John P. Wiedemer and J. Keith Baker

REAL ESTATE FINANCE Ninth Edition

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Chapter 13Other Financing Practices

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LEARNING OBJECTIVES

At the conclusion of this chapter, students will be able to:

• Explain varying types and uses of construction takeout commitments.

• Understand key differences in the various major mortgage types formaximum loan amounts and how loan-to-value ratios tie into the residential real estate finance process.

• Describe the various types of leases involved in real estate and how they can serve to conserve cash, increase flexibility, and reduce liquidity risk.

• Differentiate between syndications and realty funds.

• Explain the differences between judicial and nonjudicial foreclosure as well as deficiency judgment.

• Describe the various title issues that face owners, lenders, and otherprofessionals dealing with real estate acquisition, funding, and management.

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Home Builder Commitments

• When a new home is purchased directly from a builder, the builder may already hold a takeout commitment for mortgage money that can be used by the home buyer to provide permanent financing to the buyer and take out (pay off) the construction lender or builder if the lender or builder is using his or her own sources of funding.

• There are four methods used.

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Home Builder Commitments - Competitive Method

• Small-to medium-sized builders may have their construction money secured without any commitment for the permanent loans.

• If there is no commitment, the purchaser is free to seek whatever source of mortgage money may be found.

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Home Builder Commitments - Commitment Method: Construction

• When any builder obtains construction money, the lender may request a first-refusal right to all permanent loans on the project.

• The construction lender thus ties up a good source of loans for the future, which is one of the incentives to make the construction loan in the first place.

• A purchaser cannot be required to borrow money from a particular lender, but it can be a bit more costly to go elsewhere.

• This type of arrangement is more common in commercial construction loans than in residential construction.

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Home Builder Commitments - Commitment Method: Purchase

• Some larger builders who can qualify for the lowest rates on their construction money, or use their own funds, may purchase a future commitment for money to protect future customers needing loans.

• The builder will pay at least 1% of the commitment amount to hold the money, or additional fees to ensure buyers a lower interest rate.

• This expense is a prepayment of interest by the builder for the benefit of the buyer, is charged back to the cost of the house.

• This is how builders can advertise lower-than-market interest rates and obtain a competitive advantage in the housing market.

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• Most larger builders own affiliated mortgage companies.

• The rate is competitive with market rates and an additional source of income and competitive advantage for the builder.

• Associated companies are subject to a rule that requires full disclosure of ownership in related companies.

• These companies are not permitted to require the use of an affiliate’s service nor are they allowed to pay each other fees for referrals.

• However, they carry a competitive edge by being available at the proper time and place to consummate a deal.

Home Builder Commitments - Associated Companies

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Loan-to-Value Ratio (LTV)

• The LTV is the amount of a loan as a percentage of the property’s value.

• The property value is the lesser of the appraised value or sales price.

• The LTV ratio is an important standard for mortgage lenders.

• It is used by the industry in the following ways.

1. As a standard for pricing a loan.

2. As a standard for default mortgage insurance.

3. As a standard for quality of loan.

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Dollar Amount of Loan

• There are some dollar limitations on the amount of residential loans.

• HUD/FHA and VA set their own limits, as described in Chapter 8.

• For conventional loans, the various regulatory agencies can set limits.

• Most of these involve a limitation on the amount of any single loan as a percentage of the lender’s total assets and limits on the amount that can be loaned to any one individual.

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Fannie Mae/Freddie Mac Limits

• The two agencies adjust the limit on loans they can purchase (or allow into a mortgage pool) in accordance with federal guidelines.

• The new limit becomes effective on January 1st of the following year.

• It is adjusted based on the amount of change in the average price of a single-family house financed by a conventional mortgage.

• Based on the 12-month period prior to the end of October each year.

• The limit becomes the conforming/conventional loan limit.

• The FHA limit is calculated as a percentage of the conforming limit.

• The Fannie Mae/Freddie Mac single-family limit for this year is $______.

• Data for specific county-by-county limits are available at www.fhfa.gov/webfiles/19489/HighCost_PL111-242.pdf

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Minimum Loan Limits

• There are no regulatory minimums for mortgage loans, but there are some practical limits.

• Some conventional lenders set minimum dollar amounts for loans they will make at the risk of being charged with discrimination.

• HUD/FHA has never allowed minimum amounts for acceptable loans.

• The problem arises from the fact that smaller loans are most likely to be needed by lower-income families.

• Several conventional lenders were charged with violation of Fair Housing because they refused to make loans of less than $50,000.

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Large Residential Loans

• Loans exceeding conforming limits are more difficult to sell.

• There is a secondary market for “jumbo loans,” but yield requirements are higher.

• Some of these larger loans are held in portfolio by lenders.

• But the amounts may exceed the lender’s own limits for a single loan.

• To overcome this, two or more lenders may combine to fund the loan.

• This is called a participation loan.

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Land Leases

There is a growing use of land leases for several reasons:

Land Not for Sale: In some areas land is simply not available for purchase. Land in these areas may be limited to large holders who see greater value in leasing than converting the land asset into cash that is subject to capital gains.

Leasing May Be Lower Cost: It is quite possible to negotiate a multiyear lease on land at a lower cost than financing the purchase price. Lease payments are tax deductible (when used for business purposes), while land is nondepreciable.

Separating Ownership: To separate the ownership of improvements from the land ownership. The separation allows either one to be sold without capital gains tax being assessed on the other.

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Financing Development on Leased Land

• A lease on land is generally known referred to as a ground lease.

• Ground leases are usually net leases with terms of 55, 75, or 99 years.

• The 99-year limit derives from some early state laws that held that leases of 100 years or longer were transfers of title rather than leases.

• Financing construction on land that is leased has some limitations, as the builder can pledge only the leasehold interest as collateral.

• There are two basic ways to handle such loans: an unsubordinated ground lease and a subordinated agreement lease.

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Unsubordinated vs. Subordinated Ground Lease

Unsubordinated:The landowner does not subordinate the ownership to the leasehold interest. If the ground rent is not paid, the landowner can foreclose and terminate the leasehold rights. In such a case, improvements could be claimed by the landowner, thus defeating any claim by a lender holding only a pledge of the leasehold interest. With this kind of lease the lender would normally require the borrower to pay the ground rent in escrow to the lender as a part of each mortgage payment.

Subordinated:The landowner subordinates the ownership of the land in favor of the mortgage holder. With this kind of lease, the developer, with only a leasehold interest, can pledge title to the land itself as part of the collateral to secure a development loan. The subordination agreement signed by the landowner grants a priority claim to the lender, which is similar to granting a first lien with a mortgage instrument.

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Build-to-Lease

• The lessor agrees to construct a building to tenant specifications in return for a lease commitment from the tenant.

• The procedure is also called build-to-suit or build-to-let.

• The builder has an assured tenant and an immediate cash flow.

• The tenant obtains a building that meets its needs more precisely.

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Sale and Leaseback

• An owner/ occupant sells her property to an investor and simultaneously leases it back for continued occupancy.

• For the owner/seller, the advantage is the cash realized from the sale.

• The continued occupancy allows an uninterrupted operation.

• The lease payments are tax deductible if they are for a business.

• The investor/buyer obtains a property with an immediate cash flow.

• The procedure is most commonly used with commercial properties.

SELLER/TENANT AND BUYER/LANDLORD

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Sale of Equity Interests

SyndicationProperty acquisition by a group of participants. A syndicate is not a type of business organization; it is a name applied to any group set up to pursue a limited objective in business. Participants may be individuals, partnerships, or corporations. Real estate syndicates operate by two basic methods, either a sale of interests in existing properties or a sale of interests in property to be acquired.

Realty FundsWhenever a larger group (generally more than 35 persons or companies) is formed to participate in a real estate venture, registration with federal and state regulatory agencies is necessary. The participation can be in the form of “units” purchased in a realty fund, which is usually organized as a limited partnership. Realty funds are organized by persons or companies wishing to raise equity money for real estate projects, such as the purchase of raw land, a construction project, or the purchase of existing income properties.

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SEC Regulations for Real Estate Transactions

There are several ways that real estate transactions can become involved with Securities and Exchange Commission requirements.

Sale of Mortgage BondsThis consists of borrowing in the financial markets through the sale of bonds. Such an issue of bonds would be secured by a pledge of the real estate being developed. If such an issue is sold to the general public, it is subject to registration with the SEC.

Advance Payments on Real EstateReal estate transactions that may be subject to SEC registration include the sale of predevelopment certificates for lots; the sale of condominium units in a building yet to be constructed for which a down payment is required; and the sale of limited partnership interests, if offered publicly.

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Supplier Financing

Extended TermsA few companies utilize credit terms as an incentive to do business with these firms and, in so doing, provide additional financing for the customer. A major supplier may agree to extend payment terms for 60 or 90 days or, in some cases, until the project is finished and sold.

Supplier LoansThe ulterior motive in supplier financing is always to ensure the use of the lender’s products. This could be heating and air conditioning equipment or a full range of kitchen equipment, or it could be a utility company.

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Seller-Financed Home Mortgages

• Most sellers want cash, but some think otherwise.

• These are mostly older people whose financial obligations have dwindled, and to whom sound investments are important.

• A source of income could be more important than top-dollar price.

• Home mortgages carry very high ratings as creditworthy investments.

• Less than 1% suffer default.

• Accepting a secured note can be a wise investment.

• If a seller-financed loan is handled by an approved seller/servicer with uniform documentation, Fannie Mae is able to purchase the loan should an emergency need for cash arise.

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Refinancing

• A decline in interest rates usually brings many property owners back to the mortgage market to refinance loans at lower rates.

• Some homeowners have taken this step two and three times.

• In February of 2011, refinancing accounted for 64% of loan originations.

• Most lenders consider refinancing the payoff of an existing loan from the proceeds of a new loan.

• The benefits of refinancing differ and costs can vary substantially.

• A discussion of the major questions involved with refinancing follows.

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Refinancing

Where to Refinance: The best place to start is with the holder of the existing note. Most lenders accept a lesser rate than lose the customer.

Rate Reduction: Add the costs of refinancing, then compare those with the savings to see how many months it will take to recover the costs.

Refinancing Costs: No specific regulations apply. They may require a new application fee, title insurance, attorney’s fees, appraisal, discount points.

Effect of Tax Law: A discount for refinancing must be amortized over the life of the loan.

Restructuring the Loan: Refinancing is a negotiable transaction. It is possible that a lender wants a change from a fixed-rate to an ARM.

Appraisal Problems: When the market value of the house has declined and/or negative amortization has increased the loan amount.

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Title Protection

• A standard requirement for approval of a mortgage loan is that the title to pledged property must be valid.

• The lender wants assurance that the borrowers are the true owners and hold valid title to the property pledged.

• Many problems can occur in a chain of title ownership.

• Forged documents, undisclosed heirs, mistaken legal interpretation of wills, misfiled documents, confusion resulting from a similarity of names, and incorrectly stated marital status.

• A purchaser must take the necessary steps to assure good title.

• Three methods are commonly used to protect both a purchaser and a lender from future title problems.

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Attorney’s Opinion Based on Abstract

• The chronological collection of all recorded documents that affect land title is called an abstract of title.

• Prepared by an abstracter who specializes in researching land records.

• Includes conveyances, wills, law suits, liens, and encumbrances.

• An abstract, by itself, does not assure the validity of title.

• The status of title comes from an opinion given by a qualified attorney.

• After review, a qualified attorney issues an opinion as to validity of title.

• This method provides no insurance against an adverse claim, leaving the purchaser with only the seller as recourse against future loss.

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Title Insurance

• Protects against loss from something that has already happened.

• Title companies examine the chain of title to make sure it is insurable.

• Policies list exclusions such things as rights of parties in possession, unrecorded easements, encroachments, zoning laws, and other governmental restrictions.

• What is insured is sometimes called a marketable title, free from plausible or reasonable objections.

• There are two different kinds of title insurance, one indemnifies an owner against loss, and the other indemnifies a lender against loss.

• Practice varies throughout the country in regard to who pays for an owner’s title policy.

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Torrens System

• A method of registering the ownership of land and encumbrances.

• The landowner petitions a state court to register the subject property.

• Title information must be filed and notice given to all interested parties.

• The court’s determination is made in the form of a decree.

• Title cannot pass, nor are encumbrances or conveyances effective until they also are registered on the certificate of title.

• Initial use of the Torrens system is optional, but once registered, all subsequent transfers must follow the registration procedures.

• In some states, Torrens-registered property is not subject to general judgment liens, nor can title be lost through adverse possession.

• One of the problems with the use of the Torrens system is that the cost may exceed the cost of title insurance.

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Foreclosure

• Foreclosure is a legal procedure by which property pledged as collateral is sold to satisfy the debt thereby secured.

• A mortgage grants a lender the right to foreclose in the event of default.

• Title passes at an auction to the highest bidder.

• Lender is entitled only to money due, any surplus goes to the owner.

• Foreclosure is a step that lenders want to avoid if at all possible.

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Judicial Foreclosure

• A judicial foreclosure is normally used when a regular mortgage is the security instrument.

• A default is handled by filing the required notices to the debtor, followed by a suit in court to foreclose the mortgage claim.

• If the court agrees with the claim, it can order that the property be sold to satisfy the debt.

• The sale is handled through a public auction, usually called a sheriff’s sale.

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Nonjudicial Foreclosure

• Power of sale is contained in the mortgage or deed of trust.

• No court action is required.

• The lender notifies the trustee of a default and requests foreclosure.

• Notification is given to the debtor prior to the property being sold.

• The trustee, who is the third party in a deed of trust, may sell the property at public auction.

• The trustee is authorized to bid for the property on behalf of the lender, usually up to the amount of the mortgage debt.

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Strict Foreclosure

• Strict foreclosure is possible in only a few states because it results in the borrower losing all equity invested in the property.

• After notice is given to a borrower and papers are filed, the court establishes a specific time during which the entire debt must be paid.

• If full payment is not made within that time, the borrower’s redemption rights are waived and the court awards full legal title to the lender.

• There can be no deficiency judgment claimed under strict foreclosure.

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Deficiency Judgments

• Foreclosure may not produce sufficient funds to pay the amount owed.

• The borrower may be obligated to the lender for the balance still due.

• The lender may have the right to seek a deficiency judgment.

• Some states limit the lender’s right to a deficiency on a homestead.

• Some states grant a foreclosed debtor the right to cite the market value of foreclosed property as a defense against a deficiency claim.

• If a borrower is granted relief from any unsatisfied obligation, income tax law treats this relief of debt as income.

• Taxpayers are generally allowed to exclude up to $2 million in mortgage debt forgiveness on their principal residence, at least through 2012.

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Obligations Involved with Default Insurance: Indemnity

• If the loan is insured against default, the note holder can claim reimbursement for the loss.

• This can be PMI, FHA insurance, or a VA guaranty.

• All default protection insures the lender against loss, not the borrower.

• This is true even though the borrower pays the insurance premiums.

• The benefit to a borrower is in obtaining a loan that might otherwise not be available.

• The insuring company (or federal agency) has a right to demand reimbursement from the defaulted borrower.

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Questions for Discussion

1. Discuss methods a builder might use to assist with a home buyer’s permanent financing.

2. Discuss maximum and minimum dollar limits on loan amounts.3. When is refinancing a mortgage loan practical? Why?4. How is loan-to-value ratio used in lending practices?5. What kind of real property transaction might fall under jurisdiction of

the SEC?6. Who benefits from a sale-and-leaseback deal, and how?7. What is the risk involved in an unsubordinated leasehold mortgage,

and how might protection from this risk be obtained?8. Describe two of the three ways that title to property is protected

against adverse claims.9. What is syndication? What is a realty fund?10. Describe a judicial foreclosure proceeding. How is it different from a

nonjudicial foreclosure?