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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
© 2011 Cengage Learning
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
© 2011 Cengage Learning
Risks Facing Real Estate Lenders
Default risk
Interest rate risk
Reinvestment risk
© 2011 Cengage Learning
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
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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.
© 2011 Cengage Learning
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)
© 2011 Cengage Learning
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
© 2011 Cengage Learning
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
© 2011 Cengage Learning
Financing Costs
Simple Interest
Compound Interest
Add-On Interest
Application of an Interest Rate
Loan Discount
© 2011 Cengage Learning
Other Loan Fees
Application Fee
Origination Fee
Commitment Fee
Stand-By Commitment Fee
© 2011 Cengage Learning
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
© 2011 Cengage Learning
Mortgage Repayment Plans
Fixed-Rate Mortgage
Adjustable-Rate Mortgage
Prime Rate Loan
Construction Loans
Mezzanine Loan