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Chapter 1: Overview of Real Estate FinanceDefinitions:Characteristics (Read notes): Physical Institutional Economic
Real EstateLand and all natural part of the land and attachments to the land e.g. buildings, etc
Real PropertyAll rights, interests and benefits related to ownership of real estate
Real Estate FinanceThe 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
See Notes for Overview of Capital Market
Chapter 2: Institutions & Instruments of Financial MarketsFinancial AssetsLegal claim to future cash flow
Financial MarketForum for trading funds where suppliers and demanders of funds interact to transact business
Money MarketArena for trading short-term funds e.g. marketable securities
Capital MarketForum for trading in equity and long term debts e.g. long-term securities
Real Estate Financial MarketForum for trading legal claims to future cash from real estate assets
Financial AssetsProperties of Financial Assets: See Notes for full explanation Moneyness Divisibility Reversibility Term to maturity Liquidity
Convertibility Currency Cash flow & Return Predictability Complexity Tax Status
Role of Financial Assets Transfer funds from those with surplus to invest on those who needs funds. Redistribute risk generated by tangible assets among seekers and providers of fundsFinancial MarketsMajor Institutions in financial markets Households Governments Nonfinancial Corporations
Depository institutions (banks) Insurance companies Asset management firms
Investment banks Non-profit organizations 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 participantsInstruments of Financial Markets (Asset Class) Common Stock Bonds Residential MBS Commercial MBS CDOs Derivatives (Value depends on assets)
Financial IntermediariesRole 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) Maturity Intermediation Risk reduction via diversification (doesnt work, only redistribute but not reduce risk) Reducing costs of contracting the information processing Providing payment mechanism
Chapter 5: Mortgage Markets IMortgageSpecial form of debt that uses real estate as a security for the loanGives 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 Owners interest subordinate to lenders interest
Mortgage documentPledges the property as collateral for the loan
Promissory NoteWritten document of agreement detailing financial and legal details of transactionSee Notes for its contents
Mortgage LoanA contractual document that protects mortgagees interest w.r.t. 3rd party claims on collateralClarify purposes and proof of borrowers and lenders intent
Mortgagor BorrowerMortgagee Lender
Default and Foreclosure
LienA charge upon the property for the discharge of a debtLien status Indicates loans seniority in the event of a foreclosure
DelinquencyNon-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 ClauseProvision that enables lender to demand payment of entire outstanding when first monthly payment is missed
Due-on-sale ClauseProvision allowing lender to demand full repayment if borrower sells 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 wasnt sold
Loan Terminology
Loan-to-value ratio
Loan Principal Amount actually borrowed Remaining Balance of loan
Debt ServicePeriodic payments for interest and principal
Interest RateRate charged for use of money
Market i/rRate that clears the market for loanable funds
Contracted i/rRate specified in contract for purpose of calculating interest charges
Nominal i/rRate stated in a particular currency
Real i/rRate in purchasing power
Loan DurationTime given to borrower to repay loan
Loan AmortizationRegular, periodic repayment of principal
, Real rate of Interest
, Inflation Expectation
, Risk Premiums
Mortgage Interest Rate (See Notes for Demand VS Supply)
Amortization SchemeConstant Payment Mortgage: Loan is fully amortized with level paymentsGraduated Payment Mortgage: Loan is fully amortized with rising paymentsConstant Amortization Mortgage: Loan balance reduced by a constant amount each periodBorrower took on a $500,000 loan at 5% interest for 30years
Constant Payment MortgageConstant Amortization Mortgage
1) Compute Monthly Debt Service
2) Compute Loan Outstanding End of Month1
3) Difference between PV is the Principal Paid
4) Difference between principal payment and PMT is Interest Payment
5) Repeat for all 360 months1) Compute constant amortization amount
2) Compute monthly interest on loan balance
3) Compute Total Months Payment
4) 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 Costs1) Compute monthly loan payments
2) Calculate net cash disbursed (Loan amount Origination fee / Discount points = Net disbursed)
3) Compute effective i/rMonthly
Early repayments and Prepayment PenaltySimple
Loan Balance EOY5 = $58,597.93 Outstanding + Prepayment Penalty = 1.03% $58,597.93 = $60,355.87 Monthly Debt Service = $617.17 Net Cash Disbursed = $58,200 Holding period = 5 years
QUICK REFERENCE GUIDEGEK2013 REAL ESTATE FINANCE
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Chapter 6: Alternative Mortgage InstrumentsTypeUsageMathematics
Adjustable-Rate Mortgage See Notes for ARM Variables and Index Allows lender to adjust contract i/r to reflect changes in market i/r. Change in rate reflected by change in monthly payment
Loan Amount = $100,000Index = 1 year Margin = 2.50Term = 30 years2/6 i/r capsTeaser Rate = 5%See Notes for computation
Graduated-Payment MortgageGraduated Payment Mortgage designed to offset tilt effect by lowering payments on an FRM early on and increasing over time
Price-Level Adjusted MortgageSolves tilt problem and interest rate risk by separating real rate of return and inflation rate:
$100,000 30years, 6% interestPMT in Year 14% inflation
Year 24% inflation
Year 3-3% inflation
Year 42% inflation
Year 5-30 0% inflation
Shared Appreciation MortgageLow initial contract rate with inflation collected in a lump sum based on house price appreciationAppreciation amt. computed when house is sold or appraised in future
Reverse Annuity MortgageBorrower receives a series of payments and repays in a lump sum at some future time i.e. Reverse Mortgage$200,000 at 9% for 5 years, annual payments
Pledged Account Mortgage / Flexible Loan Insurance ProgramCombines a deposit with lender and fixed rate loan to form a graduated-payment structureDeposit in pledged as collateral
TypeAdvantagesDisadvantages
Fixed Rate Mortgage Future housing costs are known with relative certainty
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
Default rates are generally low, simplicity and standardization encourage securitization, easier to police Default rates are lower because payment shocks are avoided Exposes lenders with short-term liabilities to severe interest rate risk
Adjustable-Rate Mortgage If interest rates are expected to fall in the future, good for borrowers Provides lower initial rate and payment than FRMs Greater uncertainty about future mortgage payments Difficult to understand. Subject to possible large increases in future payment
Allows lenders with short-term liabilities to manage interest rate risk Default rates are higher than on FRMs. Diversity discourages securitization
Graduated-Payment Mortgage 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 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)
Default rates are lower because payment shocks are avoided Solves tilt effect Long duration makes management of interest rate risk difficult Negative amortization
Price-Level Adjusted Mortgage 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 Interest rates changes doesnt reflect changes in income levels Mortgage balance increases faster than price appreciation
Lenders are protected against sudden inflation and enjoy relatively constant rates of returns Solves tilt effect and interest rate risks Sudden inflation would result in large payments, increasing default risk
Shared Appreciation Mortgage Relatively low interest rate and monthly payments 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
Reverse Annuity Mortgage 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 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
Flexible Loan Insurance Program May result in lower payments for borrower and thus greater affordability and lower risk for default
Flexible Maturity Adjustable Rate Mortgages Future payments are known in advance Rate increases do not cause payment problems for borrowers resulting in defaults Initial payment is higher. Payoff period is uncertain Loan duration is not known in advance
Chapter 7: Financing DecisionsHouse Value = $100,000
80% LTV, 12% i/r, 25 years90% LTV, 13% i/r, 25 years
Down payment
Down payment
Compute internal rate of return, irrBorrow $10,000 more but pay $172.47 more per month
Evaluate this percentage. Would you pay 20.57% interest just to borrow an extra $10,000?
Assume borrower relocates after 5 years
Loan Outstanding EOY5Loan Outstanding EOY5
Difference in loan outstanding
With 2% origination fee
Loan disbursementLoan disbursement
Difference at time zeroBorrow $10,000 more but pay $172.47 more per month
Assume Alternative #2 changed to 30 years
80% LTV, 12% i/r, 25 years90% LTV, 13% i/r, 30 years
Down payment
Down payment
Difference at time zeroDifference in monthly payment: First 300 months: $153.00; Final 60 months: $995.58
Loan Refinancing$80,000 loan at 15% for 30 years 5 years ago
StickSwitch
Refinance at 14% for 25 years, 2% prepayment penalty and upfront fee payable to $2,525
Year 0 EOY5
Loan outstanding EOY5
Returns from Refinancing Investment
Effective Cost of Refinancing
Buyer plans to relocate after 10 years of refinancing or not refinancing
Loan Outstanding EOY10Loan Outstanding EOY10
Difference in loan outstanding
Two or more LoansFinancial PackageIndividual LoansPayment of individual loans
$500,000:$100,000 at 7%, 30 years$200,000 at 7.5%, 20 years$200,000 at 8%, 10 years
Chapter 9: Controlling Default RiskLoan Underwriting: Process of determining and controlling default risk, evaluate borrowers loan request in terms of profitability and risk See Notes for Underwriting ProcessTypeFormulaExample
Loan-to-Value (LTV)
Payment to Income Ratio-OR-Mortgage Servicing Ratio
Jacks gross income is $5,500Monthly loan payment is $4,540
See Notes for variation in this ratio
Debt Coverage Ratio
Breakeven Ratio
How much can a buyer finance?Gross household monthly income$7870
Car Loan$1500
Car Insurance250
Credit Card700
Personal Loan500
Property tax & Insurance300
Bank to grant 25-year 80% LTV at 3.5% p.a. with monthly payments subject to HEIR 30% and TDSR 60%
Housing-Expense to Income RatioGross Monthly Income$7,780
Times: HEIR0.30
Max Permissible long term obligations$2,361
Less: Property tax & insurance300
Max Principal & interest payment$2,061
Total Debt Service RatioGross Monthly Income$7,780
Times: TDSR0.60
Max Permissible long term obligations$4,722
Less: Property tax & insuranceLess: Payments on long-term debt3002950
3,250
Max Principal & interest payment$1,472
Chapter 11: Asset-Backed SecuritiesSecuritizationProcess by which assets are packaged into securities sold on organized exchanges
Asset-backed SecurityA security created by pooling loans
Bankruptcy RemoteA bankruptcy remote company is a company within a corporate group whose bankruptcy has as little economic impact as possible on other entities within the group
Two types of assets used as collateral existing and futureSecuritization StructureAmortizing Assets (Self-liquidating Structure)Non Amortizing Assets (Revolving Structure)
Periodic payments consisting if principal & interestAmortization schedule on a pool/loan level
See Notes for further explanation No amortizing schedule Lockout/revolving periodNo fixed period, only minimum payment, e.g. credit card
Fixed RateFloating Rate
Possibility of mismatch between cash flow characteristics of underlying asset and liabilities. Interest rate derivatives are used to mitigate the risk
Asset Classification
Credit Risks
Asset RiskStructural RiskThird-Party Providers
Underlying borrowers ability to pay and service loans Experience of originators Concentration of loans: a single huge loan borrower? Assessment of most likely lost via weighted average loss & variability of lossCan Cash Flow satisfy all obligations? Loss allocation Cash flow allocation Interest rate spread Potential of occurrence of trigger events Changes in credit enhancement See Notes for Subordination Principle & Cash Flow Waterfall Credit guarantors (bond insurers) Servicer Trustee Lawyer
Credit Enhancement (See Notes for Credit Enhancement)
*Monoline Insurance: An insurance company that provides guarantees to issuers to enhance the credit of the issuer. Issuers will often go to monoline insurance companies to either boost the rating of one of their debt issues or to ensure a debt issue does not become downgraded.+Main motivation is to maintain ratio of senior-subordinate: Redirect prepayments disproportionately from subordinate to senior to ensure no deterioration of credit protection for senior bond classResidential Mortgage Backed Securities
Prepayment Risk
Conditional Prepayment Rate Single-Monthly Mortality rate (SMM)
Default Risk
1) Conditional Default Risk (CDR)Annualized value of unpaid principal balance of newly defaulted loans in a month as percentage of unpaid balance of pool
2) Cumulative Default Rate
Commercial Mortgage Backed Securities
Prepayment terms Role of servicer: transference of loan to special servicer when borrower is in default, imminent default, or in violation of covenants Role of buyers: junior bond buyers
Special Purpose VehicleA Special purpose vehicle is a legal entity created to fulfil a Specific or temporary objective. SPVs are typically used by companies to isolate the firm from financial risk. They are also commonly used to hide debt, hide ownership, and obscure relationships between different entities which are in fact related to each other Some of the reasons for creating Special purpose entities are as follow: Securitization: SPVs are commonly used to securitise loans. For example, a bank may wish to issue a mortgage-backed security whose payments come from a pool of loans. However, to ensure that the holders of the mortgage-back securities have the first priority right to receive payments on the loans, these loans need to be legally separated from the other obligations of the bank. This is done by creating an SPV, and then transferring the loans from the bank to the SPV. Risk sharing: Corporates may use SPVs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk. Finance: Multi-tiered SPVs allow multiple tiers of investment and debt. Asset transfer: Many permits required to operate certain assets (such as power plants) are either non-transferable or difficult to transfer. By having an SPV own the asset and all the permits, the SPV can be sold as a self-contained package, rather than attempting to assign over numerous permits Asset-Backed SecuritiesWhen a consumer takes out a loan, their debt becomes an asset on the balance sheet of the lender, collecting principal and interest payments from borrowers. The lender can then sell these assets to a trust or special purpose vehicle, which packages them into an asset backed security (ABS) that can be sold in the public market. The interest and principal payments made by consumers pass through to the investors that own the asset backed securities. ABS benefit lenders because they can be removed from the balance sheet, allowing lenders to acquire additional funding as well as greater flexibility to pursue new business. 1) Investors of ABS and MBS are usually institutional investors and they use ABS to obtain higher yields than comparable-maturity U.S. Treasury securities among triple-A rated assets, as well as to provide a way to diversify their portfolios and augment their portfolio diversification. 2) ABS are one of the most secure investment vehicles from a credit standpoint. Predictable cash flow. The certainty and predictability of cash flow for many types and classes of ABS are well established. Investors can buy these securities with considerable confidence that the timing of payments will occur as expected. (Prepayment uncertainty). 3) Because ABS are secured by underlying assets, they offer significant protection against event-risk downgrades, particularly in contrast to corporate bonds. A major concern investors have about unsecured corporate bonds, no matter how highly rated, is that the rating agencies will downgrade them because of some disruptive event affecting the issuer. Such events include mergers, takeovers, restructurings and recapitalizations, which are often undertaken by corporate managers trying to boost shareholder value.
NameFormulaUsageExample
Simple InterestInterest earned on principal amount onlyTotal amount accumulated EOY2 if $1,000 invested at 10% simple interest:
Future ValueCompute compound interest Total amount accumulated EOY2 if $1,000 invested at 7% interest
Present ValueValue of an investment in todays moneyPresent value of obtaining $105,000 EOY1 at 7% interest
Future Value AnnuityFuture value of a series of constant paymentsInvestor pays $200 per month for 5 years at 8% interest p.a.
Sinking Fund Factor (PMT)Amount set aside to be invested in order to accumulate desired future amountCompute PMT to accumulate $33,100 EOY3 at 10% interest p.a.
Present Value AnnuityArrears
How much to pay for an investment that hands out constant paymentsInvestment pays out $300 each month over 6 months at 8% interest p.a., how much to pay?
Advance
Mortgage ConstantDebt service necessary to amortize a present mortgage loan amountYou raised a mortgage of $100,000. Loan is for 15years, interest at 7% p.a.
Loan Outstanding EOY1
Loan Outstanding
Effective RatesVSNominal RatesConvert nominal quotes to effective ratesEffective annual rate of 1% i/r per monthSimple interest rate of 1% per month=12% p.a.