The impact of gearing on equity returns Flashcards
What is the gearing vs risk idea?
The more leverage / debt you have in your investment, the more exposed you are to risk but more opportunity for return
What is the effect of gearing in property returns?
Gearing may magnify investment returns
More gearing = high initial investment amount
If the market rises say 10%, you can gain more in your investor’s equity because you were able to achieve a higher equity payback amount with gearing, once the loan is paid back
BUT gearing may also magnify investment losses!
What is sensitivity analysis? How would you use it in terms of IRR and LTV?
A sensitivity analysis checks the impact of different variables on the IRR and LTV, such as the investment term and market rent, exit yields, vacant periods
I.e. how does a period of reduced market rent effect the IRR and NPV?
What is the cost of equity idea?
For you to take a risk you need to be compensated
What models can be used to measure the cost of equity?
CAPM
Implied Equity Return
Equity Risk Premium
How do you calculate the (private) cost of debt?
Private cost of debt = k(d) = interest costs / outstanding debt amount = weighted cost of % you are paying
What are some investor’s constraints?
Liquidity
Time horizon - is the investor close to retirement?
Investor expertise - expertise in certain asset classes (e.g. mobile homes)?
Investor size - relationship between single investment and entire investment wealth / portfolio
Capital constraint - how much money you can apport from outside investments
What are some key financial covenants ratios to consider with an investment?
Interest Coverage Ratio (ICR)
Debt Service Coverage Ratio (DSCR)
Loan To Value (LTV)
Debt yield
What is the Interest Coverage Ratio (ICR)?
ICR = an income-based risk measure and looks at un-geared net cash flow from project and compares with the amount of interest that is due in the period
In essence, ICR measures how many times over the project could pay its interest payment with available cash
What is the Debt Service Coverage Ratio (DSCR)?
DSCR = another income-based risk measure that looks at un-geared net cash flow from project and compares with amount of interest and amortisation due in the period
As with ICR, the DSCR measures how many times over (or under) the project could pay its total debt obligation with available cash
What is the Loan to Value (LTV)?
LTV = the ratio of debt / value of the property
At the start of the borrowing, this is the amount of debt divided by the purchase price of the property
What does k(e) represent in the Capital Asset Pricing Model (CAPM)?
k(e) = return on equity
What is the risk-free rate in the Capital Asset Pricing Model (CAPM)?
how much you can get if you invested elsewhere in another company / government bond (which is low risk)
What does Beta represent in the Capital Asset Pricing Model (CAPM)?
Beta = relationship between stock you are looking at and average market (FTSE EPRA = combines all real estate companies in one index), e.g. relationship between price of British Land and the market
What is the EPRA return in the Capital Asset Pricing Model (CAPM)?
Market return = EPRA return
