Transcript Chapter 17 An Introduction to the Process of Real Estate

Chapter 17
An Introduction to the Process
of Real Estate Finance
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Major Topics
 Mortgage Terms and Clauses
 Sources of Real Estate Finance
 Mortgage Money in the Context of the
Capital Market
 Primary and Secondary Mortgage Markets
 Commercial Mortgage Backed Securities
 Economic of Interest Rates
 Impact of the Federal Reserve
 Trends in Real Estate Finance
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction
 Real estate finance is traditionally the
process of borrowing or lending, most often
involving a third party that is neither the
buyer nor seller of the property in question
 From the borrower’s point of view a loan is
a debt and liability, while from the lender’s
point of view a loan is an investment and an
asset with the property serving as collateral
for the loan
 Financing a real estate transaction involves
significant risk to both the owner of the real
estate (the borrower) and to the lender
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
What is a Mortgage Loan?
 The combination of Equity and Debt used to
buy a property is known as the capital
structure of the property
 When debt involves real estate as collateral
security for the loan it is referred to as a
Mortgage
 A mortgage loan is a contractual
agreement between the mortgagor and the
mortgagee
 Important to have relationship documented
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Promissory Note
 A promissory note is a written document
containing the contract terms between the
borrower and the lender
 Legally, the promissory note provides
evidence of the debt between borrower and
lender since a mortgage cannot be
enforced unless the mortgagor owes a debt
to the mortgagee
 Practically, the promissory note documents
the agreement between the borrower and
the lender and contains the financial and
legal details of the transaction
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Clauses contained in “the note”
1. Loan Amount
2. Method of Repayment
3. Interest Rate
4. Term
5. Acceleration Clause
6. Prepayment Provisions
7. Late Payment Provisions
8. Due on Sale Clause
9. Escrow for Property Taxes/ Insurance
10. Maintenance of Property
11. Default
12. Loan Guarantees
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Mortgage Markets and the
Role of Intermediaries
 Financial Markets bring together savers
who have surplus income to invest and
borrowers who have a need for funds
beyond their current cash holdings
 Financial Intermediaries bring together
those who use borrowed funds and those
who have surplus funds to lend or invest
 Play an extremely important role in
financial markets because they absorb
many of the risks associated with lending
by and provide important services to both
savers and borrowers
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Uses of Mortgage Money
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Primary Sources of Mortgage
Money
 Single Family Housing
 Dominant secondary market players,
Freddie Mac and Fannie Mae
Multifamily Mortgage Loans
Commercial banks followed by Federally
related agencies, Fannie Mae, Ginnie Mae
etc.
Commercial Mortgages
For office and industrial property,
commercial banks, followed far behind by
life insurance companies and the larger
savings and loan associations
Commercial mortgage backed securities
market (CMBS) becoming important
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
CMBS
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Primary Suppliers of Mortgage Funds
 Savings and Loans
 Commercial Banks
 Mortgage Bankers/ Mortgage
Companies
 Life Insurance Companies
 Pension Funds
 Individuals
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Other Sources of Debt Capital
 Mortgage and Hybrid REITS (Real Estate




Investment Trusts)
Credit Unions Companies and Private
Personal Finance Agencies especially
important for home equity second
mortgages.
Investment Banking Firms through
Commercial Mortgage Backed Securities or
Direct Placements of larger loans ($100
million plus).
The Government Agencies such as the
Farmers Home Administration
Bank Trust Departments
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Impact of the RTC
 RTC had to establish standard procedures
and rating criteria in order to dispose of
much of the real estate held by the failed
institutions
 As a result, these procedures have been
used by investment bankers as a way of
structuring commercial financing
transactions on performing properties that
can be securitized and sold in the
secondary markets
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Impact of the CRA
 CRA requires that each insured depository
institution's record to meet credit needs of
its entire community be evaluated
periodically
 As a result of CRA more loans are made to
disadvantaged areas, often at below
market rates, as part of the community
oriented policies of local financial
institutions
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Influences on Mortgage
Interest Rates
Generally, the interest rate on any investment
consists of several components:
 The real risk free rate of interest
 Expected inflation over a given term
 A risk premium for interest rate risk and
liquidity concerns,
 Risk premiums for default and loss of
principal risk
 Other risk premiums such as political risks,
currency risks, or other factors that may
influence investment return volatility or
safety
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Yield Curves
 All real estate loans are affected by yields
on Treasury securities
 These yields on Treasury securities are
used by economists and financial market
reporters to construct what is called a
term structure Yield Curve
 Most yield curves are upward sloping
 Tend to flatten out or even become
downward sloping just before and during
economic recessions
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Yield Curves
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
The Real Risk Free Rate of Interest and
Expected Inflation Levels
 Nominal risk free returns were theorized to
have a real component and expected
inflation component by Ernest Fisher:
nominal rate = (1+ real rate)(1+ expected inflation) – 1
 Using this same relationship, if we know
expected inflation and nominal rates, we
can estimate real rates:
real rate = (nominal rate + 1)/(1 + expected inflation) – 1
 The level of expected inflation also has an
important influence on fixed rate mortgage
payments through the tilt effect
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Yield Curve (Contd.)
 Real risk free rates in the United States
have run about .5% to 1.5% for short term
investments and 1.5% to 4% for longer term
investments over the last few decades
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Impact of Global Capital Markets
on Mortgage Rates
 Real interest rates are ultimately driven by
the opportunity costs of capital, not just
domestically but globally
 If sufficient mechanisms evolve for foreign
capital investment in rapid growth
countries in Asia, Eastern Europe etc., they
will be able to pay greater real rates of
return than anything provided in more
developed countries
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Impact of Federal Reserve
 The overall mission of the Federal Reserve
is to keep the economy stable by balancing
the total amount of money available in the
economy with the economy’s growth and
productivity
 The three tools that the Federal Reserve
uses to accomplish this goal are as follows:
 Open-market Operations
 Discount Rate
 Reserve Requirements
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Other Risk Premia added on
Mortgages
 Default Risk
 Prepayment and Interest Risk
 Liquidity Risk
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Trends in Real Estate Finance
 The days of purely relationship borrowing
are gone, although many commercial banks
still rely heavily on relationship based
marketing
 Today we continue to see an increasing
prevalence of securitizing all types of
mortgages
 Securitization is the process of converting
an individual mortgage into a security,
often is pooled form where many similar
mortgages are combined, that is then sold
to investors in secondary markets
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
END
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner