Okay, so now if we’re going to do this in the real world, if CAG is going to do this in the real world, they’re going to get a loan. Anything that’s worth doing is worth levering so a loan is considered a form of financial leverage. Things to know about financial leverage in real estate or anywhere else throughout finance, leverage, taking out loans, having a contract saying you're going to get some money now with the contractual promise of paying it back with interest in the future that's always going to increase your risk of bankruptcy. It's going to reduce your flexibility a bit because you'll soon we're going to have to adhere to a very strict schedule. But it's going to increase our return on equity, our return on the amount of money that we as developers put into this project and it's going to enable increased diversification. If for example, CAG has 10 million available to spend, they could put all that 10 million into one project or they could put 1 million into each of ten projects and get loans to help develop the rest of it, so that would help them diversify. Okay, so very quickly, I just want to make sure we all understand the mechanics of Financial Leverage. So I'm going to pause at a situation like this where there are two groups of you in the audience, one group is a conservative group and one group is a bunch of cow boys. Each group gets $100 million, just thrown at them, $100 million. And they want to buy, let's consider a cashflow producing property, not just a little easier. They want to buy a cashflow producing property that is on the market for $100 million. So what are the conservatives going to do. They don't like the risk of bankruptcy, they want to be very careful, they're conservative. So what they're going to do, is they're going to buy this property with their $100 million with no debt, okay. And they own it free and clear and that's great and we worked through what happens to them in a year. This is looking a little bit like their income statement or their P&L. So they're going to get rental revenue of say $50 million, clearly a high end building. And they have operating expenses for the building of $30 million. And they don't have to pay any interest or worry about anything so their earnings before tax is a cool $20 million, not bad. And their tax rate is 5%, they pay the tax at, sorry 25%, $5 million and they wind up with the year for $15 million. And their return on equity, the equity is $100 million that they threw into this building is 15, their net income over their equity of 100 or 15%. Okay, so that's good for the conservatives, let's look at the cowboys. So the cowboys, they get that $100 million thrown at them, and they say we don't want to use all this $100 million on this project. Why don't we just put in $10 million of our own money and we'll go to JPMorgan Chase or Goldman Sachs or another bank and say, why don't you lend us $90 million to help us purchase this wonderful $100 million property. So this is what private equity folks in real estate do. So let's say they pull that off with JPMorgan Chase and this is how they financed the building. And they however, have a loan with 10%, they have the same 25% tax rate. So they have to pay back the bank 10% every year of that $90 million. So that's going to be $9 million. So let's see how things look for the Cowboys in their first year. They get the same revenue from tenants that has nothing to do with the financing structure. They have the same operating expenses but now they have another operating expense. They've got to pay that interest back to JPMorgan Chase of 10% or $9 million. So their earnings before tax is only $11 million, so maybe not such a smart move. They have to pay tax on that $11 million, 25% or $2.75 million and they only wind up with $8.25 million. However, if we consider how they did with these property, compared to the money of theirs that they put into it, they only put in 10, okay, and they got 8.25 back. So their return on equity is 8.25 divided by 10 or a whooping 82.5%. And remember they still have $90 million of that $100 million they were given to go do other projects. So what could they do? They could do nine other projects and be diversified, not have all their eggs in one basket like the conservatives have, okay? All right, so far so good. So let's say that both of these sets of folks, you in the audience out there, the conservatives and the cowboys, you run this property for two years. So in each case, looks like this. So the conservatives wind up with a total of $30 million they've extracted out of the property after two years, and the cowboys have extracted $16.5 million and also they have other projects going on. And then they get into in their third year, a bad year, so let's see what happens. For the conservative, so a bad year, we have sales dropping, rentals dropping all the way to $30 million. It's the type of thing that happened in the great recession. This was not uncommon to have a 40% drop in revenue like this. And the conservatives can bring down their operating expenses, but you can never bring them down as much as quickly as your revenue drops in a really bad situation. Happily they don't have to pay any interest so they still have positive earnings before tax of $5 million, they pay some tax on that. And they're still walking away with, in this horrific economic climate, $3.75 million, not bad. Let's see what happens to the cowboys. So the cowboys also are just going to get $30 million in rental revenue. Their operating expense is going to be the same still $25 million. Can they go to JPMorgan Chase and say I'm sorry we're having a bad year, we can't pay our interest. No, I don't think so. So they're going to have to pay that 9 million in interest and what's their earnings before tax? Minus $4 million, they've lost $4 million on this property this year. Tax at 25%, very long story, but under some certain circumstances if you're an entity that's been doing well for a long time and you have a bad year, you can actually get a cash refund from the government. We don't have time to go into that there, so we're assuming they get a cash refund here. But they're still out after the cash rebate from taxes and everything else, their out $3 million which is not good. And what if they get to this point and they don't have any excess cash in the bank and they can't cough up that $9 million for JPMorgan Chase, could be big trouble, what's going to happen? Well, in the loan contract, JP Morgan says if you can't make all of your interest payments, guess what? We, JP Morgan, get the keys to your building, we get to take ownership, okay. So, that's looking bad for the cowboys, looks like the conservatives were pretty smart. But is it really? Remember the cowboys ran this property for two years before we had this huge economic collapse. They got, what, $16.5 million out of this property. How much did they put in? They put in 10 million, okay. So they've got $6.5 million profit over this. So at that point if they have to say, okay we surrender, we give up, JPMorgan we're giving you the keys to the property, do they care? Not so much, right, they've done pretty well on this. This is why private equity is such an enticing type of thing to do. But one more question on this, what's going to happen when the cowboys go to get a loan for their next deal, what's going to happen? Well any smart lender is going to say, I don't think so. You got into big trouble in just two years and your last project, you walked away. You left us holding the keys to the place. We're not in the business of acquiring buildings through the faults of the folks we lend money to, so we don't want to lend to you. So that's a problem, so you have to be careful not to use so much leverage that you are going to go bankrupt. And of course here we have, on the next slide, the exception that proves the rule and that's President Trump whose real estate properties went bankrupt, not once, not twice, not three times but four times. And you can the quote here from Bloomberg News about this and he's really the exception that proves the rule in this case.
