Real Estate Investment

& Finance
Joseph Shaw
Agenda – Week 9

 Review of the Mid Term

 Lecture – Chapters 4, 12
Chapter 4
Fixed Interest Rate Mortgage Loans
Determinants of Mortgage Interest
Rates: Real vs. Nominal Interest Rates

 Real Rate of Interest

◦ Time Preference for Consumption
 Compensation to delay a purchase
◦ Production Opportunities in the Economy
 Competition for funds when there are other investment opportunities

 Nominal Interest Rate – the contract interest rate agreed

on by borrowers and lenders.
Determinants of Mortgage Interest
Rates: Interest Rates and Risk

 Default Risk
 Interest Rate Risk

◦ Anticipated Inflation and Unanticipated Inflation

 Prepayment Risk
 Liquidity Risk
 Legislative Risk
Determinants of Mortgage Interest
Rates: Summary

 where:
◦ i = interest
◦ p = premium
◦ f = anticipated inflation
◦ r = real rate of interest
Understanding Fixed Interest Rate
Mortgage (FRM) Loan Terms

 Loan amount – the amount borrowed and what the

borrower is legally required to repay
 Loan maturity date – the date by which the loan must

be fully repaid
 Interest rate – nominal annual rate of interest
 Periodic payments – regular cash flows from the

borrower to the lender according to the amortization

schedule
Mortgage Payment Patterns
 Constant Payment Mortgage (CPM)
• Loan Amortization Changes
• Monthly Payment Remains the Same

 Constant Amortization Mortgage (CAM)

• Loan Amortization Remains the Same
• Monthly Payment Changes
Calculating Payments and Loan Balances
– Accrued Interest and Loan Payments

 Accrual rate – the frequency at which a loan requires

interest to be accrued calculated as

 Pay rate – the ratio of the loan payments to the loan

amount (which is not necessarily equal to the accrual
rate).
Calculating Payments and Loan Balances – Loan
Amortization Patterns

 Fully amortizing – the pay rate will exceed the accrual rate
 Partially amortizing –the pay rate will exceed accrued
interest but less than the fully amortizing loan.
 Interest-only (zero-amortizing) – the pay rate will equal the
accrual rate.
 Negative amortizing –the pay rate will be less than the
accrual rate.
Calculating Payments and Loan
Balances – Fully Amortizing CPM
Loans
 Assume a fixed rate mortgage
(FRM) loan is made in an amount of
$60,000 at a 6 percent (nominal) rate
of interest for 30 years.
 n = 30 × 12 = 360
 i = 6%/12 = 0.50%
 PV = $60,000
 FV = 0
 Solve for PMT = -$359.73
Calculating Payments and Loan Balances
– Partially Amortizing CPM Loans

 Assume a fixed rate mortgage (FRM) loan is made in an

amount of $60,000 at a 6 percent (nominal) rate of
interest for 30 years with a $40,000 balloon payment at
maturity.
 n = 30 × 12 = 360
 i = 6%/12 = 0.50%
 PV = $60,000
 FV = -$40,000
 Solve for PMT = -$319.91
Calculating Payments and Loan Balances – Zero
Amortizing (Interest-Only) CPM Loans

 Assume a fixed rate mortgage (FRM) loan is made in an

amount of $60,000 at a 6 percent (nominal) rate of interest
for 30 years with principal due at maturity.
 n = 30 × 12 = 360
 i = 6%/12 = 0.50%
 PV = $60,000
 FV = -$60,000
 Solve for PMT = -$300.00
Calculating Payments and Loan Balances
– Negative Amortizing CPM Loans

 Assume a fixed rate mortgage (FRM) loan is made in an

amount of $60,000 at a 6 percent (nominal) rate of interest
for 30 years with an $80,000 balloon payment at maturity.
 n = 30 × 12 = 360
 i = 6%/12 = 0.50%
 PV = $60,000
 FV = -$80,000
 Solve for PMT = -$280.09
Summary and Comparisons: Monthly
Payments and Outstanding Balances
Summary and Comparisons:
Determining Loan Balances
 Assume a fixed rate mortgage (FRM) loan is made in an
amount of $60,000 at a 6 percent (nominal) rate of interest
for 30 years but repaid after 10 years.
 Find the balance after 10 years by solving for the present
value of the remaining payments.
 n = 20 × 12 = 240
 i = 6%/12 = 0.50%
 PMT = -$359.73
 FV = $0
 Solve for PV = $50,211.39
Summary and Comparisons: Loan
Balances for Other Amortization Patterns

Zero Amortizing (Interest

Partially Amortizing Negative Amortizing
Only)
n = 20 × 12 = 240 n = 20 × 12 = 240 n = 20 × 12 = 240
i = 6%/12 = 0.50% i = 6%/12 = 0.50% i = 6%/12 = 0.50%
PMT = -$319.91 PMT = -$300.00 PMT = -$280.09
FV = $0 FV = $0 FV = $0
Solve for PV = $56,737 Solve for PV = $60,000 Solve for PV = $63,263
Summary and Comparisons: Loan
Closing Costs
 Statutory
◦ Transfer
◦ Recording Fees etc.
 Third Party Charges
◦ Appraisals
◦ Surveys
◦ Inspections, etc.
Summary and Comparisons: Loan
Closing Costs
 Additional Finance Charges
◦ Loan Origination Fees
 Cover origination expenses
◦ Loan Discount Fees – “Points”
 Used to raise the yield on the loan
 Borrower trade-off: points vs. contract rate
 1 Point = 1% of the loan amount
Summary and Comparisons: Loan
Closing Costs
 Why Points?
◦ Sticky mortgage rates
◦ Price in the risk of a borrower
◦ Early repayment of a loan does not allow recovery of
origination costs
◦ Earn a profit on loans sold to investors at a yield equal to the
loan interest rate.
Summary and Comparisons:
Effective Borrowing Costs

 Assume a fixed rate mortgage (FRM) loan is made in an amount

of $60,000 at a 6 percent (nominal) rate of interest for 30 years
with fees equal to 3% of the loan.
 n = 30 × 12 = 360
 PV = $60,000 – (3% × $60,000) = $58,200
 PMT = -$359.73
 FV = $0
 Solve for i = 0.5239% (monthly)
 Effective interest rate (nominal) = 6.29% (0.5239 × 12)
 Effective annual interest rate = 6.47%
Summary and Comparisons: Loan
Fees and Early Repayment

 Assume a fixed rate mortgage (FRM) loan is made in an

amount of $60,000 at a 6 percent (nominal) rate of interest for
30 years with fees equal to 3% of the loan. The borrower
prepays after 5 years. What is the effective interest rate on this
loan?
Early Repayment Solution
 n = 25 × 12 = 300  n = 5 × 12 = 60
 i = 6%/12 = 0.50%  PV = $60,000 – (3% ×
 PMT = -$359.73 $60,000) = $58,200
 FV = $0
 PMT = -$359.73
 FV = -$55,832.57
 Solve for PV = $55,832.57  Solve for i = 0.5609%
(monthly)
 Effective interest rate
(nominal) = 6.73% (0.5609
× 12)

Step 1: Step 2:
Solve for Remaining Balance Solve for the Interest Rate
Summary and Comparisons:
Charging Fees to Achieve Yield

 Assume that a lender wishes to earn a 7% yield on 30-

year, 80% mortgages and expects repayment after 10
years. What fee should the lender charge along with a
6% contract rate in order to earn a 7% yield?
 Fee Solution
Step 1: Solve for Payment per Step 2: Solve for Loan Step 3: Solve for Present Value
$ Borrowed Balance after 10 Years at 13%
n = 30 × 12 = 360 n = 10 × 12 = 120 n = 10 × 12 = 120
i = 6%/12 = 0.50% i = 6%/12 = 0.50% i = 7%/12 = 0.5833%
PV = -$1 PMT = -$0.005996 PMT = $0.005996
FV = $0 PV = -$1 FV = $0.836857
Solve for PMT = $0.005996 Solve for FV = $0.836857 Solve for PV = $0.932931

 In order to achieve a 7% yield, the lender should

disburse $0.9329 for every $1 borrowed (93.3%).
 This results in a 6.7% (100% - 93.3%) origination fee.
Financing Loan Fees and Other
Closing Costs
 The lender may agree
to finance the loan fees.  n = 30 × 12 = 360
 In the preceding  i = 6%/12 = 0.50%
example, the loan
amount would be
 PV = $61,800
$61,800 ($60,000 +  FV = 0
(3% × $60,000))  Solve for PMT = -$370.52
 Payments would
increase to $370.52
Other FRM Loan Patterns – Declining Payments
and Constant Amortization Rates

 Constant Amortizing Mortgage (CAM) – a constant amount of

each monthly payment is applied to principal
 Callable Loan – a loan that the lender will or may demand to
be repaid prior to the maturity date
 Loan Structuring – a process of adjusting loan terms to
calibrate loan payments, loan balances, amortization rates, and
so on, to achieve desired results.
 “Reverse Mortgages” – the loan amount is taken down as
irregular periodic payments until such payments and accrued
interest reach the agreed upon loan amount.
Chapter 12
Financial Leverage and
Financing Alternatives
Financial Leverage
 What is financial leverage?
◦ Benefit of borrowing at a lower interest rate than the rate of
return on the property.
 Why use financial leverage?
◦ Diversification benefits of lower equity investment
 Can invest in other property
◦ Mortgage interest tax benefit
◦ Magnify returns if the return on the property exceeds the cost
of debt
Financial Leverage: Before-Tax
 Positive Financial Leverage
◦ Returns are higher with debt
 Unlevered BTIRR
◦ Return with no debt
 If unlevered BTIRR > interest rate on debt
◦ The BTIRR on equity increases with debt.
◦ There is positive financial leverage.
Introduction to Financial Leverage

 Unleveraged BTIRR is
greater than the interest rate  The after-tax return on total
paid on the debt funds invested must exceed
the after-tax cost of debt.

Conditions for Positive Conditions for Positive

Leverage – Before Tax Leverage – After Tax
Break-Even Interest Rate
 Break-even interest rate – the maximum interest rate
that could be paid on the debt before the leverage
becomes unfavorable

 Leverage and the Incremental Cost of Debt

◦ As the amount of debt increases, lenders may charge a higher
interest rate to obtain additional financing.
Risk and Leverage
 There is an implicit cost associated with the use of
financial leverage due to higher risk.
 The decision to use leverage cannot be made by only

looking at BTIRRP and BTIRRE.

 The investor must ask whether the higher expected
return with leverage is commensurate with the higher
risk.
 The investor should also ask if there is a way to realize

the higher return with less risk.

Underwriting Loans on Income Properties

 Market Study
◦ Economic base
◦ Submarkets
◦ Appraisal
 Borrower Financial Statements
◦ Nonrecourse clause
 Loan to Value Ratio
 Debt Coverage Ratio
Market Study Elements
 Analysis of the economic base
 Prospective employment growth for the city or region
 Analysis of the submarket showing vacancy rates and

rents on competing properties

 New construction and renter demand
Borrower Financials
 Non-recourse clause – releases the borrower from
personal liability and makes the property the sole
source of security for the loan
 Non-recourse clause may be viewed as a put option

held by the borrower

The Debt Coverage Ratio
Common Mortgage Covenants
 Lender must approve all new major leases
 Lender must approve any modification to existing

leases
 Lender must approve any additional construction
 Borrower must supply periodic updates
 Borrower must supply annual appraisal
 Borrower must notify lender of any lawsuits
 Borrower must notify lender of any major capital

expenditures to correct structural defects

Other Loan Terms
 Lockout Period – prohibits the borrower from
prepaying the loan within a specified period
 Yield maintenance fee (YMF)

◦ In the event of prepayment, the lender must continue to earn a

certain yield for the remaining term.
◦ The borrower must pay the difference between the lender’s
lowest potential reinvestment rate and the original yield.
Alternatives to Fixed Rate Loan
Structures
 Mortgage payments increase over time (like graduated
payment mortgage)
 Lender receives a portion of the proceeds from sale of

the property (like a shared appreciation mortgage)

 Lender receives an option to purchase the property at a

specified exercise price.

Participation Loans
 Lender’s rate of return is at  The borrower pays less
least comparable to what initially than they would
the return would have been have with a straight loan.
with a fixed interest rate  The investor may have more
loan. cash flow during the early
 The lender gets a hedge years.
against unanticipated  Debt coverage ratio may be
inflation. higher in the early years.

Lender Motivations Investor Motivations

Sale-Leaseback of the Land
 Investor owns the land and sells it with an agreement to
lease the land back from the purchaser.
 Benefits:
◦ A way of obtaining 100 percent financing on the land.
◦ Lease payments are tax deductible.
◦ Investor may have the option to purchase the land back at the end
of the lease.
 Effective cost of the sale-leaseback
◦ Assume land is sold for $100,000 (PV), held for five years (N),
leased back for $3,500 per year (PMT), and repurchased for
$110,408 less than without the sale-leaseback (FV).
◦ The resulting yield is 5.32% (I/Y)
Interest-Only Loans
 Interest-only loan – no amortization is required for a
specified period.
 Balloon payment – lump sum payment due at the end

of the interest-only period if the loan is not amortized

 Bullet loans – short-term loans that require little or no

amortization
Accrual Loans
 Accrual loans – payments for a specified number of
years are lower than the amount that would be required
to cover the monthly interest charge.
 Pay rate – the rate used to calculate the loan payment
that is different from the rate used to calculate the
interest charged.
 Accrual rate – the rate used to calculate the interest
charged
 Negative amortization – when a loan payment is less
than the amount of interest due on the outstanding loan
balance
Convertible Mortgages
 Convertible mortgage – gives the lender an option to purchase
a full or a partial interest in the property at the end of some
specified period.
 Assume:
◦ A $700,000 convertible mortgage that allows the lender to acquire 55% of
the equity ownership in the property at the end of the fifth year when the
property is valued at $1,104,080. Loan is amortized over 20 years with
monthly payments. Interest rate is 4.25% compared to 5% on a
conventional loan.
◦ Effective yield:
 N = 5 × 12 = 60
 PV = $700,000
 PMT = 52,016/12 = 4,334.67
 FV = $1,104,080 × 55% = $607,244
 Solve for I = 5.10%
Comparison of Financing
Alternatives
 The table ranks the six BTIRRE ATIRRE DCR IRRD
financing alternatives Convertible 5 4 5 4
compare regarding Participating 6 6 3 1
before- and after-tax Sale-Leaseback 1 3 5 2
returns, debt coverage,
Interest-Only 2 1 1 4
and lender’s yield
Accrual 3 2 2 4
(IRRD).
Convertible 4 5 4 3
Other Financing Alternatives
 Mezzanine Loan – bridges the gap between the first
mortgage debt on the property and the equity
investment
 Preferred Equity – an equity interest in the property

but has debtlike characteristics because preferred

equity investors have a claim on cash flows from the
property that comes before that of the regular equity
investors