QUICK REFERENCE GUIDEGEK2013 – REAL ESTATE FINANCE
Chapter 1: Overview of Real Estate Finance
Definitions:
Real Estate / Land and all natural part of the land and attachments to the land e.g. buildings, etcReal Property / All rights, interests and benefits related to ownership of real estate
Real Estate Finance / 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
See Notes for Overview of Capital Market
Chapter 2: Institutions & Instruments of Financial Markets
Financial Assets / Legal claim to future cash flowFinancial Market / Forum for trading funds where suppliers and demanders of funds interact to transact business
Money Market / Arena for trading short-term funds e.g. marketable securities
Capital Market / Forum for trading in equity and long term debts e.g. long-term securities
Real Estate Financial Market / Forum for trading legal claims to future cash from real estate assets
Financial Assets
Properties 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 funds
Financial Markets
Major 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 participants
Instruments of Financial Markets (Asset Class)
-Common Stock / -Bonds- Residential MBS
- Commercial MBS
- CDOs
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)
- Maturity Intermediation
- Risk reduction via diversification (doesn’t work, only redistribute but not reduce risk)
- Reducing costs of contracting the information processing
- Providing payment mechanism
Chapter 5: Mortgage Markets I
Mortgage / Special 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
-Owner’s interest subordinate to lender’s interest
Mortgage document / Pledges the property as collateral for the loan
Promissory Note / 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. 3rd 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 Clause / Provision that enables lender to demand payment of entire outstanding when first monthly payment is missed
Due-on-sale Clause / Provision 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 wasn’t sold
Loan Terminology
Loan-to-value ratio /
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 i/r / Rate specified in contract for purpose of calculating interest charges
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 Amortization / Regular, periodic repayment of principal
, Real rate of Interest
, Inflation Expectation
, Risk Premiums
Mortgage Interest Rate(See Notes for Demand VS Supply)
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
Constant Payment Mortgage / Constant 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 months / 1)Compute constant amortization amount
2)Compute monthly interest on loan balance
3)Compute Total Month’s 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 Costs
1)Compute monthly loan payments
2)Calculate net cash disbursed (Loan amount – Origination fee / Discount points = Net disbursed)
3)Compute effective i/r
Early repayments and Prepayment Penalty
-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
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QUICK REFERENCE GUIDEGEK2013 – REAL ESTATE FINANCE
Chapter 6: Alternative Mortgage Instruments
Type / Usage / MathematicsAdjustable-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 = $100,000
Index = 1 year
Margin = 2.50
Term = 30 years
2/6 i/r caps
Teaser Rate = 5% / See Notes for computation
Graduated-Payment Mortgage / Graduated Payment Mortgage designed to offset tilt effect by lowering payments on an FRM early on and increasing over time
Price-Level Adjusted Mortgage / Solves tilt problem and interest rate risk by separating real rate of return and inflation rate:
/ $100,000 30years, 6% interest / PMT in Year 1
4% inflation /
Year 2
4% inflation /
Year 3
-3% inflation /
Year 4
2% inflation /
Year 5-30
0% inflation /
Shared Appreciation Mortgage / 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
Reverse Annuity Mortgage / Borrower 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 Program / Combines a deposit with lender and fixed rate loan to form a graduated-payment structure
Deposit in pledged as collateral
Type / Advantages / Disadvantages
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 doesn’t 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
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QUICK REFERENCE GUIDEGEK2013 – REAL ESTATE FINANCE
Chapter 7: Financing Decisions
House Value = $100,00080% LTV, 12% i/r, 25 years / 90% LTV, 13% i/r, 25 years
Down payment
/ Down payment
Compute internal rate of return, irr
Borrow $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 EOY5 / Loan Outstanding EOY5
Difference in loan outstanding
With 2% origination fee
Loan disbursement / Loan disbursement
Difference at time zero
Borrow $10,000 more but pay $172.47 more per month
Assume Alternative #2 changed to 30 years
80% LTV, 12% i/r, 25 years / 90% LTV, 13% i/r, 30 years
Down payment
/ Down payment
Difference at time zero
Difference 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 agoStick / Switch
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 EOY10 / Loan Outstanding EOY10
Difference in loan outstanding
Two or more Loans
Financial Package / Individual Loans / Payment of individual loans$500,000: / $100,000 at 7%, 30 years
$200,000 at 7.5%, 20 years
$200,000 at 8%, 10 years /
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QUICK REFERENCE GUIDEGEK2013 – REAL ESTATE FINANCE
Chapter 9: Controlling Default Risk
Loan Underwriting: Process of determining and controlling default risk, evaluate borrower’s loan request in terms of profitability and risk
See Notes for Underwriting Process
Type / Formula / ExampleLoan-to-Value (LTV) / /
Payment to Income Ratio
-OR-
Mortgage Servicing Ratio /
/ Jack’s gross income is $5,500
Monthly 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 Insurance / 250
Credit Card / 700
Personal Loan / 500
Property tax & Insurance / 300
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 Ratio / Gross Monthly Income / $7,780
Times: HEIR / 0.30
Max Permissible long term obligations / $2,361
Less: Property tax & insurance / 300
Max Principal & interest payment / $2,061
Total Debt Service Ratio / Gross Monthly Income / $7,780
Times: TDSR / 0.60
Max Permissible long term obligations / $4,722
Less: Property tax & insurance
Less: Payments on long-term debt / 300
2950
3,250
Max Principal & interest payment / $1,472
Chapter 11: Asset-Backed Securities
Securitization / Process by which assets are packaged into securities sold on organized exchangesAsset-backed Security / A security created by pooling loans
Bankruptcy Remote / A 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 future
Securitization Structure
Amortizing Assets (Self-liquidating Structure) / Non Amortizing Assets (Revolving Structure)Periodic payments consisting if principal & interest
Amortization schedule on a pool/loan level
See Notes for further explanation / -No amortizing schedule
-Lockout/revolving period
No fixed period, only minimum payment, e.g. credit card
Fixed Rate / Floating Rate
Possibility of mismatch between cash flow characteristics of underlying asset and liabilities. Interest rate derivatives are used to mitigate the risk
Asset Classification
Asset Risk / Structural Risk / Third-Party Providers
-Underlying borrower’s 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 loss / Can 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 class
Residential Mortgage Backed SecuritiesPrepayment 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 Vehicle
A 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 Securities
When 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 portfoliosand 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.