Chapter 4 HOW LEVERAGE AFFECTS RISK AND THE VALUE OF REAL ESTATE Flashcards
1
Q
What is leverage?
A
A measure of the positive or negative benefits of financing obtained in relation to interest gained and interest lost through debt payments.
2
Q
What are the two forms of leverage?
A
- Positive leverage
- Negative leverage
3
Q
Define positive leverage.
A
Occurs when borrowing money at a lower interest rate than the return earned on the cash that would otherwise be invested.
4
Q
How is cash flow affected by positive leverage?
A
Cash flow is reduced by the cost of debt, but the return on invested cash increases.
5
Q
What is the effect of negative leverage?
A
Occurs when borrowing costs exceed the returns from the investment, reducing the overall yield.
6
Q
What happens to cash flow in a negative leverage scenario?
A
Cash flow decreases significantly, leading to a lower return on investment.
7
Q
What can increase the value of a property in a positive leverage situation?
A
Higher net operating income (NOI) or reduced expenses.
8
Q
What role does risk play in leverage?
A
Risk is inherent in all investments and affects buyers, lenders, and sellers differently.
9
Q
True or False: A higher loan-to-value ratio is always considered high risk.
A
False
10
Q
What is the loan-to-value ratio?
A
The ratio of a loan to the value of an asset purchased.
11
Q
In Example 1, what financing structure does Winkle use?
A
A combination of a first mortgage and a seller-held second mortgage.
12
Q
What is a potential risk for lenders in Winkle’s transaction?
A
The total financing equals a 100 percent loan-to-value ratio, increasing repayment risk.
13
Q
How can Winkle improve his financing situation?
A
By providing additional security to the seller, such as a first mortgage on another property.
14
Q
What is the significance of the buyer’s equity in a transaction?
A
It helps lenders assess the risk associated with the loan.
15
Q
What can be a consequence of management issues in real estate investments?
A
Inability to properly assess investment needs can lead to failure in achieving projected results.
16
Q
Fill in the blank: Leverage can increase the _______ on cash invested.
A
[yield]
17
Q
What does effective management in real estate investment help mitigate?
A
It helps buffer the loss of capital and manage investment risks.
18
Q
What is a common misconception about high leverage?
A
That it always equates to high risk.
19
Q
What can be a benefit of using multiple forms of debt?
A
It can create a mix of positive and negative leverage.
20
Q
What happens if an investor successfully increases rents?
A
It can turn a negative leverage situation into a positive leverage situation.
21
Q
What is the relationship between interest rates and cash flow in positive leverage?
A
Lower interest rates compared to returns increase cash flow.
22
Q
Why might a seller hold a second mortgage?
A
To improve their position in a deal when the buyer’s financing is risky.
23
Q
What common misconception do investors have about leverage?
A
Investors often relate high loan-to-value ratios to high risk, believing that greater leverage equates to greater risk.
24
Q
How can leverage reduce risk according to the text?
A
If financing is used to its maximum benefit, greater leverage can actually lower the risk.
25
What is desirable leverage?
Desirable leverage results from borrowing money at a constant rate lower than the net operating income rate generated by the property.
26
What is the effect of not having an income-producing property on leverage?
The benefit or disadvantage of leverage can still be applied if the property is appreciating in value.
27
What is an example of positive leverage?
Borrowing $380,000 at 10 percent to purchase a property yielding $44,000 annually, resulting in a return increase from 11 percent to 30 percent.
28
What happens to cash yield when financing is introduced?
The cash yield on cash invested can increase due to the effect of financing.
29
What is the cash yield on cash invested when $200,000 is put down on a property with a $27,760 cash flow?
13.88 percent.
30
What is overleverage?
Overleverage occurs when too much is borrowed, leading to thin cash flow margins that can create negative cash flow with vacancies.
31
True or False: Negative leverage can accelerate losses in an investment.
True.
32
What should be the goal when using leverage?
Use the highest leverage that allows you to meet your goals while keeping financial obligations within control.
33
What is the constant rate in relation to mortgages?
The constant rate refers to the combined principal and interest payments of total mortgages, fixed at the time of the mortgage.
34
How is the constant rate calculated?
By dividing the total annual payment by the amount of principal owed.
35
What factors affect constant rates in loans?
Time and interest rates.
36
What is appreciation in real estate?
Appreciation is the increase in the value of a property over a period of time.
37
What happens to appreciation if financing tools reduce cash flow yield?
The appreciation of the property would be slowed or eliminated.
38
What is equity buildup?
Equity buildup is the gradual payoff of the principal owed on the debt against the property.
39
What type of mortgage has no equity buildup?
An interest-only mortgage.
40
What can excessive constant rates lead to when refinancing?
They may not be worth the loss of cash flow despite attractive interest rates.
41
Fill in the blank: The cash flow generated by income-producing properties is generally the _______ used to value them.
safest guide.
42
What is the relationship between cash flow and market value?
Cash flow is generally the safest guide to market value for income-producing properties.
43
What is the risk of a high negative leverage situation?
It can result in significant financial strain if rental income does not meet expectations.
44
What is the significance of the relationship between cash flow and financing in real estate?
It affects overall investment yield and property valuation.
45
What is appreciation in real estate investment?
Appreciation is the increase in the value of a property over time
46
Define equity buildup in the context of real estate.
Equity buildup refers to the gradual increase in ownership of a property as the principal on the debt is paid down
47
What happens with an interest-only mortgage regarding equity?
An interest-only mortgage has no principal payback, resulting in no equity buildup
48
What is a negative payment mortgage?
A negative payment mortgage occurs when the monthly payment does not cover the interest due, increasing the principal owed
49
What do many investors desire regarding cash flow?
Many investors desire positive cash flow from their real estate investments
50
True or False: A low interest rate can sometimes sacrifice cash flow for greater yields later.
True
51
What do some investors prioritize over immediate cash flow?
Some investors prioritize greater tax credits over immediate cash flow
52
How can the maximum use of investment funds be achieved?
By obtaining the highest mortgage possible and investing the least cash
53
What is a potential risk of investing on a shoestring?
Great fortunes can be made and lost when investing with minimal cash
54
What should you avoid when assessing a deal's viability?
Overworking a transaction to justify an investment
55
What is the importance of effective due diligence?
Effective due diligence provides reliable economic figures for a transaction
56
What is a common characteristic of real estate investments?
Real estate is often viewed as secure collateral for mortgage financing
57
What can cause distortions in the real estate market?
A flushed banking system with excess cash can lead to distortions
58
What is the term used for excessive borrowing beyond repayment ability?
Overextension
59
What is one guideline to avoid overextension?
Invest within your comfort zone
60
Fill in the blank: A key factor in preventing overextension is ensuring the investment moves you closer to your _______.
[goals]
61
List three factors that can affect property value.
* Inflation
* Improved infrastructure
* Supply and demand
62
What are the eight reasons property values increase?
* Inflation
* Improved infrastructure
* Government control and regulation changes
* Neighborhood sizzle
* Economic conversion
* Increased bottom line
* Capital improvements
* Supply and demand
63
What is the impact of inflation on real estate values?
Inflation increases the monetary value of a property due to declining buying power and increased cost of living
64
How did Frank York's investment demonstrate the effects of inflation?
His property value increased significantly while he benefited from rent increases, resulting in high yield
65
What role does improved infrastructure play in property value?
Improved infrastructure can predictably increase property value, though not all changes are beneficial
66
What is the effect of improved infrastructure on real property value?
Changes in infrastructure can produce predictable effects on the value of real property, which may not always be beneficial.
## Footnote
Infrastructure includes elements like roads, bridges, hospitals, and schools.
67
What are some components of community infrastructure?
* Roads
* Bridges
* Hospitals
* Water systems
* Schools
## Footnote
These components can be publicly or privately financed.
68
What is a potential negative impact of construction on property values?
Construction can cause major disruption, leading to decreased property values in the short term.
## Footnote
Issues may include noise, detours, and dust.
69
What is voluntary economic conversion?
Voluntary economic conversion occurs when an owner actively changes the use of a property, such as converting a home into offices.
## Footnote
This differs from involuntary conversion, which may occur due to government actions.
70
What is the best immediate real estate investment strategy?
Voluntary economic conversion is often considered the best immediate real estate investment strategy.
## Footnote
It allows investors to act based on current facts rather than future uncertainties.
71
What are steps necessary to increase cash flow in a property?
* Increase collected revenue
* Reduce operating expenses
* Reduce fixed expenses
* Reduce cash invested
## Footnote
These steps can be combined or acted on individually.
72
How can landlords increase collected revenue?
* Increase monthly rent
* Increase occupancy
* Introduce added income
* Enforce rent penalties
## Footnote
Examples of added income include fees for pets or extra services.
73
What is a way to reduce operating expenses for a property?
Get competitive prices from different service providers.
## Footnote
This helps in managing costs effectively.
74
What is the impact of capital improvements on property value?
Capital improvements can increase property value, especially if they enhance revenue potential.
## Footnote
Examples include landscaping and maintenance upgrades.
75
What does supply and demand indicate about property value?
Limited supply with high demand increases property value, while high supply with low demand decreases it.
## Footnote
This is fundamental economic principle affecting real estate.
76
What is neighborhood sizzle?
Neighborhood sizzle refers to areas with higher real estate values due to community improvements and pride in maintenance.
## Footnote
Factors include crime watch and community commitment.
77
True or False: Government control and regulation changes can lead to sudden increases in property value.
True
## Footnote
Positive changes can enhance community investment and create job opportunities.
78
What should real estate investors monitor regarding local government?
Investors should assess whether local government is friendly toward new investment or anti-growth.
## Footnote
Changes in government can significantly affect property value.
79
Fill in the blank: Economic conversion occurs when there is a _______ in the use of a property.
[change]
## Footnote
This can be voluntary or involuntary.
80
What is the relationship between cash flow and property value?
Higher cash flow generally increases the value of a property.
## Footnote
Cash on cash yield is a crucial metric for investors.
81
What role does preventative maintenance play in managing property value?
Preventative maintenance can reduce major repair costs and extend the life of property systems.
## Footnote
This leads to better management of operating expenses.
82
What is a common strategy for reducing fixed expenses?
Appeal for a reduction in real estate tax assessments.
## Footnote
Hiring specialists can help in negotiating tax reductions.
83
What is a technique for reducing cash invested in a property?
Refinance the property to access tax-free cash.
## Footnote
This can double cash yield if cash investment is halved.
84
What should you have in mind before selling property?
A clear goal
## Footnote
A clear goal helps in evaluating alternatives and making informed decisions.
85
What is one potential goal when downsizing living accommodations?
To maintain or improve your present living standard while living within a fixed income
## Footnote
This goal involves balancing living standards with financial constraints.
86
What is a potential strategy for someone living in a large apartment?
Downsize to a smaller place
## Footnote
Downsizing can lead to reduced expenses and additional cash for investment.
87
What is a concern when trying to sell a large apartment?
Big apartments are very hard to sell and there are few buyers in the marketplace
## Footnote
Market conditions can significantly affect the sale of property.
88
What is important to focus on when selling a property?
Attaining your goal
## Footnote
The goal should drive the decision-making process rather than just selling the property.
89
What is one approach to strengthen annual income?
Look for an investment property
## Footnote
Investing in income-producing properties can provide additional cash flow.
90
How can equity in an apartment be utilized?
Incorporate the equity to purchase a new investment property
## Footnote
Using equity can leverage financial capacity for new investments.
91
What loan-to-value ratio is indicated if an apartment worth $800,000 is used for a $2,000,000 property purchase?
60 percent
## Footnote
A loan-to-value ratio of 60% indicates a conservative borrowing approach.
92
What might the net operating income (NOI) be for a $2,000,000 income-producing property?
$220,000
## Footnote
NOI is a key metric for assessing the profitability of a real estate investment.
93
What would be the total debt payment per year with a loan at a constant rate of 10 percent?
$120,000
## Footnote
This payment must be considered when evaluating cash flow from an investment property.
94
What cash flow would result from the scenario described?
$100,000
## Footnote
Positive cash flow can support further investments or personal expenses.
95
What is leverage in the context of real estate investment?
An opportunity to maximize benefits in buying property
## Footnote
Leverage can enhance investment potential but must be used wisely.
96
True or False: Leverage is a standalone solution to investment problems.
False
## Footnote
Leverage must align with overall investment goals and conditions.
