Chapter 14 focuses on why you might borrow. The chapter notes four reasons:
- You do not have sufficient cash to cover the full cost of purchasing or developing the asset.
- To diversify your investments (i.e., you do not want to commit a significant portion of your capital to just one investment).
- To enjoy the tax shield that interest provides.
- To enhance your equity returns.
While debt can be your friend in a rising market, you must remember that it substantially increases the investment risk for the equity holder. How much you should borrow depends on your needs, risk profile, and tax status.
U.S. commercial real estate mortgages are held overwhelmingly by banks (60%), followed by insurance companies, asset-backed securities issuers, and finance companies (a combined 28%), mortgage REITs (7%), and pension and retirement funds and others (6%).
Debt capital is inextricably linked to equity and property values. Senior debt is typically 60%-70% of the capital structure of a real estate transaction. There is a self-reinforcing mechanism between senior mortgage LTVs and property values, wherein LTVs rise along with property value and fall when property values fall.
Positive leverage means that the property cash flow yield (NOI after standard reserves) is greater than the interest rate paid to the lender. Negative leverage means that the property cash flow yield is less than the interest rate paid to the lender.
In Japan from 1997 to 2007, investors enjoyed positive leverage despite declining property values. Specifically, there was a big enough spread between financing costs and unlevered yields (i.e., large cash-on-cash returns) to enable investors to make money, even while their equity value was cut in half (property values declined by approximately 10%) during their hold period.
Mezzanine debt is any type of junior debt, whether holding the second, seventh, or other unsecured position. Mezzanine financing can also manifest as preferred equity, where you have specified rights above common equity but below senior debt. Additionally, mezzanine can be convertible debt where you hold debt but have the right to convert into common equity at specific terms. Mezzanine can also take the form of participating debt, where you receive an interest payment each year and also participate in any property income above a specified level. Simply put, mezzanine financing can be anything that is senior to the equity but junior to the most senior debt.
These are the types of questions you’ll be able to answer after studying the full chapter.
1. Why would someone choose to use debt?
2. What do positive and negative leverage mean?
3. How can someone earn a profit with debt financing when the value of their underlying asset is decreasing significantly?
4. What is mezzanine financing?
5. If you acquire a property for $10 million at an 8% cap rate and are able to finance 70% loan-to-value at 6% interest-only, what is your cash-on-cash return?
6. You just acquired a $200 million office building. What is your weighted average cost of debt financing if you take out a mortgage at 70% loan-to-value at 5.5% and a mezzanine loan at 10% that brings your loan-to-value up to 85%?
The two types of debt-related risk
Good debt underwriting
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The use of one or more layers of debt financing in a real estate transaction.
The mix of debt and equity that comprise a real estate transaction.
The return you earn as the building’s value increases (or decreases).
The return earned from the cash flows generated by the property, net of any debt service.
The annualized compounded rate of return earned on an investment.
When the annual property cash flow yield % (NOI after normal reserves / Purchase Price) is higher than the annual interest rate paid to the lender.
When the annual property cash flow yield % (NOI after normal reserves / Purchase Price) is lower than the annual interest rate paid to the lender.
Annual cash flow after debt service divided by cumulative equity investment.
The expected average annual cash-on-cash yield plus the expected annualized capital appreciation.
All types of financing that are not secured by the real estate.
Debt holding the second, seventh, or another unsecured position.
Equity with specified rights above common equity, but below senior debt.
Debt that has the right to convert into common equity at specific terms.
Debt that receives an interest payment each year and also participates in any property income above a specified level.
A property’s blended cost of capital across all equity and debt components.
- Sources of Debt Capital
- The Four Reasons to Use Debt in a Transaction
- Do Not Have Enough Money
- Interest Tax Shield
- Enhanced Equity Returns
- Capital Appreciation
- Cash Flow Return
- Positive Leverage
- Negative Leverage
- Japan and Positive Leverage
- How Much Should You Borrow?
- Mezzanine Finance
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