Loan 2 value ratio and its impact on risk for equity investors

Hi everyone,

EOC 19, Reading 50.


Right answer is C.

What does an equity investor’s risk has to do with Loan 2 value ratio? I don’t quite get it, maybe if he is long some REITs shares? Making his position an “equity position” since he has shares of a fund?

This may sound confusing but it is not:

Look at the equity holder to a real estate portfolio as somebody owning the company ( or part of it) as a call option holder, the strike price of which is the face value ( or the market value) of debt. The higher the debt proportion bigger is the strike price. Bigger is the strike price lesser is the probability the option will come into money.

In other words a levered structure puts unnecessary pressure on the equity holder to first service the debt and then encash it’s own yield.

Refer Modigliani and Miller proposition

Refer sub prime crisis of 2008. At $500 down payment a borrower could own a million dollar home. Somebody who could only put $500 how much pressure (s)he has subject (her) himself to meet the mortgage payment every month ?

And the only motivation is the value of the underlying property appreciates. If it does not or if (s) he loses the job what happens . He defaults, the property confiscated and the debt goes kaput. In other words both suffered

( Actually somebody else suffered a lot that time. But that let’s keep that story for some other time )

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Your breakeven point increases because you have higher interest payments. Your DOL increases as well.

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