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MIT 11 431J - Lecture Notes

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“Capital Structure”= How investment (asset ownership) is financed . . .= Use of debt vs equity (how much of each) as sources of financial capital.Traditionally this question has focused on publicly-traded corporations, but…• Much real estate investment is made more directly, not through publicly-traded companies.• Much real estate investment is financed at the project level (individual assets are financed directly).• Real estate assets trade directly, and are relatively simple, transparent cash generators.15.1 Debt When There is an Equity Capital ConstraintIn theory, publicly-traded corporations never face an equity capital constraint (if the stock market is efficient). Whenever they face a positive-NPV investment opportunity, they can simply issue new stock to obtain equity financing.This is not the case for private companies or individuals.Nor for tax-exempt institutions such as pension funds.In real estate investment, debt finance can be useful simply as a NECESSARY source of capital if you face an equity constraint, and:1. You face a positive (or at least non-negative) NPV opportunity (at least from IV perspective), or2. You seek more diversification across properties than your equity alone can allow, given the size of properties and the amount of your equity.A particular point for small-scale individual entrepreneurs:Use debt financing to leverage your “human capital” (as well as your financial capital:• Your skill and talent and knowledge enable you to successfully manage income property.• This enables you to earn “wages” or “profits” effectively as a “property manager” or “asset manager”.• The more properties you own, the more you can guarantee yourself a job managing, hence, the more earnings you can make on your managerial human capital.• Use of debt allows you to own more properties, to extend your human capital earnings.(How else could you possibly cash in on such human capital without taking on the financial investment role as well?...)How would the leveraging of human capital show up in the quantitative DCF and NPV mechanics we described in previous chapters? . . .• Define multiple “profit centers” for the firm, some of which derive from operations as distinct from passive investment. • “Operating expenses” that are pure cash outflows from the investment perspective, may contain an element of profit from the operational perspective. Thus, a deal contains more than one source of value:• NPV from the pure investment perspective (return on financial capital).• NPV from operational profit centers (return on human capital).• Together the two (or more) NPVs above equal the total NPV of the deal from the firm’s (or individual’s) particular IV (“investment value”) perspective (see Ch.12).15.1.3: Beware: constraints on equity capital availability may not be as great or as binding as you first might think. There are lots of ways to “joint venture” in real estate deals.3. Leverage as a "disciplinary tool" to "incentivize" good mgt: - Real estate physical assets are "easy to manage, not much risk or excitement or growth potential in bricks & mortar" (e.g., compared to high-tech industries, world trade, etc). - With not much downside and not much upside, managers may tend to get "lazy", letting value-enhancing possibilities pass them by unnoticed. - With sufficient leverage, real estate becomes a high-risk, high-growth investment, making it sufficiently "exciting" to attract good mgrs, giving mgrs sufficient incentive to max value. - This argument not based on a capital constraint or capital mkt failure for small investors, and so this argument for debt financing applies not only to small individual investors but to large insts & REITs. 15.2.1Debt as an Incentive and Disciplinary Tool for Management15.2.2Debt and Liquidity1. Leverage reduces the equity investor's "liquidity": - "Liquidity" = Ability to quickly obtain "full value" as cash. - Underlying (physical) R.E. assets are illiquid. - By not borrowing to the hilt, you can obtain cash by mortgaging the prop. (i.e., if you don't borrow now, you can borrow later), thereby reducing the illiquidity problem of real estate investment.- Liq. valuable because it gives the investor flexibility, provides options: Pounce on pos.-NPV opportunities; Avoid being foreced into neg.-NPV deals. - Liq. Allows you to use the R.E. cycle to your advantage instead of being a victim of it. (More important in R.E. than stocks due to lack of info.effic. in R.E. mkts.2. The "Cost of Financial Distress" (COFD): - (See Brealey-Myers Ch.18.) - Bankruptcy or foreclosure has large "deadweight costs". - Also “agency costs”: High L / V ratio Î Conflict of interest betw equity owner vs debtholder. Can cause prop.owner to act suboptimally (e.g.: avoid CI, pad expenses, high-stakes “repositioning” of rent roll, exercise mortgagor’s “put”): "moral hazard". - Mere probability of these costs (deadweight, agency) reduces value of prop. if L / V too high (even though L / V still < 1). - Thus, optimal L / V always < 1. However,… - The "easy management", low risk nature of R.E., & transparency (relatively easy for outsider to detect poor mgt, in part via ability to observe prop.val. in asset mkt) Î COFD does not “kick in” for R.E. until higher L / V ratio than for other types of investments (e.g., typical stock) 15.2.3Cost of Financial DistressExhibit 15-1: Cost of Financial DistressV-COFDPropertyPropertyIndustrial firmLTVEffect of Expected Costs of Financial Distress (COFD) on theValue of the Firm and on Property ValueImage by MIT OCW.2. Inflation: - "The more you borrow, the more money you make just from inflation!" - Do borrowers know more about inflation than lenders? . . . - Inflation is only the borrower’s friend ex post. - Ex ante (which is when it matters for leverage decision) the inflation argument is a fallacy. No positive NPV to borrower in loan transaction due to inflation. However, fixed-rate debt leverage makes equity position more of an "inflation hedge". 15.2.4Debt and InflationExhibit 15-2: Example of effect of inflation on ex-post levered equity appreciation returns with 1-year loan...Scenario: Ex Post- Ex Ante Ex Post+ Inflation: 0% 2% 4% Values*... Property: Yr.0 $100 $100 $100 Yr.1 $99 $101 $103 Debt Balance Payable: Yr.0 $60 $60 $60 Yr.1 $60 $60 $60 Levered Equity: Yr.0 $40 $40 $40 Yr.1 $39 $41 $43


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MIT 11 431J - Lecture Notes

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