Ch 1. Real Estate Finance: An Overview



Real Estate Finance: Theory and PracticeEdited Chapter Summaries and Learning NotesClauretie & Sirmans: 2010, 6th EditionCengage LearningTable of Contents TOC \o "1-3" \h \z \u Ch 1. Real Estate Finance: An Overview PAGEREF _Toc250414594 \h 1Chapter 2. Money, Credit, and the Determination of Interest Rates PAGEREF _Toc250414595 \h 2Chapter 3. Finance Theory and Real Estate PAGEREF _Toc250414596 \h 3Chapter 4. The Early History of Residential Finance and the Creation of the FRM PAGEREF _Toc250414597 \h 3Chapter 5. Postwar Residential Finance PAGEREF _Toc250414598 \h 4Chapter 6. Alternative Mortgage Instruments PAGEREF _Toc250414599 \h 6Chapter 7. Financing and Property Value PAGEREF _Toc250414600 \h 7Chapter 8. Federal Housing Policies: Part I PAGEREF _Toc250414601 \h 8Chapter 9. Federal Housing Policies: Part II PAGEREF _Toc250414602 \h 10Chapter 10. The Secondary Mortgage Market PAGEREF _Toc250414603 \h 11Chapter 11. Valuation of Mortgage Securities PAGEREF _Toc250414604 \h 12Chapter 12. Controlling Default Risk Through Borrower Qualification, Loan Underwriting and Contractual Relationships PAGEREF _Toc250414605 \h 13Chapter 13. Loan Origination, Processing and Closing PAGEREF _Toc250414606 \h 14Chapter 14. Mortgage Default Insurance, Foreclosure and Title Insurance PAGEREF _Toc250414607 \h 15Chapter 15. Value, Leverage and Capital Structure PAGEREF _Toc250414608 \h 15Chapter 16. Federal Taxation And Real Estate Finance PAGEREF _Toc250414609 \h 17Chapter 17. Sources of Funds for Commercial Real Estate Properties PAGEREF _Toc250414610 \h 18Chapter 18. Acquisition, Development and Construction Financing PAGEREF _Toc250414611 \h 19Chapter 19. Permanent Financing of Commercial Real Estate Properties PAGEREF _Toc250414612 \h 20Chapter 20. Ownership Structures For Financing and Holding Real Estate PAGEREF _Toc250414613 \h 21Chapter 21. Real Estate in a Portfolio Context PAGEREF _Toc250414614 \h 22Chapter 22. Liability, Agency Problems, Fraud and Ethics in Real Estate Finance PAGEREF _Toc250414615 \h 23Ch 1. Real Estate Finance: An OverviewCHAPTER 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 RatesCHAPTER SUMMARYThe 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 EstateCHAPTER SUMMARYThis 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 FRMCHAPTER SUMMARY AND SUGGESTIONS FOR TEACHINGChapter 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 FinanceCHAPTER 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 InstrumentsCHAPTER SUMMARYChapter 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. ?How the tax treatment of income and expenses affects the desirability of each of the AMIs. ?The reasons why, with the exception of ARMS, few AMIs have gained in popularity.Chapter 7. Financing and Property ValueCHAPTER SUMMARY This is a relatively brief chapter that discusses the effect of the terms of financing on the transaction values of properties. It centers on what is commonly referred to as “creative financing” which is a collective term for any financing that provides the borrower with an interest cost that is lower than the prevailing, market rate. This includes- low-rate assumable loans, wraparound loans, builder buy-downs, and owner (seller) financing. With creative financing the monthly payment on a given loan amount is less than if the loan were financed at market rates. It is the payment savings that gives the financing package “value.” The term cash equivalence is explained and the text indicates how, in the literature, “cash equivalent” has come to mean the present value of the payment savings.Most of the discussion takes place in terms of residential properties. Chapter 7 traces the literature on this topic in terms of its chronology. Then it first discusses the early crude theoretical work that suggested that the full value of creative financing as measured by the present value of the payment savings should be included in the price of the property. Then it turns to the early empirical work that suggested that transaction prices did not, as a rule, include the full cash-equivalent value. Next it discusses some additional work on the theory of creative financing that suggests that the full cash-equivalent value should not be included (capitalized) into the price of the property. Some of these suggestions are mentioned but dismissed with a final discussion of the value of assumable loans in terms of their option values. Chapter 7 concludes with a discussion of mortgage revenue bonds and the effect these have on property values.It should be noted that the issue of cash equivalence is one that exists when market rates become historically high, and even though market rates are presently moderate, the issue can easily reappear in the future. Also, note the importance of the topic from the practical standpoint of obtaining correct appraisal values by the use of comparables. Additionally, this material provides a good background for the discussion of the effect of finance on commercial property values (see Chapter 17).Chapter 8. Federal Housing Policies: Part ICHAPTER SUMMARY Chapter 8 and Chapter 9 discuss federal policies toward the purchase and financing of residential properties. To make it easier to understand federal policies the content has been divided into four main categories. They are federal policies as they relate to the following:1.Affordability-programs designed to lower the cost of purchasing and financing residential properties.2.Efficiency-programs designed to make the residential property market operate more efficiently.petition-policies designed to foster competition among the suppliers of residential property financing.4.Equity-programs designed to make housing available to all citizens regardless of race, gender, religion, national origin familial status, or handicap.The first three objectives are covered in this chapter. The last objective (4), a major focus of government policies, is covered in Chapter 9.Affordabi1ity. Be sure to understand that government programs increase affordability in many ways, some not so obvious. The obvious programs are the grant programs undertaken by HUD such as the well-?known Section 8 program that subsidizes the rent for low-income families. The not-so-obvious programs have the effect of reducing the cost of homeownership by reducing the interest and insurance costs. Interest costs are reduced because financial intermediaries are subsidized by some government programs such as the low insurance premium for deposit insurance or inexpensive loans from the regulatory agencies. Also, mortgage insurance costs are subsidized through the VA and FHA programs. Be sure to understand the effect of the secondary mortgage market interest rates. An efficient secondary market has the effect of integrating the mortgage market with the capital market and lowering mortgage rates which, of course, increases affordability. Finally, the federal government in regulating the secondary mortgage market can and does require that Fannie Mae and Freddie Mac purchase a certain number of mortgages originated for very low and low-income families.Efficiency. While one impact of a secondary mortgage market is to lower interest costs, it also affects the efficiency of the mortgage market, a somewhat related issue. The success of the secondary mortgage market is the result of government policies. The federal government chartered and backed GNMA, FHLMC, and FNMA. In addition, various federal tax laws have been enacted to allow the secondary mortgage market agencies to operate and compete in the capital petition. The Congress has enacted several laws to increase the degrees of competitiveness in the housing and housing finance markets. Note the desirable results from competitive models in terms of efficient resource allocation. Also note that one of the primary assumptions of models of perfect competition is that market participants have full knowledge of all pertinent information. Finally, the primary object of several federal laws is to require the disclosure of information to buyers and borrowers. In short, several federal laws encourage and require the dissemination of information in the hope that such dissemination will make housing, and housing-finance markets more competitive.The three main laws that require publication of information are: (1) the Interstate Land Sales Full Disclosure Act, (2) the Real Estate Settlement Procedures Act, and (3) Regulation Z. The first Act requires disclosure about the characteristics of raw land sold to buyers across state lines. The second requires the disclosure, before settlement, of the costs associated with a loan closing. The third law requires two pertinent pieces of information be given to the borrower in a mortgage transaction—the annual percentage rate of interest on the loan and the total amount of finance charges over the stated period of maturity of the loan.In this chapter we introduce the concept of computerized loan origination systems (CLOS) and indicate their effect on competition and recent HUD decisions concerning the relationship of real estate salespersons to mortgage originators. This may be an emerging issue as more and more institutional lenders (such as fife insurance companies) purchase franchised residential mortgage brokerage firms.Chapter 9. Federal Housing Policies: Part IICHAPTER SUMMARYChapter 9 completes the discussion of federal policies toward housing. The focus of this chapter is on federal policies designed to protect the rights of minorities and the disadvantaged in the purchasing and financing of housing. There are several laws and amendments which address housing equity. The two primary laws relate to purchasing (Fair Housing Act) and financing (Equal Credit Opportunity Act [ECOA]).The laws were passed as a reflection of the civil rights movement of the 1960s and the continual vigilance which the federal government has over the rights of minorities and disadvantaged individuals. Here we are concerned with the economics of discrimination. While the laws and penalties are described, the introduction of the theory of discrimination in competitive markets is emphasized. Students are encouraged to think conceptually about the economic theory of discrimination. Also introduced is a heavy dose of empirical results. This topic can be controversial and emotional for some students. Approach the topic from a neutral role and discuss all sides of the various issues. An attempt has been made to present a balanced view of the empirical literature on discrimination. In this regard, it is important that some of the methodological problems of some of the empirical studies be discussed.The authors also urge students to be aware of the practice of “FHAing” and indicate how it is a market reaction to the Home Mortgage Disclosure Act and the Community Reinvestment Act.Chapter 10. The Secondary Mortgage MarketCHAPTER SUMMARYChapter 10 is a description of the secondary mortgage market and the institutions that participate in that market. No attempt is made here to describe, in detail, the mortgage-related securities that the secondary mortgage market agencies and firms issue in order to fund their mortgage purchases. Neither is an attempt made to explain the cash flows and the valuation of these securities. The authors feel that the student will get a better grasp of the nature of the secondary mortgage market if the description and valuation of mortgage-related securities are treated in a separate chapter.Begin first by explaining what a secondary market is and how it differs from a primary market. Next, describe the secondary mortgage market. After that, explore why the secondary mortgage market exists, that is, why it creates value, or how the services it provides are valued by the financial markets. Here it should be emphasized that the secondary mortgage market solves two mismatch problems: the maturity mismatch and the geographical capital flows mismatch. The importance of the federal government should not be overlooked. Be aware that the federal government passed legislation that overrode state securities laws that impeded the development of the market by obstructing the sale of mortgage-related securities. Also note how the federal government influenced the development of the market through its implicit insurance function.Next, understand the three desirable characteristics of mortgage related securities: credit enhancement, avoidance of double taxation, and rearrangement of the cash flows of a pool of mortgages. In regards to credit enhancement be sure to list the ways that the enhancement is accomplished including pool insurance, letters of credit, and agency equity or overcollateralization.Be sure you are able to differentiate between the different types of mortgage related securities and emphasize that the major distinction is based on how the cash flows from the pool are (or are not) rearranged for delivery to the security holders.Next, review the major secondary mortgage market agencies and firms and emphasize the sources of funds for them. Note the nature of their obligations in terms of their maturity. Go over the financial statements of Fannie Mae and Freddie Mac and show where they derive their profits and how the structure of their balance sheet exposes or insulates them from interest rate risk.The “decade of change” section in this chapter gives the students a short history of the development of the secondary mortgage market and they should be encouraged to read it. The description of the flow of funds in the primary and secondary mortgage markets is not intellectually challenging but is, nonetheless, interesting. The relative importance of the major agencies can be grasped by a review of the data in this section. The chapter closes with a discussion of the regulation of the government-sponsored agencies (GSEs; Fannie Mae and Freddie Mac) because it is a recent and timely topic.Chapter 11. Valuation of Mortgage SecuritiesCHAPTER OUTLINEChapter 11 discusses the valuation of the cash flows of mortgage-related or mortgage derivative securities. The mortgage-related securities were described in Chapter 10. Here the cash flows of the mortgage-related securities plus those of a few of mortgage-derivative securities (such as IOs and POs) and servicing rights are described. The central theme of this chapter is that many of the mortgage-related and derivative securities have interest-contingent cash flows. This means that as interest rates change not only does the valuation of the cash flows change but also the amount and timing.The chapter opens with a discussion of traditional debt securities. This may be familiar territory for a lot of students and it gives a good starting point to indicate the differences between traditional debt securities and those that are interest-rate contingent. The authors discuss the concepts of yield-to-maturity and duration so as to lay the groundwork for understanding how these concepts are applied to traditional debt securities. It is an easy transition to apply these concepts to mortgage-related securities. Since prepayments from a pool of mortgages have such an important influence on the amount and timing of the cash flows from the pool, much time is spent discussing the various models of prepayments and the determinants of prepayments—especially market interest rates.Next, the authors discuss the cash flow patterns of the mortgage-related securities in the order that they were discussed in the previous chapter. This discussion begins with passthroughs and the pricing of premium and discounted types of these securities. Then discussion proceeds to the mortgage-backed bonds and shows how prepayments affect the residual fund balance required to retire the issue at maturity. Perhaps the most intricate of the mortgage related securities is the collateralized mortgage obligation. Here the student is taken step by step through the flows of the mortgage pool to the various tranches. Some software is provided with the text. The authors suggest students become familiar with the portion of the software that deals with collateralized mortgage obligations. Here one can alter the prepayment assumptions or the coupon yields on the various tranches (or other variables) and see how the cash flows to the various tranches pay off in different years. The authors students compute the cash flows to the various tranches for only the first few years or so.Always an interesting topic is the behavior of the cash flows of the IOs and POs in reaction to changes in the market rate of interest. Be sure to mention the interest rate risk hedging qualities of the I0 strip. Show how the hedge works with a numerical example. The I0 strip represents a good introduction to servicing fights because the cash flows of the two are very similar. A small part on the availability of data on mortgage pools is introduced next, and concludes with a discussion on value creation through mortgage-derivative securities. The authors indicate that in a perfectly efficient market there is no reason to believe that a separation of the cash flows into various components should create greater value than that of the cash flows as a package. There are some reasons why value may still be created, however, including different risk preferences and asymmetric information concerning default risk.Chapter 12. Controlling Default Risk Through Borrower Qualification, Loan Underwriting and Contractual RelationshipsCHAPTER SUMMARYChapter 12 discusses the various methods that lenders use to ensure against default risk on residential mortgages. There are two main avenues through which lenders reduce risk. One is through borrower qualification whereby the characteristics of the borrower and those of the property are analyzed to assess the risk of default. The second avenue is through the contractual relationships in the loan documents (the note and the mortgage or the deed of trust). As regards the first point, the authors emphasize the two theories of default: the ability-to-pay theory, and the equity theory. It should be noted that the two theories are not conflicting but rather support one another. If a borrower has negative equity in a property he or she may still not default if there is some reason not to do so. The reason may be the cost associated with a bad credit rating or a subjective valuation of the house in excess of the market. However, if an event such as loss of employment or a sudden unexpected large liability (illness) occurs, the borrower may be unable to make the payments on the mortgage. In this case the loss of the house and the credit rating become inevitable and the optimal decision to default. Of course there is always ruthless default when the borrower defaults on the loan whenever there is negative equity in the property and the borrower places no value on his or her credit rating.Regarding the second method of protecting against default-contractual relationships-be sure to emphasize that the contractual provisions are made to protect against agency problems. A classic example of this is the provision that hazard insurance and property taxes be placed in escrow. In this fashion the lender is assured that these items are paid and that there will be no compromise of the collateral through the failure to pay taxes or in the event of an uninsured hazard.In the context of borrower qualification, the guidelines for FHA and VA loans are reviewed. Indicate that the guidelines are constantly changing with minor variations occurring annually. A numerical example is included (the Smith family) so that the student can see the differences in the borrower qualifications between the FHA, VA, and conforming conventional loans.Chapter 13. Loan Origination, Processing and ClosingCHAPTER SUMMARY AND SUGGESTIONS FOR TEACHINGThis is a brief and descriptive chapter concerning the mechanics of loan origination and processing. The authors also place some descriptive material on mortgage banking in this chapter. This material is placed here because these firms are not investors in mortgages. Their expertise is m the mechanics of loan origination and processing as described in this chapter. The students should be advised that the material is very descriptive and not at all abstract. In fact, many of the precise steps involved in the origination of government-insured loans are very regimented and must be followed without deviation. These steps and paperwork will change from time to time.For convenience we address the steps in the origination and closing process in the order in which they occur. If the instructor is not particularly “up” on these procedures but wants the students to have knowledge concerning this process, consider inviting a loan processor from a local bank or mortgage company to give this lecture. Generally, they will be knowledgeable about the latest requirements and forms that need to be completed. Although an in-depth treatment of appraisal issues is not provided in this text, a very brief treatment of appraisal techniques is given here. If a more in-depth treatment of appraisal techniques and practices than provided in this text is preferred, then explore some supplementary material. It is impossible to cover everything about real estate in a finance text; therefore, a choice was made as to which topics would receive only a brief treatment. Appraisal practices was one of those.Chapter 14. Mortgage Default Insurance, Foreclosure and Title InsuranceCHAPTER SUMMARYChapter 14 covers three basic topics: One is the mortgage-default insurance plans of private mortgage insurers, the FHA, and the VA. Second is the economics of foreclosure and the manner in which state laws affect the costs of foreclosure and the incentives of lenders under each of the insurance plans discussed in the first section. The final topic is that of title insurance and the economics of the title industry.The first topic covered compares the various insurance plans in terms of their coverage and incentive conflicts with lenders. The difference between partial coverage (VA), complete coverage (FHA), and co-insurance (PMI) should be pointed out, and the way plans work should be shown, perhaps with a common numerical example. Indicate that the complete coverage insurance of the FHA sets up an incentive conflict between the lender and the FHA. The lender has little or no incentive to mitigate losses because all losses are covered by the FHA. This is not the case with partial and coinsurance. Like Chapter 13, some of the material in this section is descriptive and may change from year to year as government insurance programs change their rules and regulations. The FHA rules and regulations covered here are those in force as of the Spring of 1995. Check for any recent changes.As regards state foreclosure laws, the differences in costs among the various state laws are pointed out. Generally, states that require a judicial procedure and allow a statutory fight of redemption impose greater costs on lenders than states that allow a power-of-sale procedure and terminate the redemption fight with the foreclosure (equitable fight of redemption). Much of the added costs come from the carrying costs that the lender incurs when the lender is forced to hold the property for a long period of time. Carrying costs can double and even triple the amount of the claim on a foreclosed property. Private mortgage insurers attempt to reduce this cost through the co-insurance provisions but the FHA picks up all of these costs. The authors also discuss the existence of anti?deficiency judgment statutes in a handful of states and the effect such legislation has on foreclosure losses. Finally, Chapter 14 closes with a discussion of title insurance. Be sure to note the difference between title insurance and property and casualty insurance: the former insures against past events and the latter against unforeseen future events. Also note that title insurance is protection against unknown events that may have occurred since the last transaction and not, as many persons believe, events that occurred many generations ago. Be sure to note the difference between an owner’s policy and a lender’s policy. The former only insures against unknown clouds on the title and not those hens and encumbrances that are known to exist prior to sale. The latter insures against all possible defects in title. The latter is, of course, a little more expensive. Also realize that owners can buy lender’s insurance if they want. This is typical of all cash transactions where the buyer wishes to enjoy the protection usually afforded a lender.Chapter 15. Value, Leverage and Capital StructureCHAPTER SUMMARY AND SUGGESTIONS FOR TEACHINGChapter 15 discusses the age-old question of the relationship between methods of financing and property values. The authors approach the question in much the same fashion as do texts on corporate finance. After, one would get into the same sorts of issues if a corporation were formed for the sole purpose of buying and holding a commercial real estate property.The topic is first approached from the standpoint of the traditionalist theory in a no-tax world. That is, the discussion of leverage and capital structure assuming that taxes do not matter. The traditionalists argue that debt financing produces value because the required return to the debt holders is less than the return on the asset. In other words, debt financing is valuable to the owner of the property because borrowed funds (debt, other people’s money) has a cost less than the return on the asset. If a portion of the asset earns a rate of return greater than the cost of financing it (through debt) then the residual accrues to the benefit of the equity holder. The authors explain the traditionalist view with the commercial real estate example used in other parts of the text.The traditionalist argument of leverage and value is countered with the typical Miller--Modigliani (MM) argument that the value of the property is determined by the expected cash flows of the property and their risk and not by how those expected cash flows arc divided between debt (mortgage) holders and equity holders (property owners). The authors even attempt an arbitrage example here just as Miller and Modigliani did, again using the same commercial real estate property example.An agency problem is also introduced here. The text indicates that the MM arguments hold only if the property owner was able to borrow personally at the same rate as a corporation (or at the same rate as the property could). But this is unlikely because lenders value the collateral that property serves in the credit arrangement. In short, borrowing costs are different at the personal level than at the property level so that the debt is driven to the property and not to the investor personally.Next, it is shown how consideration of taxes and other property characteristics affect the choice and use of debt to finance commercial real estate properties. In particular, the authors discuss the role of taxes and the impact of interest and depreciation deductions. Also shown is how the use of debt can be influenced by the form of ownership of the property (partnership, corporation, and so forth), the access to equity markets, risk of the property, bankruptcy costs, and the level of interest rates.Chapter 16. Federal Taxation And Real Estate FinanceCHAPTER SUMMARYChapter 16 summarizes major tax legislation as it affects investment in commercial real estate properties. Because tax laws change frequently, students should be aware of any recent changes in the tax law since this text went to press in the Fall of 1998. The focus of the material in this chapter is the manner in which tax laws affect the after tax cash flows from a commercial property and, therefore, the value of the property.The tax laws affect the value of commercial properties in two ways: (1) the way in which taxable income is computed or defined, and (2) the tax applied to taxable income. As regards the first way the authors concentrate on such things as the role of depreciation and limitations on interest deductions. Regarding the second way, the authors focus on such matters as the passive loss rules, capital loss limitation rules, and “at risk” rules. It is suggested that students begin by reviewing both Table 16-1 and Figure 16-1 in the text. These sources represent a good summary of current tax legislation. The body of the material begins with a discussion of tax shelters and the role that depreciation has historically played in the creation of tax shelters. Here the importance of cash flows as opposed to income statements is emphasized. The authors also stress the fact that generous tax shelter rules (as with depreciation) can create positive cash flows for commercial real estate projects that would otherwise be uneconomical. A numerical example is provided so that the student can visualize the role of depreciation allowances in transforming an uneconomical project into a cash-generating property.In the next section the tax rules for depreciation are compared under several different tax regimes. Be sure to note the dual role of the amount of depreciation and the maximum tax bracket. Tax shelters have their greatest value when the amounts of allowable depreciation are generous and the maximum tax bracket is high. Also discussed are some of the old tax regulations, created in an earlier environment, that are still with us, such as the OID rules, interest limitation rules, and at-risk rules. Some numerical examples are provided here so that the students can see the numbers work out.Under the section on the determination of taxes the authors outline the rules on active, passive, and portfolio income; discuss the alternative minimum tax rules; and treat favored classes of investment for which there are tax credits such as historic rehabilitation and low-income housing. Next, a section on the effect of the TRA of 1986 on investment in commercial real estate properties is included. The way in which interest in real estate limited partnerships has all but dissolved as a result of the passive loss limitations rules imposed on these entities is demonstrated. Finally the chapter discusses the rules for tax-free exchanges and installment sales.It should be noted tax rules are much more complex than can be indicated in this short chapter, and that they are constantly changing and being interpreted by the tax courts.Chapter 17. Sources of Funds for Commercial Real Estate PropertiesCHAPTER SUMMARY Chapter 17 discusses the sources of funds for developing and purchasing commercial real estate. For convenience it is broken down into sources of debt and sources of equity financing. It is a very descriptive chapter. The authors have tried to “spice it up” by including material on some of the actual companies involved in raising real estate capital. Also included are some data on the sources of funds by investment vehicle such as real estate limited partnerships and real estate investment trusts (REITs). The instructor should note that because of delays in data collecting, some of the material might be dated.Because pension funds are expected to play an increasingly important role as a source of funds the authors have included a section on pension funds and the constraints they may face in their investment plans for real estate. Here, restrictions imposed by the Employment Retirement Security Income Act (ERISA), tax rules applied to unrelated income, and accounting rules established by the Financial Accounting Standards Board (FASB) are discussed. A section on public/private partnerships for developing real estate properties and a section on finding sources of funds are also included.Chapter 18. Acquisition, Development and Construction FinancingCHAPTER SUMMARYChapter 18 treats the topic of ADC financing. The business of the real estate developer is different from that of other real estate investors. The developer requires funds to acquire and develop property, not for long-term investment. Thus ADC financing is typically short-term. Because ADC financing is short-term the developer will need to arrange for a long-term “take-out” loan. This long-term loan will provide the funds to repay the ADC loan. Also, since ADC loans are short-term they generally do not provide for payment of interest prior to the maturity of the loan. That is, interest is accrued over the period of the loan, several months to a year or so, and included in the final amount due to the ADC lender.Since the collateral for the ADC loan is the property being developed, the ADC lender must assure that the loan proceeds are used for their intended purpose: To improve the value of the property being developed. In this regard there may be an agency problem between the ADC lender and the real estate developer. The lender has an incentive to make sure that the loan proceeds are used to increase the value of the collateral. The borrower may have an incentive to use the loan proceeds for other purposes including improving the value of other properties that the developer owns or even for personal gain. For this reason ADC lenders employ several techniques to reduce agency costs. First, the terms of the ADC loan will be very precise as to the use of the loan disbursements. The terms will stipulate that the loan proceeds can be used only to construct the project in question. The terms will also state that all of the components of the structure including, in some cases, furniture and fixtures, will represent collateral for the ADC loan. Also, the ADC lender will employ the services of an independent party called a voucher control agent. It is the job of the voucher control agent to make sure that the loan disbursements are used for the construction of the facility and that all contractors who have worked on the project have been paid. This ensures that no mechanics or material liens will be outstanding on the property.Chapter 19. Permanent Financing of Commercial Real Estate PropertiesCHAPTER SUMMARYChapter 19 reviews long-term, permanent financing arrangements for commercial properties. After a brief description of standard long-term fixed-rate loans the authors introduce two alternatives that have some interesting implications and applications. They are: the equity participation loan and the sale-leaseback arrangement. Regarding the equity participation loan, the terms of the trade-off of lower interest rates for a share of profits or appreciation is emphasized. Here the implications of an efficient market are discussed, and a suggestion made that the trade-off would be priced efficiently. In this regard, the authors discuss the effect of the terms of the trade-off on the risk-adjusted discount rate employed by the borrower and the lender. It is shown that value can be created through the rearrangement of the cash flows from the real estate property if the risk-adjusted discount rates change disproportionately for the lender and the borrower. If the equity participation loan increases the risk for the lender less than the reduction for the borrower, then both parties may benefit from the terms of the participating loan.As regards a sale-leaseback, it should be noted that the cash flows involved in a sale-leaseback-repurchase are identical to obtaining a loan collateralized by the property. Thus, sale-leaseback is considered a form of financing. Also, it should be pointed out that there are several reasons for entering into a sale-leaseback, including tax reduction, improving the return on assets, and lowering the debt-equity ratio. Point out that the last two are accounting effects only and, in an efficient market, should not affect the value of the arrangement. However, since a sale-leaseback may lead to a step up in the depreciable basis of the property tax, savings can result for the entity that purchases the property and leases it back to the former owner. These tax savings can, in turn, lead to lower lease payments and a savings for the seller of the property as well. In other words, because the total tax payments going to the government is reduced, both the seller and the buyer of the property can benefit and share the extra cash flows. The chapter concludes with some notes on, and examples of, accounting for sale- leaseback.Chapter 20. Ownership Structures For Financing and Holding Real EstateCHAPTER SUMMARYChapter 20 discusses the various forms in which real estate can be held from sole proprietorship to limited partnerships and real estate investment trusts (REITs). There are three primary determinants that affect the decision as to which type of ownership structure is used to hold real estate-tax laws, access to capital markets, and issues of personal liability. Emphasize that, depending on the circumstances, one type of ownership structure will be better than the others. Students should refer to the summaries of each type of ownership structure as a quick guide. Although the authors mention sole ownership and corporate ownership, the bulk of the chapter concentrate on limited partnerships and real estate investment trusts. Regarding limited partnerships, note the effects of the Tax Reform Act of 1986. Also, be aware that the new depreciation rules and the limitation of passive losses have materially affected the desirability of this form of ownership.Toward the end of the chapter considerations are indicated that affect the decision to hold real estate in corporate versus partnership form. This is an excellent summary of the critical factors and should be emphasized. Also, at the end of the chapter, a summary of the various ownership forms is presented in table format (Table 20-5 in the text).Chapter 21. Real Estate in a Portfolio ContextCHAPTER SUMMARYThe focus of Chapter 21 is on the risk-reduction properties of portfolio construction and its implication for real estate investment. The chapter begins with a general discussion of the concept of risk reduction through portfolio construction. The student is guided through a non-rigorous history of portfolio construction and asset pricing theory. Because there may be some non-finance majors in the class, the material is not too demanding. It may be wise to review the simple example in the text of the two asset portfolio. In this example, the student can easily grasp the concept of a reduction in risk through the combination of two assets with identical distributions of returns but with independent correlation. Be sure to emphasize that risk reduction through diversification is more efficient where the correlation in returns is less than perfectly positive and that, additionally, the efficiency increases as the correlation decreases. This is essential so that students may understand the significance of the correlation coefficients in the matrices that are presented in the second half of the chapter.After the introduction on the theory of portfolio construction and asset pricing the authors present some empirical evidence on the diversification benefits of real estate. This is begins with a discussion of within-real estate diversification; that is, the effect of combining different types of properties into a real-estate-only portfolio. Here the effects of different property classifications and different geographical regions are discussed. In this regard, the instructor should point out how the diversification benefits of real estate differ depending on how geography is defined. East–West types of definitions do not provide the benefits of diversification nearly as well as geography defined by the nature of the regional economy. The chapter concludes with a discussion of the diversification benefits of adding real estate assets; that is, a mixed-asset portfolio.Chapter 22. Liability, Agency Problems, Fraud and Ethics in Real Estate FinanceCHAPTER SUMMARYChapter 22 deals with topics that are typically neglected in real estate finance texts. Yet, for students who may someday enter the field of real estate lending, the topics covered in this chapter are vital. The bulk of the chapter deals with the legal and liability problems of real estate lenders. The chapter begins with a discussion of liability issues under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) regulations. The heart of the material here is a discussion of some of the more important cases that have helped to define lender liability in this area. In line with the discussion in this area, some material on risk management for lenders is presented.Next, a discussion of some sources of liability for the lender that emanate from the relationship with the borrower occurs. There has been a proliferation of lawsuits against lenders by real estate developers and investors who have suffered losses and seek a solution in the deep pockets of the lender. At the heart of this material are the various. theories of lender liability, which range from promises and commitments for loans, promissory fraud, nondisclosure fraud, breach of contract, and tender control or duress.Some developing issues related to borrower bankruptcy and the cram-down process are next discussed. More and more borrowers are attempting to relieve themselves of their debt obligation through the protection of the bankruptcy courts. The threat of cram-down is becoming more serious in this area, and lenders need to be aware of the dangers. The chapter concludes with a discussion of fraud, ethics, and agency relations. Here several real-world examples of fraud and agency problems in the real estate finance context are presented. ................
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