a loan, and the loan is at 8 percent, so the investor is benefiting from the spread between 11.20 percent and 8 percent.