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Sometimes when Rainmaker
gives a structured finance presentation or due diligence presentation on
behalf of a given client, the client gets lost in the jargon of the
industry. The purpose of this page is to better define these terms
for the benefit of clients and the public.
One of the most common terms is really a concept and not a term,
per se. Financial investment leverage is a three-part concept:
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How much financing are we talking
about?
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How much of the financing does the
client have to put up?
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How does this amount relate to the
rest of the capital funding plan structure?
To understand the term and the concept analyze a basic commercial
finance transaction. We'll use the classic multifamily
housing capital financing structure to illustrate our discussion.
Boudreaux is developing a $20,000,000 Class "B"
multifamily rental housing project. Boudreaux decides to go the
HUD route because, "HUD offers a 90% LTV ratio," and that
provides $18,000,000 of the $20,000,000 in financing. This means
Boudreaux only has to put in $2,000,000, right? Well, it doesn't
work out that way and the real amount Boudreaux has to put into the deal
is more like $3,000,000 because of the carrying costs and other HUD
requirements. At the $2 million level, he was getting the leverage
of 9:1 - every dollar he put up is being matched with $9 of bank
financing. When it went to $3 million, his leverage dropped to
5.6:1 - every dollar he put in only leveraged $5.6!
So, now that we know the terms of the deal, let's look into the
financial investment leverage. When the deal was first proposed,
the property was expected to throw off a net of about $350,000 per year
to Boudreaux's $2,000,000 investment; that works out to a cash-on-cash
return of 17.5% per annum. Not the highest, but not chump change
either. But in reality, a total of $3,000,000 in at-risk capital
actually went into the transaction and that changed the financial
investment leverage and the return. Now the cash-on-cash return is
only 11.67% per annum. Boudreaux could get the same leverage by
buying S&P depository receipts.
Financial investment leverage can be created using a whole host of
entitlements to further reduce the at-risk capital contributions the
developer would otherwise make. Suppose there was a tax credit
that ended up providing $1 million. Boudreaux's investment is back
to $2 million and the tax credit investor is getting his/her return
based on the tax credits. Boudreaux gets his original deal
back. That's how financial investment leverage can be modified to
help a developer achieve all the success they can stand.
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