FINC 475 1nd EditionExam # 2 Study Guide Lectures: 13-15Lecture 13 (October 6)Chapter 7: Financial Leverage and Investment AnalysisWhat is the difference between debt and equity?Debt and equity together make up the total purchase price. Debt is borrowed money and equityis investment of personal capital. For a home, a down payment is usually equity. Nearly all real estate is financed by debt where loans are made in the primary market and debt is bought and sold in the secondary market. Financial leverage: Why is it so popular? How do you measure it? Financial leverage is popular because it is often used to borrow funds to amplify the outcome ofan equity investment. Also, a favorable spread, the difference between the rate of return on assets and cost of borrowing, magnifies return on equity of highly leveraged investment. Another reason for popularity is that federal income tax law creates major incentive to use financial leverage. There are two main ways to measure financial leverage, through two ratios: 1. Debt/equity ratio – ratio between borrowed funds and equity funds and 2. Loan/value ratio – ratio between borrowed funds and market value of asset being financed. What is the right amount of financial leverage?Lenders frequently express maximum amount of loan in terms of the minimum permissible debtcoverage ratio. Lenders specify a maximum permissible loan-to-value ratio. As more money is borrowed to finance an investment, the venture becomes increasingly risky. Increasing the amount of borrowed funds relative to equity funds drives up the cost of borrowing.Who are today’s lenders?Commercial banksLife insurance companiesPension fundsCommercial mortgage-backed securities: Conduit LoansDiscuss the difference between positive and negative leverage.Positive Leverage is when the rate of return on the asset is greater than the interest rate or the debt service constant. Negative Leverage is the reverse.Discuss the “constant”.The constant is the factor used to calculate the monthly installment or payment to fully amortize a loan. This constant adjusts with the rate or the term. Lecture 14 (October 8)Chapter 8: Credit Instruments and Borrowing ArrangementsWhat are the instruments for credit?1. Promissory notes2. Mortgages: Purchase-money, blanket, and open-ended3. Deed of trustDescribe the four primary types of loans.The first loan is a fixed rate loan where interest stays constant over the life of the loan. On the contrary, there are floating or (ARM) adjustable rate loans where rates change with short-term rates like Libor or Fed Funds. In these loans, the amortization time stays constant so the payment changes. The third type of loan is an amortizing loan where partial amortization resultsin a balloon payment. These loans are thirty years or less. On the contrary, there are interest only loans where, during the life of the loan, interest is paid and the original balance is due at the end.What are the most common loan forms?1. Maturity Date Fixed and Fully Amortizes: interest and payment are the same each month2. Bullet Loan (Partially Amortizing Loan): maturity is less than amortization period 3. Primary vs. Second Mortgages: Junior Liens aka subordinated loansWhat are the loans with equity participation?1. Fixed Rate Loans - no inflation protectionSometimes lenders want to share in profitability so they use “equity kickers”2. Shared Equity Participation Mortgage: if revenues or NOI exceed a base amount, the lender collects more interest3. Shared Appreciation Mortgage: lender participates in the increase in property valueList a few alternate financing strategies.Installment sales contracts, sale and leaseback, and junior mortgagesList and describe the mortgage loan types.Purchase Money Mortgage: used upon purchase of propertyBlanket Mortgage: lien is secured by more than one piece of real estateConstruction Loan: short-term loan only for the life of the construction periodOpen-End Mortgage: secures future loans as well as the current loan up to a maximum balanceSeller Financing: lender is actually the sellerRefinancing: further borrowing once you already own the propertyWraparound: refinancing used when you want to retain the existing financingList and describe a few government-sponsored credit & loans.There are state and local government private activity bonds as well as redevelopment bonds. Low-income housing qualifies for reduced interest rate from the Department of Housing and Urban Development of the government. There is also a form of municipal bonds, tax-exemptbonds. These have a reduced interest rate and are used when the government wants to encourage development, such as airports or utilities. Other government bonds include industrialrevenue bonds, municipal utility district bonds, and redevelopment bonds (the government will pledge the tax revenues to pay off loan).What is a foreclosure?A foreclosure is when the court must sell a property in order to satisfy an unpaid debt. For something to be considered a foreclosure, default must occur, especially payment on the note.Lecture 15 (October 22nd)Chapter 9: Cost of Borrowed MoneyWhat is the difference between the nominal rate, the effective rate, and the real rate of interest?The nominal rate is the interest rate based on face amount of promissory note, whereas the effective rate is the rate actually paid considering all the loan terms. The annual percentage rateis the actual rate paid by the borrower when points and fees are added in. The real rate is the nominal rate adjusted for price inflation.Why do effective interest rates differ?Effective interest rates differ because of differences in loan origination fees or discount fees.Describe points, buydown, and prepayment. Points are prepaid interest which is paid on the first date of the loan (each point is 1%). A buydown is when lenders are willing to lower the rate by the payment of points. A prepayment is an early payment and often lenders attach a prepayment penalty or extra fee. The extra money that would be paid to make the yield or NPV the same is called a make whole provision or a yield maintenance fee. What is a lockout period?A lockout period is a time within tenants may not prepay (e.g. 30 year loan pre-payable after 10 years). In commercial loans the use of yield maintenance is common.What is the formula for the debt coverage ratio, the loan to value ratio, and the formula for finding the loan amount?Debt Coverage Ratio: NOI/ADS (net