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Real Estate Real Estate Investment Investment Chapter 10 Chapter 10 Financing Real Estate Investments © 2011 Cengage Learning

Real Estate Investment Chapter 10 Financing Real Estate Investments © 2011 Cengage Learning

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Real Estate Investment Real Estate Investment

Chapter 10Chapter 10

Financing Real Estate Investments

© 2011 Cengage Learning

© 2011 Cengage Learning

Key TermsKey Terms

Add-on interest

Amortization

Annuity

Balloon note

Cap rate (CR)

Commercial loan

Compound interest

Construction loans

Conventional loan

Debt coverage ratio

Debt service

Discount

Equity participation

Foreclosure

Loan discount

Loan-to-value (LTV)

© 2011 Cengage Learning

Key TermsKey Terms

Mezzanine loans

Mortgage loan amortization

Non-recourse loan

Origination fee

Primary mortgage market

Refinance

Residential loans

Secondary mortgage market

Simple interest

Underwriting standards

Wrap-around mortgage

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Risk and the Impact of Leverage

How borrowing can increase returns

What are the disadvantages?Too much leverage

Loss of major tenants

Greater equity requirements

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Risks Facing Real Estate Lenders

Default risk

Interest rate risk

Reinvestment risk

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Primary Mortgage Market

Where loans are originated

It is the market where borrowers negotiate with lenders, discussing the cost of a loan

Interest rate

Discount points

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Secondary Mortgage Market

Where loans are sold to investors, hence making more money available to lend.At its beginning, the secondary mortgage market consisted of the Federal National Mortgage Association (FNMA or Fannie Mae).The Emergency Home Finance Act of 1970 created the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).FIRREA in 1989 made regulation of Fannie Mae and Freddie Mac consistent.

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The Secondary Market

Following the “thrift crisis” of the late 1980s, the General Accounting Office and the Department of Treasury were instructed to conduct studies of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. These studies laid the foundation for comprehensive regulatory modernization for both Fannie Mae and Freddie Mac in 1992.

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The Secondary Market

The Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac

It created the Office of Federal Housing Enterprise Oversight (OFHEO) as a new regulatory office within HUD.

OFHEO did not achieve this primary objective, with the failures of Fannie and Freddie.

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The Secondary Market

Adjacent to the collapse of Fannie and Freddie and under the auspices of the Housing and Economic Recovery Act (HERA) of 2008, OFHEO and the Federal Housing Finance Board were combined to form the new Federal Housing Finance Agency.

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The Secondary Market

HERA was passed to strengthen governmental oversight of Fannie Mae and Freddie Mac

Established the Federal Housing Finance Agency replacing OFHEO and HUD as Fannie Mae’s safety and soundness and mission regulator.

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Evaluating the Commercial Loan

Somewhat similar to evaluating a residential loanLender is primarily concerned with the source of the funds that will be used to make the loan payments.

With a residential loan the lender will look at the income of the borrower.

The funds used to pay the debt service on a commercial loan come from the property rather than the borrower.

The major focus of the commercial lender is to evaluate the property, both for its ability to generate sufficient income and also its adequacy as collateral for the loan.

© 2011 Cengage Learning

Using the Debt Coverage Ratio Method

The debt coverage ratio is not based on any specific standards

The lender will look at the type of property, the experience of the developer, the risks involved, the strength and quality of the property’s income, and other variables.Typically the ratio will vary between 1.2 and 1.4 for most properties.

The debt coverage ratio is DCR = NOI/DSIn other words, the ratio equals the net operating income divided by the debt service.

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Evaluating the Property

Most lenders will require an appraisal of the property that is to be pledged as collateral for the loan. For a property that is basically an income producing property, the appraiser will rely heavily on the income approach to establish value.The appraiser will develop a Pro Forma based on market data Like many commercial.The appraisal is frequently for a property to be built.

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Using the Loan to Value (LTV) Method

Once a value is established, the lender will then establish the loan amount for the project being considered.In previous times lenders would make loans based entirely upon the appraised value. In recent times the lender will require that the borrower have a large verifiable equity in the property.There is no standard but a 75 % LTV is probably about the highest that can be arranged unless there are extenuating circumstances.

A 60 % to 65 % LTV, or lower, is more common

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Lender Criteria

No rigid standards for setting lender criteria.Vary from month to month, from lender to lender, and from property type to property type.A borrower must determine the criteria that are currently being used by several different lenders before attempting to establish the feasibility of a proposed development.A project that may be feasible under certain assumptions may instantly become infeasible under different criteria.

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Effects of Underwriting on Commercial Borrowers

Much of the credit demand for residential mortgage money has shifted from savings deposits and insurance company reserves to the financial markets.The historic participation of institutional lenders in residential loans in lending for their own portfolios can now be more focused on commercial loans.Mortgage companies have expanded their market share of commercial loans.Also, there is a growing effort by private lenders, such as large commercial banks, to pool blocks of commercial loans for the issuance of mortgage-backed securities.

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Why Borrow Money?

To increase the return, or yield

Impact of mortgage loans on investment returns

ROR

ROE

Internal Rate of Return (IRR)

Manager’s Rate of Return (MRR)

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Positive and Negative Leverage

If ROE > ROR, there is positive leverage

If ROR > ROE, there is negative leverage

Also,

If ROR > K, there is positive leverage

If ROR < K, there is negative leverageWhere K is the mortgage constant

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Participation by Mortgage Lenders

A way to seek some risk protection is for the lender to participate in the mortgaged project

Income participation

Equity participation

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Financing Costs

Simple Interest

Compound Interest

Add-On Interest

Application of an Interest Rate

Loan Discount

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Other Loan Fees

Application Fee

Origination Fee

Commitment Fee

Stand-By Commitment Fee

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Other Finance Charges

Funding fee

Renewal fee

Assumption fee

Warehouse fee

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Mortgage Loan Amortization

Straight mortgage loan

Partially amortized loan

Fully amortized loan

Calculation of Amortized PaymentsPmt = Loan Amount x K

Where K is the loan constant

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Mortgage Repayment Plans

Fixed-Rate Mortgage

Adjustable-Rate Mortgage

Prime Rate Loan

Construction Loans

Mezzanine Loan

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Mortgage Variations

Shorter-Term Loans

Biweekly Payment Plan

A Negative View on Early Pay-off

Shared-Equity Mortgage

Junior Mortgage

Wrap-Around Mortgage