GEK2013 Real Estate Finance

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GEK2013 – REAL ESTATE FINANCE

Chapter 1: Overview of Real Estate Finance Definitions: Real Estate Real Property Real Estate Finance

Land and all natural part of the land and attachments to the land e.g. buildings, etc All rights, interests and benefits related to ownership of real estate The study of the institutions, markets and instruments used to transfer money and credit for purpose of developing or acquiring real property - Contract results in mutual benefits - Inherent risks to one/both parties

Air Rights Surface Rights Land

Characteristics (Read notes): - Physical - Institutional - Economic

Real Estate (physical)

Mineral Rights Fixtures To-the-land

Right to Use

Real Property Ownership rights (legal)

Improvements On-theland

Right to Possess Right to exclude ppl Right to dispose

See Notes for Overview of Capital Market

Real Estate Market

Space Market (Tangible) Supply: Property Owners Demand: Property Users

Asset Market (Intangible) Supply: Investors willing to sell Demand: Investors willing to buy

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Chapter 2: Institutions & Instruments of Financial Markets Financial Legal claim to future cash flow Assets Financial Forum for trading funds where suppliers and demanders of funds interact to Market transact business Money Market Arena for trading short-term funds e.g. marketable securities Capital Forum for trading in equity and long term debts e.g. long-term Market securities Real Estate Forum for trading legal claims to future cash from real estate assets Financial Market Financial Assets Properties of Financial Assets: See Notes for full explanation -

Moneyness

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Divisibili ty Currency

Convertibili ty Role of Financial Assets -

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Reversibility

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Cash flow & Return Predictability

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Term to maturity Complexity

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Liquidity

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Tax Status

Transfer funds from those with surplus to invest on those who needs funds. Redistribute risk generated by tangible assets among seekers and providers of funds

Financial Markets Major Institutions in financial markets -

Households Depository institutions (banks) Investment banks

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Governments Insurance companies

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Nonfinancial Corporations Asset management firms

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Non-profit organizations

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Foreign investors

Service Provided by Financial Institutions -

Transform financial assets into a different, and more widely preferable type of asset Exchange financial assets both for customers and own account Assist in creation of financial assets for customers and selling these assets Provide investment advice and manage portfolio of other market participants

Instruments of Financial Markets (Asset Class) -

Common Stock

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Bonds o Residential MBS o Commercial MBS o CDOs

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Derivatives (Value depends on assets)

Financial Intermediaries Role of Financial Intermediaries -

Flow of funds for Financial Institutions & Markets Transform less desirable financial assets into other financial assets preferred by public by: (See Notes) o Maturity Intermediation o Risk reduction via diversification (doesn’t work, only redistribute but not reduce risk) o Reducing costs of contracting the information processing

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GEK2013 – REAL ESTATE FINANCE

Providing payment mechanism

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GEK2013 – REAL ESTATE FINANCE

Chapter 5: Mortgage Markets I Mortgage

Mortgage document Promissory Note

Special form of debt that uses real estate as a security for the loan Gives lender a lien on the property - If property is sold, owner not entitled to cash proceeds until loan amount and interest accrued have been paid off - Owner’s interest subordinate to lender’s interest Pledges the property as collateral for the loan

Written document of agreement detailing financial and legal details of transaction See Notes for its contents Mortgage Loan A contractual document that protects mortgagee’s interest w.r.t. 3 rd party claims on collateral Clarify purposes and proof of borrower’s and lender’s intent Mortgagor – Borrower Mortgagee – Lender Default and Foreclosure Lien A charge upon the property for the discharge of a debt Lien status – Indicates loan’s seniority in the event of a foreclosure Delinquency Non-payment of a mortgage payment due Default - Occurs when borrower fails to perform one or more duties under terms of note - Occurs when borrower missed 90 days’ installment Acceleration Provision that enables lender to demand payment of entire outstanding Clause when first monthly payment is missed Due-on-sale Provision allowing lender to demand full repayment if borrower sells Clause property Foreclosure - Judicial foreclosure: Obtain court order to sell - Non-judicial foreclosure: trustee sale without court order - Notice of foreclosure - Public auction followed by private sale if property wasn’t sold Loan Terminology Loan-to-value Loan LTV = ratio min ⁡( Market Value of Property , Selling Price of Property) Loan Principal

- Amount actually borrowed - Remaining Balance of loan Debt Service Periodic payments for interest and principal Interest Rate Rate charged for use of money Market i/r Rate that clears the market for loanable funds Contracted Rate specified in contract for purpose of calculating interest charges i/r Nominal i/r Rate stated in a particular currency Real i/r Rate in purchasing power Loan Duration Time given to borrower to repay loan Loan Regular, periodic repayment of principal Amortization r1 ,

Mortgage Interest Rate (See Notes for Demand VS Supply)

Real rate of Interest

f 1 , Inflation

Expectation

p1 , Risk

Premiums

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i t=r 1+ p1 + f 1

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GEK2013 – REAL ESTATE FINANCE

Amortization Scheme Constant Payment Mortgage: Loan is fully amortized with level payments Graduated Payment Mortgage: Loan is fully amortized with rising payments Constant Amortization Mortgage: Loan balance reduced by a constant amount each period Borrower took on a $500,000 loan at 5% interest for 30years Constant Payment Mortgage Constant Amortization Mortgage 1) Compute Monthly Debt Service 1) Compute constant amortization 5 amount

PV =500,000 ; n=360 ; i=

12

; FV =0

Amortization=

PMT =$ 2,684.11

500,000 360

¿ $ 1,388.89

2) Compute monthly interest on loan balance

2) Compute Loan Outstanding End of Month1

5 12

5 PMT =2,684.11 ; n=359 ; i= ; FV =0 12

i month 1=500,000×

PV =499,399.23

i month 2=498,611.11 ×

3) Difference between PV is the Principal Paid

5 12

¿ $ 2,077.55

3) Compute Total Month’s Payment

M 1=1388.89+ 2083.33

Principal Paid=$ 600.77

4) Difference between principal payment and PMT is Interest Payment

¿ $ 2,083.33

¿ $ 3,472.22

4) Repeat for all 360 months

Interest Paid =$ 2,083.33

5) Repeat for all 360 months $60,000 loan for 30years at 12% interest. 3% origination fee and 3% prepayment penalty on outstanding balance. Loan Fees and Borrowing Costs 1) Compute monthly loan payments

PV =60,000 ; n=360 ; i=

12 ; FV =0 12

PMT =$ 617.17

2) Calculate net cash disbursed (Loan amount – Origination fee / Discount points = Net disbursed)

Net cash disbursed=60,000× ( 1−3 )

¿ 58,200

3) Compute effective i/r

PV =−58,200; n=360 ; PMT =617.17

i=1.034 Monthly

Early repayments and Prepayment Penalty Simple - Loan Balance EOY5 = $58,597.93 -

Outstanding + Prepayment Penalty = 1.03%

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Monthly Debt Service = $617.17 Net Cash Disbursed = $58,200

×

$58,597.93 = $60,355.87

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Holding period = 5 years

PV =−58,200; FV =60,355.87, PMT =617.17 ; n=60

i=1.1043

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GEK2013 – REAL ESTATE FINANCE

Chapter 6: Alternative Mortgage Instruments Type Adjustable-Rate Mortgage See Notes for ARM Variables and Index

Usage Allows lender to adjust contract i/r to reflect changes in market i/r. Change in rate reflected by change in monthly payment

Mathematics Loan Amount = $100,000 Index = 1 year Margin = 2.50 See Notes for computation Term = 30 years i n=min ⁡( Index + Margin , in −1 +Cap) 2/6 i/r caps Teaser Rate = 5% Graduated Payment Mortgage designed to offset tilt effect by lowering payments on an FRM early on and increasing over time

GraduatedPayment Mortgage Price-Level Adjusted Mortgage

Solves tilt problem and interest rate risk by separating real rate of return and inflation rate:

i=constant ror +inflation rate

$100,000 30years, 6% interest

PMT in Year 1 4% inflation

PV =100,000 ; n=360 ; i=

6 12

PMT =$ 599.55 Year 2 4% inflation

PV =98,772 ×1.04 ; n=348 ; i=

6 12

PMT =$ 625.53 Year 3 -3% inflation

PV =101,366 ×0.97 ; n=336 ; i=

6 12

PMT =$ 604.83 Year 4 2% inflation

PV =96,929 ×1.02 ; n=324 ; i=

6 12

PMT =$ 616.92 Year 5-30 0% inflation

PV =98,868 ; n=312; i=

6 12

PMT =$ 612.92 8

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Shared Appreciation Mortgage

GEK2013 – REAL ESTATE FINANCE

Low initial contract rate with inflation collected in a lump sum based on house price appreciation

Appreciation amt. computed when house is sold or appraised in future

a=

V −β , a :share of appreciation , V : LTV , β :reduction∈loan∫ ¿ 1−t '

t :lende r s tax rate Reverse Annuity Mortgage Pledged Account Mortgage / Flexible Loan Insurance Program Type Fixed Rate Mortgage

Disadvantages

Future housing costs are known with relative certainty

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Default rates are generally low, simplicity and standardization encourage securitization, easier to police Default rates are lower because payment shocks are avoided If interest rates are expected to fall in the future, good for borrowers Provides lower initial rate and payment than FRMs Allows lenders with short-term liabilities to manage interest rate risk Future housing costs are known with relative certainty Easier to qualify for lower income households to take advantage of future earning power Lower monthly payments early in mortgage Default rates are lower because payment shocks are avoided Solves tilt effect

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GraduatedPayment Mortgage

Advantages

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Adjustable-Rate Mortgage

Borrower receives a series of payments $200,000 at 9% for 5 years, annual payments and repays in a lump sum at some future n=5; i=9 ; FV =200,000 PMT =$ 33,418.49 time i.e. Reverse Mortgage Combines a deposit with lender and fixed rate loan to form a graduated-payment structure Deposit in pledged as collateral

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Young households with lower incomes may not qualify for loans with the different ratios in play / Interest rates will be higher for those on mortgages with unstable payments Exposes lenders with short-term liabilities to severe interest rate risk

Greater uncertainty about future mortgage payments Difficult to understand. Subject to possible large increases in future payment Default rates are higher than on FRMs. Diversity discourages securitization Interests larger than fixed rate mortgage to make up for the risk of rising mortgage outstanding Payments will be higher in later stages of the loan (must be confident that income will rise) Long duration makes management of interest rate risk difficult Negative amortization

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Shared Appreciation Mortgage

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Reverse Annuity Mortgage

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Flexible Loan Insurance Program Flexible Maturity Adjustable Rate Mortgages

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GEK2013 – REAL ESTATE FINANCE

While borrowers may face large payments at end of mortgage, its actual buying power is similar to initial payment  if real income increases, then burden is reduced Lenders are protected against sudden inflation and enjoy relatively constant rates of returns Solves tilt effect and interest rate risks Relatively low interest rate and monthly payments

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Way to access home equity without having burden of repayment Creates income Owners enjoy tax-free annuities Continue to live in the house and benefit from appreciation and property deductions May result in lower payments for borrower and thus greater affordability and lower risk for default

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Future payments are known in advance Rate increases do not cause payment problems for borrowers resulting in defaults

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Interest rates changes doesn’t reflect changes in income levels Mortgage balance increases faster than price appreciation Sudden inflation would result in large payments, increasing default risk Not feasible in regions with declining home values Buyer may not be able to buy out lender when specified payoff time arrives; buyer would be forced to refinance or sell the house Reduces value of estate (accumulating debt) Home must be sold after death to repay mortgage if liquid assets not sufficient Annuities may place owners above certain welfare schemes

Initial payment is higher. Payoff period is uncertain Loan duration is not known in advance

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Chapter 7: Financing Decisions House Value = $100,000 80% LTV, 12% i/r, 25 years 90% LTV, 13% i/r, 25 years Down payment ¿ 20 ×100,000=20,000

Down payment ¿ 10 ×100,000=10,000

PV =80,000 ; n=300; i=12 /12

PV =90,000 ; n=300; i=13 /12

PMT =$ 842.58

PMT =$ 1,015.05

Compute internal rate of return, irr Borrow $10,000 more but pay $172.47 more per month

PV =10,000 ; n=300 ; PMT =172.47

i=1.7142× 12=20.570

Evaluate this percentage. Would you pay 20.57% interest just to borrow an extra $10,000? Assume borrower relocates after 5 years Loan Outstanding EOY5 ¿ 76,522.56

Loan Outstanding EOY5 ¿ 86,639.88

Difference in loan outstanding ¿ 86,639.88−76,522.56=10,117.32 n=60 ; PMT =172.47

PV =10,000 ; FV =10,117.32 ;

i=1.73596 ×12=20.832 With 2% origination fee

Loan disbursement ¿ 98 × 80,000

Loan disbursement ¿ 98 × 90,000

¿ $ 78,400

¿ $ 88,200

Difference at time zero ¿ $ 88,200−$ 78,400=$ 9,800 Borrow $10,000 more but pay $172.47 more per month

PV =9,800 ; n=300; PMT =172.47

i=1.750 ×12=21.00

Assume Alternative #2 changed to 30 years 80% LTV, 12% i/r, 25 years 90% LTV, 13% i/r, 30 years Down payment ¿ 20 ×100,000=20,000

Down payment ¿ 10 ×100,000=10,000

PV =80,000 ; n=300; i=12 /12

PV =90,000 ; n=360; i=13 /12

PMT =$ 842.58

PMT =$ 995.58

Difference at time zero ¿ $ 10,000 Difference in monthly payment: First 300 months: $153.00; Final 60 months: $995.58

irr (−10,000, {153, 995.58 } , { 300,60 } )=1.5720 ×12=18.864

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Loan Refinancing $80,000 loan at 15% for 30 years 5 years ago Stick Switch Refinance at 14% for 25 years, 2% prepayment penalty and upfront fee payable to $2,525 Year 0 – EOY5

PV =80,000 ; n=360; i=15 / 12

PMT =$ 1011.56

Loan outstanding EOY5 ¿ $ 78,976.50

PV =78,976.50 ; n=300 ; i=14 /12

PMT =$ 950.69 ∴ new monthly payment =$ 950.69 Returns from Refinancing Investment

Cost ¿ refinance=Prepayment Penalty +Upfront Costs

¿ 2 × $ 78,976.50+2,525=$ 4,104.53

Benefit ¿ refinancing=Initial Monthly Payment−New Monthly Payment

PV =4,104.53 ; n=300 ; PMT =60.87

¿ $ 60.87

i=1.464 ×12=17.569 >14 cost of new borrowing

Effective Cost of Refinancing

PV =78,976.50−4,105.53=$ 74,871; n=300 ; PMT =950.69

i=1.238 ×12=14.857