Question 1

A loan in which the lender receives part of the proceeds from the sale of the property is known as a convertible loan.

Accepted Answer

A loan in which the lender receives part of the proceeds from the sale of the property is known as an equity loan or a shared appreciation loan, not a convertible loan.

Question 2

The loan alternative with the highest ATIRR will always be preferable to the borrower.

Accepted Answer

The loan with the highest Adjusted Total Internal Rate of Return (ATIRR) might not always be preferable to the borrower because it does not account for other factors such as loan terms, risk, or the borrower's specific financial situation and needs.

Question 3

When constructing a convertible mortgage, the lender will require a contract interest rate equal to or greater than the market rate on a similar mortgage without conversion option.

Accepted Answer

False

Question 4

If a property has positive leverage, the owner should borrow as much as possible.

Accepted Answer

Positive leverage indicates that the return on investment from borrowed funds exceeds the cost of borrowing, but borrowing as much as possible can increase risk significantly, including the risk of default or negative cash flow situations. It's important to balance leverage with risk management.

Question 5

Everything else equal, the loan balance on a negative amortization loan will be less than that on an interest-only loan after the first year.

Accepted Answer

The loan balance on a negative amortization loan actually increases in the first year due to the deferred interest. In contrast, the loan balance on an interest-only loan remains the same as payments only cover the interest. Therefore, after the first year, the loan balance on an interest-only loan will be greater than that on a negative amortization loan.

Question 6

A lender requires a 1.20 debt coverage ratio as a minimum. If the net operating income of a property is $60,000, what is the maximum amount of debt service the lender would allow?
A) $30,000
B) $50,000
C) $60,000
D) $72,000

Accepted Answer

The maximum amount of debt service the lender would allow can be calculated by dividing the net operating income by the debt coverage ratio:

Maximum debt service = Net operating income / Debt coverage ratio
Maximum debt service = $60,000 / 1.20
Maximum debt service = $50,000

Therefore, the maximum amount of debt service the lender would allow is $50,000, which is answer choice B.

Question 7

One benefit of leverage is that it reduces the variation in returns or losses.

Accepted Answer

Leverage actually increases the variation in returns or losses because it amplifies the effects of gains and losses in the underlying asset.

Question 8

Under which conditions would one be MOST LIKELY to see an interest rate swap?
A) A borrower wants a fixed rate loan, but the bank only offers floating rate loans; the borrower "swaps" loans with someone who has a fixed rate loan
B) A borrower does not have enough equity for a conforming loan, so he or she takes out a "second" mortgage loan
C) A borrower does not have enough equity for a conforming loan, so he or she "swaps" mortgage insurance for increased equity investment
D) A bankruptcy court orders a lender to "swap" a debtors high interest rate for a lower interest rate

Accepted Answer

An interest rate swap involves two parties exchanging their existing interest rate payments. In this scenario, the borrower wants a fixed rate loan but the bank only offers a floating rate loan, which means the borrower would prefer to swap their floating rate loan with someone who has a fixed rate loan. Therefore, option A is the most likely scenario to see an interest rate swap. The other options do not involve an interest rate swap.

Question 9

An interest only loan will provide a higher debt coverage ratio than an amortizing loan with the same interest rate.

Accepted Answer

Since an interest-only loan only requires the borrower to pay the interest on the loan while the principal remains the same, the monthly payment will be lower than an amortizing loan. This lower payment will result in a higher debt coverage ratio. However, it is important to note that an interest-only loan carries more risk as the borrower could end up owing more than the initial loan amount if the principal is not paid off over time.

Question 10

All other things being equal, which of the following best describes the effects of leverage on an investment's risk-return characteristics assuming the expected return is greater than the lending rate)?
A) Lower expected return, lower risk
B) Lower expected return, higher risk
C) Higher average return, higher risk
D) Higher average return, lower risk
E) Risk-return characteristics have no role in investment decision making

Accepted Answer

Leverage amplifies both potential returns and potential risks because it involves borrowing money to invest, aiming to earn more than the cost of borrowing. If the expected return is greater than the lending rate, leverage can lead to a higher average return but also increases the risk, as both gains and losses are magnified.

Question 11

In an inflationary environment where property values are also rising, a participation loan may provide a lender with some protection against unanticipated inflation.

Accepted Answer

Inflation typically leads to an increase in property values, which means that the collateral securing a participation loan becomes more valuable. This provides the lender with greater protection in the event of default, as the property can be sold for a higher price to recover any losses. Therefore, a participation loan can offer some protection against inflation.

Question 12

One advantage of a sale-leaseback is that the lease payments are 100 percent tax deductible.

Accepted Answer

Sale-leaseback transactions allow the owner to continue using the property while generating cash through the lease payments. One advantage is that the lease payments are typically 100 percent tax deductible, providing a tax benefit for the owner.

Question 13

To determine whether leverage is positive or negative, the investor needs to determine whether the IRR is greater than market rate of interest on mortgage loans.

Accepted Answer

The answer of To determine whether leverage is positive or...

Question 14

One advantage of using leverage is that NOI increases with higher amounts of leverage.

Accepted Answer

Leverage does not inherently increase Net Operating Income (NOI); it affects the return on equity and the cost of financing. NOI is determined by the property's income and operating expenses, independent of financing structure.

Question 15

Properties with a higher ratio of debt are considered to also have a higher risk assuming everything else is equal.

Accepted Answer

Properties with higher debt ratios are considered to have higher financial leverage, which in turn increases their risk profile. This is because a higher proportion of debt means a higher financial burden in terms of interest payments and principal repayment, which can become difficult to manage in economic downturns or when property values decline. Additionally, a high debt ratio can limit a property's ability to obtain financing for future projects or refinancing, further adding to its risk.

Question 16

One benefit of leverage is that it allows investors diversify across several investments

Accepted Answer

Leverage enables investors to use borrowed funds to increase their investment capacity, allowing them to spread their capital across multiple investments and reduce risk through diversification.

Question 17

If a property owner borrows money at a rate that is higher than the equity yield rate, negative leverage exists.

Accepted Answer

Negative leverage occurs when the cost of borrowing is higher than the return on the investment, which means the property owner is losing money on the investment.

Question 18

When the internal rate of return on an investment increases as the loan-to-value ratio increases, positive leverage exists.

Accepted Answer

Positive leverage occurs when the return on an investment increases as the amount of debt used to finance the investment (loan-to-value ratio) increases. Therefore, if the internal rate of return increases as the loan-to-value ratio increases, it indicates positive leverage.

Question 19

Financial leverage is defined as the 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.

Accepted Answer

Financial leverage occurs when an investor uses borrowed funds to increase the potential return on investment, benefiting from the difference between the borrowing cost and the investment return.

Question 20

An investment has the following characteristics: ATIRR_P: After-tax IRR on total investment in the property: 9.0% BTIRR_E: Before-tax IRR on equity invested: 17% BTIRR_P: Before-tax IRR on total investment in the property: 12% T: Marginal tax rate: 0.40 What would be the break-even interest rate BEIR), at which the use of leverage neither favorable nor unfavorable? A) 15.0% B) 20.0% C) 22.5% D) 28.3%

Accepted Answer

The break-even interest rate (BEIR) is the rate at which the before-tax IRR on equity (BTIRR_E) equals the after-tax IRR on the property (ATIRR_P). Here, the BEIR is calculated as BTIRR_P + (BTIRR_E - ATIRR_P) * (1 - T) = 12% + (17% - 9%) * (1 - 0.40) = 15%.

Quiz 12: Financial Leverage and Financing Alternatives