Edited Chapter SummariesReal Estate Finance, Winter 2010
Real Estate Finance: Theory and Practice
Edited Chapter Summaries and Learning Notes
Clauretie & Sirmans: 2010, 6th Edition
Cengage Learning
Table of Contents
Ch 1. Real Estate Finance: An Overview
Chapter 2. Money, Credit, and the Determination of Interest Rates
Chapter 3. Finance Theory and Real Estate
Chapter 4. The Early History of Residential Finance and the Creation of the FRM
Chapter 5. Postwar Residential Finance
Chapter 6. Alternative Mortgage Instruments
Chapter 7. Financing and Property Value
Chapter 8. Federal Housing Policies: Part I
Chapter 9. Federal Housing Policies: Part II
Chapter 10. The Secondary Mortgage Market
Chapter 11. Valuation of Mortgage Securities
Chapter 12. Controlling Default Risk Through Borrower Qualification, Loan Underwriting and Contractual Relationships
Chapter 13. Loan Origination, Processing and Closing
Chapter 14. Mortgage Default Insurance, Foreclosure and Title Insurance
Chapter 15. Value, Leverage and Capital Structure
Chapter 16. Federal Taxation And Real Estate Finance
Chapter 17. Sources of Funds for Commercial Real Estate Properties
Chapter 18. Acquisition, Development and Construction Financing
Chapter 19. Permanent Financing of Commercial Real Estate Properties
Chapter 20. Ownership Structures For Financing and Holding Real Estate
Chapter 21. Real Estate in a Portfolio Context
Chapter 22. Liability, Agency Problems, Fraud and Ethics in Real Estate Finance
1
JR DeLisle, Ph.D.
Edited Chapter SummariesReal Estate Finance, Winter 2010
Ch 1. Real Estate Finance: An Overview
CHAPTER SUMMARY
The purpose of this chapter is to provide the student with an overview of the field of real estate finance. It does this in several ways.
First, it describes the field of finance in general and explains how finance is similar to, but in some ways different from, the field of economics in general. In this regard the student should understand that:
1.Finance focuses on maximizing asset values whereas the microeconomics of the firm focuses on profit maximization.
2.Finance is concerned with the intertemporal transfer of funds between individuals and, as such, relies heavily on the concept of the time value of money.
3.Finance looks at cash flows, not profits, when valuing assets.
4.Finance is more concerned with risk than is the traditional field of economics.
Please note that these are only generalities, as, certainly, economics recognizes the tools used by financial analysts. It is simply a matter of traditional focus that the fields are somewhat different.
Chapter 1 divides the field of finance into its sub-fields of which real estate finance is but one. It also provides a long list of sub-areas within real estate that are of interest.
Next, the chapter discusses the environment of real estate finance. The student should be aware of the savings-investment cycle and realize that credit flows from surplus income units to deficit income units through two pathways: one directly and the other through intermediaries. Here, the major financial intermediaries are listed and a short description of each is provided. The instructor should also point out the distinction between primary and secondary markets. In this regard the chapter makes a brief mention of the secondary mortgage market.
Finally, the student should realize the distinction made between money and capital markets and realize that most of real estate finance deals with the latter.
There is a rather comprehensive exhibit, Exhibit 1-2, that describes the regulatory framework of the financial institutions. Spend a few moments going over this exhibit, as most will be unfamiliar with the tangled web of government regulations of financial institutions. It will give you some reference for later chapters when many of the regulatory agencies are introduced and discussed in detail.
Chapter 2. Money, Credit, and the Determination of Interest Rates
CHAPTER SUMMARY
The purpose of Chapter 2 is to acquaint the student with the fundamental relationships between monetary policy, monetary growth rates, inflation, expected inflation, and interest rates. Because interest rates play such an important role in finance and real estate finance, this chapter is designed to develop a sound understanding of how interest rates are determined. This chapter discusses not only the determination of the general level of interest rates but also factors that influence the interest- rate or yield on specific securities.
Insofar as the general level of rates is concerned, Chapter 2 focuses on a monetarist model that traces the relationship between monetary policy and interest rates through what is termed the transition mechanism. In this mechanism, money supply growth affects inflation, which in turn affects inflationary expectations which in turn affects the general level of rates. The relationship is positive but with a temporary liquidity effect whereby an increase in the money supply growth rate depresses interest rates only in the immediate short-run. After a discussion of the transition mechanism the chapter turns to a discussion of the characteristics that affect the yields on specific securities.
In this chapter it’s important to understand the effect of monetary policy and money supply growth on inflation (the quantity theory of money developed by Fisher and extended by Friedman) and the effect of inflation on inflationary expectations. The role of inflationary expectations in the determination of the general level of interest rates should also be emphasized. The instructor may want to specifically address the decade of the 1970s. The data from this decade clearly demonstrates the relationship between money supply growth, inflation, and interest rates.
It should also be noted how the individual characteristics of credit instruments affect the yield determined in the marketplace and the role of risks such as default, liquidity (maturity), and callability. In this regard, a brief review of the callability risk of pass-through securities would be helpful so that the student will have been exposed to this concept prior to reading Chapter 10 and Chapter 11.
Chapter 3. Finance Theory and Real Estate
CHAPTER SUMMARY
This chapter covers the important principles of finance theory and shows how they relate to real estate. In particular, the principles of finance that are discussed include: asset valuation, leverage and optimal capital structure, option valuation, the theory of intermediation, portfolio theory, efficient market theory, and agency relationships. Each of these principles is discussed on a general level and the examples of their application to real estate are given. Students should develop a sound understanding of each of these principles. Examples from the instructor’s perspective should be provided. The important concepts in this chapter are that: one, there are fundamental principles of the study of finance that the student should be aware of, and two, these principles can be applied to the study of real estate. The student should understand that real estate finance is not isolated to a description of those markets and institutions that deal with credit flows involving real estate. The conceptual framework of the study of finance can be applied to real estate. The student should be forewarned that this course does not rely on descriptions and definitions only, but includes a good portion of concepts and economic models. It applies financial economics to the study of real estate.
Chapter 4. The Early History of Residential Finance and the Creation of the FRM
CHAPTER SUMMARY AND SUGGESTIONS FOR TEACHING
Chapter 4 and Chapter 5 treat the development of real estate finance, primarily the residential finance market, from its beginning through today. This chapter is somewhat short but is separated from the next in order to better divide the material. Chapter 4 begins with ancient times and ends with World War II. Chapter 4 also introduces the student to the mechanics of the long-term fixed rate mortgage that emerged from the depression years. Chapter 5 covers the postwar history of residential finance. It is, for the most part, very descriptive with little in the way of challenging conceptual thoughts. The predominance of the five-year interest-only loan in the late nineteenth and early twentieth centuries is noteworthy. This loan was, in principle, a five-year-adjustable-rate loan. This demonstrates that the adjustable rate mortgage (ARM) is not a new concept. In fact, in the overall scheme of history the thirty-year fixed rate, fixed-payment loan is the exception rather than the rule when it comes to residential finance.
Also, point out that the Federal Housing Authority (FHA), by introducing the thirty-year amortizing fixed payment loan, introduced interest rate risk to residential lenders in exchange for the default risk associated with the short-term non-amortizing loan. Finally, review the examples of the mechanics of the fixed rate mortgage.
Chapter 5. Postwar Residential Finance
CHAPTER SUMMARY
This chapter presents a decade-by-decade review of the transition of the residential finance market from the end of World War II through the later 2000s. Along the way it touches on some important developments including the following:
1.Maturity mismatch problem of thrifts.
2.Disintermediation under regulated deposit rates creation of the secondary mortgage market.
3.Era of creative financing in the 1980s.
4.Thrift failures of the 1980s and 1990s.
5.Alternative mortgage instruments to solve the tilt problem of borrowers and the maturity mismatch problem of thrifts.
6.Effect of the call option and due-on-sale provisions of mortgages.
7.The refinancing craze of the 1990s.
8.The entrance of residential housing into the speculative investment market in the 2000s.
9.The rapid rise of house prices in the 2000s and the resulting affordability problems.
10.The emergence of alternative mortgage instruments such as interest-only ARMs and option ARMs.
11.The financial crisis of the later 2000s with bailouts for Wall Street firms and government-sponsored entities such as Fannie Mae and Freddie Mac.
The role of economic and institutional pressures in the dramatic change that occurred in the residential finance market is noteworthy. Of particular importance is the role of the following factors:
- Inflation: The fixed-rate, fixed-payment mortgage was an ideal instrument for a non¬-inflationary environment. Once inflation and inflationary expectations accelerated, interest rates rose and created severe problems for the fixed-rate loan. The tilt effect created an affordability problem for borrowers. The volatility in interest rates created the maturity mismatch problem for lenders. This in turn created the need to develop alternative mortgage instruments (AMIs) such as the graduated-¬payment mortgage (GPM), the adjustable-rate mortgage (ARM), the shared-appreciation mortgage (SAM), and the price-level adjusted mortgage (PLAM).
- Interest rate volatility: The increase in interest rate volatility had a dramatic affect on the value of the call option of a typical residential mortgage. Without prepayment penalties, a drop in interest rates made it profitable for borrowers to refinance. With a rise in rates, properties with existing, assumable mortgages rose in value. Thus, the volatile interest rates caused both the call option and the right to assume existing mortgages to become very valuable. With increasing interest rate volatility in the 1970s, lenders added a premium to the rate they charged to cover the increased value of the call option. Since the value of an assumable loan also became greater during this time a battleground developed between the right of a buyer to assume an existing loan on the one hand, and the right of the lender to enforce the due-on-sale clause on the other. And because the profitability of lenders was directly affected by the ability to enforce the due-on-sale clause, lenders put their efforts into firmly establishing that right. Regulators of financial institutions were concerned with their profitability (solvency) as well and, thus, lined up on the side of enforcement. Both court decisions and legislation (Garn-St.Germain Act, 1982) eventually favored the enforcement of the due-on-sale clause.
In essence, the lesson here is that not only did rising interest rates cause affordability problems for borrowers and maturity mismatch problems for lenders but increased interest rate volatility created its own problems. Because volatility means that interest rates take great swings—both up and down—the increased volatility raised the value of both the call option and assumability of low rate loans.
The cause of the widespread failures of savings and loans institutions should be emphasized. Begin with the negative equity produced by the maturity mismatch of the early 1980s. Indicate that deregulation caused many such thrifts to lose the value of their charter. The loss in the value of the charters exacerbated the negative equity of many thrifts. At this point they had a put option. Since they already had negative equity they had an incentive to take on risky investments such as equity participation loans. If the investments succeeded they would become profitable and restore positive equity. If not, they were in no worse position because they could put their assets to the insurance agencies (FDIC and FSLIC). Competition for funds to carry out these schemes then led to higher interest rates on deposits in the deregulated environment. Brokered deposits were a favorite source of funds. In this way failing thrifts made others non-profitable. This is the “Zombie” theory of Ed Kane.
It is important to appreciate the resolve on the part of the regulators during this whole mess. Early on, regulators were not willing to shut down insolvent thrifts and bear the cost of doing so. They hoped that falling interest rates would bring many thrifts back from the brink of failure into profitability. This did not happen. Regulatory forbearance took the form of failing to close insolvent thrifts, allowing regulatory accounting practices that differed from Generally Accepted Accounting Principles and were more lenient, producing paper profits that were not true profits for many of the thrifts, and providing window-dressing assistance such as income capital certificates and net worth certificates.
Chapter 5 also points out how the Financial Reform, Recovery, and Enforcement Act of 1989 (FIRREA) changed the regulatory structure of the financial intermediaries. Note how the structure changed by indicating the agencies that existed before and after the legislation, those that were abolished, and the new ones that were created. The effect of the FIRREA Act on the appraisal profession should also be noted.
Chapter 6. Alternative Mortgage Instruments
CHAPTER SUMMARY
Chapter 6 deals with alternative mortgage instruments (AMIs), those mortgages other than the standard long-term fixed-rate/fixed payment mortgage (FRM). Here the instructor should emphasize the supply problems (maturity mismatch) and the demand problems (tilt effect) of the standard FRM that are caused when inflation and interest rates escalate and become more variable. Note how the various features of the AMIs address the demand and supply problems. The heart of the chapter deals with adjustable rate mortgages (ARMs) so it is important to understand how ARMs work in a technical fashion using examples in which the payments are determined with reference to changing interest rates (indexes) and any rate or payment caps. Next, note not only how ARMs work in a technical fashion but also how the various terms of an ARM are priced. That is, indicate the theoretical foundation for establishing the tradeoff in terms (for example, a higher margin in exchange for tighter rate caps). Explore how the terms of the ARM are affected by the level and volatility of interest rates, especially for the first year and with fully indexed interest rates. Also, note how the level, volatility, and expected future interest rates affect the share of newly originated ARMS. It is also interesting to explore the various forms of ARMs that became popular in the mid-2000s such as interest-only ARMs, option ARMs and ALT-A loans.
Regarding other AMIs, the following should be emphasized:
•How the share of appreciation in a Shared Appreciation Mortgage is determined (formula).
•How a reverse mortgage operates.
•How the terms of a pledged account mortgage do not make sense from a financial standpoint.
•How the Price-Level-Adjusted Mortgage (PLAM) works and how it solves many of the problems of the FRM including eliminating the need to forecast the rate of inflation.
•The PLAMs major drawback remains the default rate that results from negative amortization of the loan and the possibility that individual house prices may differ from the actual rate of general inflation.
•How a graduated-payment mortgage works and how the construction of a GPM creates a problem with negative amortization, extended duration (and, therefore, interest rate risk), and forecasting the actual rate of inflation.