Debt Service

Two otherwise similar real estate programs acquire the same type of property with the same projected income. Program E finances its acquisitions with substantially more debt relative to the property's value than Program F. All else equal, how does this difference in leverage affect the risk profile of the two programs' returns to equity investors?

1. A.Leverage has no effect on risk to equity investors, since both programs project the same income from the underlying propertyWrong. Leverage magnifies the volatility of equity returns even when the underlying property income projection is identical.
2. B.Program E's higher leverage makes its equity returns less volatile, since more of the property's value is financed by lenders rather than investor capitalWrong. This inverts the relationship -- higher leverage makes equity returns more volatile, not less.
3. C.Leverage affects only the tax character of returns to investors, not the risk or volatility of the returns themselvesWrong. Leverage directly affects the risk and volatility of equity returns, not just their tax character.
4. D.Program E's higher leverage generally makes its equity returns more volatile than Program F's, since a larger share of property income must first cover debt service before anything reaches investorsCorrect. Higher leverage magnifies the volatility of equity returns because debt service is a fixed prior claim on property income.

Why: Higher leverage generally makes equity returns more volatile, since a larger share of property income must first cover debt service before anything reaches investors.

A sponsor acquires a suburban office building already leased to established tenants and expects to distribute cash to investors in the first year. Which pairing of benefit and typical risk fits this program?

1. A.Appreciation once construction completes, with the risk that projected rents are never realizedWrong. This fits a program that has still to build, whose rents are a forecast rather than a signed lease.
2. B.In-place leases producing net operating income, with the risk that falling occupancy leaves debt service uncoveredCorrect. Existing leases produce income at once, and the paired risk runs through occupancy to the debt payment.
3. C.Credits that offset tax liability directly, with the risk that a subsidy is curtailedWrong. Credits and subsidies belong to affordable housing, not to a market-rate leased office building.
4. D.Appreciation on resale, with the risk that carrying costs accrue while nothing is producedWrong. That profile describes an undeveloped holding, which is the opposite of a fully leased building.

Why: An operating-property program buys real estate that is already generating income under existing leases, so net operating income and cash distributions begin at acquisition rather than years later. The outline pairs that benefit with the risks that occupancy or rental rates decline, that maintenance and replacement costs rise, and that the resulting net operating income proves insufficient to cover debt service. Because the leases are contracts already in force, near-term revenue is far more predictable than in a program that must still build and lease. Had the sponsor bought vacant acreage instead, the benefit would be appreciation on eventual resale and the characteristic risk would be carrying costs accruing with no cash coming in.

When analyzing a municipal REVENUE bond, the most important measure of the issuer's ability to pay debt service is:

1. A.The municipality's population growthWrong. Demographics inform GO analysis; coverage is the direct revenue-bond test.
2. B.The debt service coverage ratioCorrect. Coverage of debt service by net revenues drives revenue-bond credit.
3. C.Assessed valuation of taxable propertyWrong. Property values support GENERAL OBLIGATION bonds.
4. D.The state's overall credit ratingWrong. Revenue bonds are typically self-supporting and analyzed on project economics.

Why: Revenue bonds are secured by project revenues, so the debt service coverage ratio, net revenue available divided by annual debt service, is the key credit metric; general obligation analysis focuses on the tax base. Citation: standard municipal credit analysis, MSRB/Series 7 outline. Takeaway: revenue bond = coverage ratio; GO = tax base.

The Harrow Valley Sewer Authority indenture pledges NET revenues. In what order does the trustee apply the gross revenues collected each month under the flow of funds?

1. A.Debt service, then operation and maintenance, then reserves, then surplusThis is the gross revenue pledge ordering. Under a net pledge the facility must be operated and maintained before bondholders are paid.
2. B.Operation and maintenance, then debt service, then the debt service reserve, then surplusA net revenue pledge deducts operating and maintenance costs from gross revenues first, and debt service is paid out of the net figure that remains.
3. C.The debt service reserve fund, then debt service, then operation and maintenanceThe reserve is a cushion funded after current debt service is satisfied, not a first claim on revenues.
4. D.Renewal and replacement, then operation and maintenance, then debt serviceRenewal and replacement sits below debt service in the waterfall; it funds future capital needs only after current obligations are covered.

Why: A net revenue pledge means bondholders are paid from what remains after the system is run. The flow of funds therefore takes gross revenues into the revenue fund, pays operation and maintenance expenses first, then debt service, then the debt service reserve, then renewal and replacement, with anything left over going to surplus. Only a GROSS revenue pledge reverses the first two steps.