The Market for Real Estate Knowledge

1

The Market for Real Estate Knowledge

Chapter 1

2

The real estate body of knowledge consists of four broad collections of concepts: legal analysis concepts market analysis concepts real estate service industry

concepts financial and investment

analysis concepts.

Real Estate - land and things attached to it

3

property rights restrictions on property

rights (public and private) deeds leases contracts title transfer issues

Legal analysis concepts include:

4

real estate market dynamics real estate space market real estate asset market real estate development

industry urban growth models

Market analysis concepts include:

5

real estate brokerage real estate appraisal property management

Real estate service industry concepts include:

6

financing methods time value of money

concepts mortgage mechanics investment property

analysis development project

analysis

Financial and investment analysis concepts include:

7

Market Model for Real Estate Knowledge

What is a market?

What is demand?

What is supply?

Where do supply and demand come from?

How do supply and demand interact?

Principle of supply and demand applied to the market for real estate knowledge

8

Industry Trends and Statistics

Figure 1.2 on page 7 shows number of individuals employed in the real estate industry from 1972 though 2001

Table 1.1 on page 8 shows typical earnings for brokers, salespersons, appraisers, title examiners, and property managers in 1998 and 1999.

9

Property Rights and Legal Descriptions

Chapter 2

10

Real vs. Personal Property

Real estate Property Real property Personal property Deeds Leases

11

Fixture

A personal property item that has become a part of the real property is called a fixture.

Tests for fixture status include: Intent of parties Test of attachment Test of adaptability

12

Mineral and Air Rights

Mineral rights refer to the legal interests associated with oil, gals, coal, or other minerals that may be located beneath the surface of a parcel of land.

Air rights refer to the legal interests associated with the space above the surface of a parcel of land.

13

Water Rights

Water rights refer to the legal interests associated with water that flows across, touches, or is located in or under a parcel of land. littoral proprietors. non-navigable bodies of

water riparian rights doctrine prior appropriation doctrine

14

Estates in Land

Freehold estates Present interests

Fee simple absolute estate Qualified fee estate Life estate

Future interests include: Reversion interest Remainder interest

Leasehold estates Tenancy for a stated period Tenancy from period to period Tenancy at will Tenancy at sufferance

15

Concurrent Estates

Tenancy in common Joint tenancy Tenancy by the entirety Community property

16

Other forms of joint ownership

Condominium Cooperative Timeshare

Fee interests Right to use

17

Legal Description Methods

Metes and Bounds Rectangular Survey Recorded Plats

18

Metes and Bounds

start at a designated point of beginning and, through specific distances (metes) and directions (bounds), locate the boundary lines of the parcel (see Figure 2.3 on page 27). Distances are measured in feet

(to the nearest tenth or hundredth).

Directions are measured in degrees, minutes, and seconds. (See Figure 2.2 on page 26)

Property corners are marked by reference points.

19

Rectangular Survey

Principal meridians are north-south lines

Base lines are east-west lines

Range lines Township lines Townships Sections Divisions of section

20

Reference to Recorded Plats

Many jurisdictions require developers to prepare accurate engineering drawings of their subdivision projects called plats.

These plats are then entered into the public record as legal documents that can be referred to as needed to identify individual parcels of land that are included in the plat.

With a properly prepared and recorded plat, a legal description for a property can be as simple as “Lot 4 of Block G of Grassy River Estates.”

21

Private Restrictions on Ownership

Chapter 3

22

Encumbrances

Restrictions or limitations on the owner’s ability to use a property.

23

Liens

Lien – a financial security interest in a property. Mortgage – a pledge of real

property as collateral for a debt or other obligation

Mortgagor-borrower Mortgagee-lender Foreclosure

Mechanic’s lien

24

Easement

right to use a property in a specified manner.

Types of Easements Easement Appurtenant Easement in gross

Creation of Easements by: Express grant or reservation Implication Prescription

Termination of Easements by: Agreement Merger Abandonment

25

Licenses and Profits

License – a revocable personal privilege to use land for a particular purpose

Profit - profit a prende – a non-possessory interest that permits the holder to remove specified resources from the land

26

Adverse Possession

Process by which title to land is transferred from its legal owner to someone who openly possesses the land for a statutory time period without the permission of the owner.

Requirements to obtain title by adverse possession Actual and exclusive Open and notorious Hostile Continuous Under a claim of right Statutory period

27

Other issues

Encroachment – an unauthorized invasion or intrusion of a fixture, building or other improvement onto another owner’s property.

Restrictive Covenants – also called deed restrictions, are promises made by a landowner or previous landowner that the land will or will not be used in certain ways.

See Real Estate Today Feature “Meadow Brook Ranch Use Covenants” on page 54.

See Real Estate Today Feature “Validity of Restrictive Covenants” on page 55.

28

Public Restrictions on Ownership Rights

Chapter 4

29

Four Basic Powers of Government Over Real Estate

Taxation Escheat Eminent domain Police power

30

Property Tax

“ad valorem tax millage rate assessment ratio exemptions The tax bill for a property with a market

value of $120,000 in a jurisdiction that assesses a millage rate of 25 mills on 40% of a property’s market value and permits a exemption of $2,500 for this type of property is calculated as follows:

Market Value $120,000multiplied by Assessment Ratio x .40equals Assessed Value $48,000minus Exemptions (if any) -$2,500equals Taxable Value $45,500divided by 1000 1000times Millage Rate x 25equals Property Tax $1,137.50

31

Administering the Property Tax

First step, identify all properties and estimate their values

Second step, develop a budget and tax rate. The budget is determined by the

appropriate government officials based on the costs of providing government services to the community (police and fire protection, schools, libraries, street, etc.)

Dividing the budget amount by the tax digest (total value of properties in the jurisdiction) yields the tax rate necessary to generate the budget amount.

Third step, bill the property owners and collect the taxes.

32

Power of Escheat

Government’s right to acquire ownership of land when the landowner dies without an heir or a valid will

33

Power of Eminent Domain

right of the government to take private property for public use upon the payment of just compensation

Use must be a valid public use.

Property owner must be compensated fairly.

Inverse condemnation

34

Police Power

Power to regulate use of private property to protect public health, safety, morals and general welfare

Land uses are interdependent, meaning that the way one property is used affects other nearby properties.

Comprehensive general plan projected economic development transportation plan to provide for

necessary circulation public-facilities plan that identifies

such needed facilities as schools, parks, civic centers, water and sewage disposal plants

land-use plan official map

35

Implementing Comprehensive General Plan

Zoning – division of a community’s land into districts to regulate the use of land and buildings and the intensity of various uses Type of use – residential,

commercial, industrial categories Intensity of use - developmental

density Height and bulk limitations Bulk regulations Floor-area ratio Minimum lot size and setback

regulations

36

Zoning Changes

Legislative relief Administrative relief Variances Special use permits Judicial relief

37

Other Issues:

Nonconforming Uses Building Codes Subdivision Regulations

Subdivision Approval Process Mandatory Dedication Impact Fees Innovative Land-use Control

Methods Planned unit development Performance zoning Incentive zoning Transfer of development rights

38

Deeds and Leases

Chapter 5

39

Deeds

Written document that transfers title (ownership) to real estate from the grantor to the grantee

Necessary Elements of a Deed Designation of the parties Consideration given by

grantee Legal description Specific interest conveyed Signature of the grantor and

witnesses

40

Additional Deed Elements

Covenant against encumbrances

Covenant of seisin Covenant of quiet

enjoyment Covenant of further

assurances Warranty forever

41

Types of Deeds

General warranty deed Special warranty deed Bargain and sale deed Quitclaim deed Deeds for special uses

42

Leases

Agreement between a property owner and tenant that transfers the rights of use and possession

Requirements of a Properly Prepared Lease Names of the lessor and lessee Conveyance of the premises Description of the premises Term or duration of the lease Amount of rent and manner of

payment Duties and obligations of parties Signatures of the parties

43

Classification of Leases

Duration of term Tenancy for stated period Tenancy from period to period Tenancy at will Tenancy at sufferance

Type of Use Ground Lease Residential lease Commercial lease

Methods of Payment Gross lease Net lease Net net lease Net net net lease Fixed-rent lease Graduated-rent lease Reappraisal lease Percentage lease Index lease

44

Issues in the Landlord-Tenant Relationship

Renewal option Expense stops Assignment and subleasing Security deposits Improvements Covenant of quiet enjoyment Implied warranty of

habitability Maintenance of common areas Protection against criminal

acts

45

State Statutes affecting Landlord-Tenant Relationship

Each state has enacted laws that regulate the behavior and relationship between landlords and tenants. To view these laws for individual states, visit www.nolo.com on the World Wide Web.

46

Contracts in Real Estate Transactions

Chapter 6

47

Contracts

An exchange of promises between parties, conditioned on certain events and enforceable by law.

Necessary Elements of a Contract Offer and acceptance Consideration Capacity of parties Lawful purpose Writing requirement

(Statute of Frauds)

48

Contract Issues

Oral Contracts Specific Performance Partial Performance Breach of Contract

49

Contract Contingencies

Specified conditions in a contract that relieve the parties of their promises to perform

financing contingency title contingency inspection and repair

contingency

50

Common Real Estate Contracts

Real Estate Sales Contract Option-to-Buy Contract Contract for Deed

51

Title Examination and the Closing Process

Chapter 7

52

Title Examination

the process of verifying the ownership rights being offered by the seller of a property marketable title insurable title title perfect of record

53

Title Search

Detailed examination of all public records that reveals the ownership history of a property

recording requirement grantor and grantee

indexes tax records search lien search

54

Other Title Issues

Title abstract Title Opinion Title insurance

paid for in full at the time the policy is issued

not transferable protects only against past

events that were in existence, but undiscovered at the time the policy was issued

Torrens system

55

Title Closing

the final step in the process of transferring title from grantor to grantee

Buyer’s responsibilities before closing obtaining financing examining the title evidence having the property surveyed obtaining property insurance having the property inspected

Seller’s responsibilities before closing prepare the deed remove encumbrances cooperate with inspectors

56

Closing Costs

Costs generally paid by the buyer at the closing loan origination fee loan discount points appraisal fee credit report fee lender’s inspection fee mortgage insurance premium attorney fees hazard insurance premium recording fees for the mortgage

Costs generally paid by the seller at the closing real estate brokerage commission attorney fees documentary stamp taxes, where

required recording fees for the satisfaction of

the seller’s mortgage

57

HUD Settlement Statement

Settlement statement shown in Figure 7.1 relates to the transaction between Williams and Howell.

The transaction amount is $189,000.

The seller has an outstanding loan for $113,245 that must be repaid.

The buyer is borrowing $150,000 from his lender.

Both buyer and seller must pay certain closing costs.

After consideration of these costs and the prorated taxes, the buyer must bring $37,243.28 to the closing and the seller will leave the closing with $58,548.96.

58

Understanding Real Estate Markets

Chapter 8

59

Market

the mechanism or arrangements through which goods and services are traded between market participants

60

Real Estate Space Markets

Mechanism or arrangements for trading the rights to use land and buildings

people, firms, and other entities are willing to pay various prices for the use of space for consumption or production purposes (demand)

owners of space are willing to sell the rights to use such space to the users for various prices (supply)

Space markets are segmented by location and type of use

Office space markets Retail space markets Industrial space markets Agricultural space markets Lodging space market Residential space market

61

Price Movements in Real Estate Space Markets

The demand curve in real estate markets is downward sloping.

See Figure 8.2 on page 157. The supply curve in most real

estate markets is vertical at the current quantity of space and horizontal at higher quantities.

In a typical market, therefore, demand increases are unlikely to result in long-term price increases. Demand decreases, however, may lead to dramatic price decreases.

See Figure 8.3 on page 158.

62

Real Estate Asset Market

mechanism or arrangements for trading the rights to cash flows generated by land and buildings

the real estate asset market is part of the larger capital market, which includes

publicly traded equity assets (stocks, mutual funds, real estate investment trusts)

privately traded equity assets (real property, private companies, oil and gas partnerships)

publicly traded debt assets (bonds, mortgage-backed securities, money instruments)

privately traded debt assets (bank loans, whole mortgages, venture debt)

prices in real estate asset markets are determined by:

opportunity cost of capital growth expectations risk

63

The Real Estate System

consists of real estate space markets, the real estate asset market, and the development industry

See Figure 8.6, page 164. Prevailing economic conditions influence

both the capital markets and individual space markets.

Landlords and tenants in space markets negotiate and determining rents, which produces cash flows that are of primary concern to participants in the real estate asset market.

If the cash flows are attractive in the real estate asset market relative to other capital asset categories, the development industry is persuaded to add new space to the market, thus completing the system.

64

Market Analysis

examination of the supply and demand sides of a real estate space market and the balance (equilibrium) between them

Inputs to market analysis Vacancy rate – higher vacancy rate

indicates less demand relative to supply and vice versa

Rent or price level – trends in rents and prices indicate changes in the balance between supply and demand

Quantity of new construction started – indicates new supply that will be coming into the market

Quantity of new construction completed – indicates new supply that is just arriving into the market

Absorption of new space – indicates the rate at which new supply is becoming occupied in the market

65

“Months Supply”

Using “Months Supply” to look forward in a real estate market analysis

Months supply = (vacant space + space in construction)/net absorption per month

If months supply is much greater than construction time for new projects, then the new project will likely hit the market at a time when supply exceeds demand

If months supply is equal to or less than construction time for new projects, then a new project will likely be well received by the market.

66

Key Drivers for Real Estate Space Markets

Office: employment in office occupations

Lodging: air passenger volume, highway traffic counts, tourism receipts, number of visitors

Retail: per capital income, aggregate income, wealth measures

Industrial: manufacturing employment, transportation employment, shipping volume

Apartments: population, household formation, local housing affordability, employment growth (blue and white collar)

Owner-occupied residential: population, household formation, interest rates, employment growth, income growth

67

Urban and Regional Economics

Chapter 9

68

Determinants of a City’s Comparative Advantage

Transportation facilities Educational facilities Created environment Natural resources Climate Labor force Leadership

69

Economic Base

Export activities Agriculture, manufacturing,

mining, and wholesale trade Population serving

activities Construction, public utilities,

retail trade

70

Analyzing Local Demand

Short-run demand issues Current supply of real estate

improvements Current industrial structure Recent changes in the local

economy Likely economic changes in the

near future Long-run demand issues

Long-run economic prospects for the local economy

National & regional trends likely to affect the local economy

Likelihood of new firms coming into the area

71

Bid Rent Curves and Highest and Best Use

land rent – the return that a particular parcel of land will bring in the open market

highest and best use – the use of land that results in the highest land rent

each parcel of land has a highest and best use

Bid-rent curves depict the relationship between price and distance that various user groups are willing to bid for various locations in an urban area. As the profitability of less desirable locations decreases, the prices the users are willing to pay also decrease.

Figure 9.1

72

Urban Growth Models

Concentric Circle growth (Figure 9.2) Land use patterns are defined as concentric

circles around a Central Business District As growth occurs, the rings expand, with land

uses changing to the new land use indicated by the expanding rings. For example, as the CBD grows, slums are converted to CBD-type uses. Also, as the area grows, higher-income housing becomes lower income housing as it gets older and older.

Axial growth (Figure 9.3) Based on the notion that growth tends to occur

along transportation routes and nodes, resulting in star-shaped cities.

Sector growth (Figure 9.4) Based on the notion that particular types of

land uses tend to occur in wedge-shaped sectors extending outward from the center of a city.

Multiple-Nuclei growth (Figure 9.5) Based on the notion that many cities form

more than one central business district, with certain land uses clustered around those points

73

Dynamics of Neighborhood Change

What is a neighborhood? Neighborhood Life Cycle

Stages Gestation, Youth, and

Maturity Incipient Decline Clear Decline Accelerating Decline and

Abandonment Neighborhood stabilization

and rehabilitation

74

Real Estate Brokerage

Chapter 10

75

The Real Estate Sales Process

listing agreement marketing the property

and qualifying buyers presentation and

negotiations contracts settlement or closing

76

Real Estate Brokers and Salespersons

A broker is an intermediary who brings together buyers and sellers, assists in negotiating agreements between them, executes their orders, and receives a commission (or brokerage) in compensation for services rendered.

Real estate brokers are individuals licensed by state governments to arrange real estate sale or lease transactions for a commission

Real estate salesperson are individuals licensed by state governments to arrange real estate sale or lease transactions under the supervision of a real estate broker

77

Legal Aspects of Broker-Client Relationship

In an “agency relationship,” one party (the principal) authorizes another party (the agent) to act on his or her behalf.

In real estate, a property owner may hire a real estate broker to help find a buyer for the property. Or, a potential buyer may hire a real estate broker to help find a property for purchase. Or, a real estate broker may hire a real estate salesperson to assist in locating buyers or properties.

Real estate brokers (and salespersons) who are hired by a principal as an agent owe the principal their complete loyalty and must always act in the principal’s best interest.

Dual Agency

78

Creating Agency Relationships

Listing Agreements establish the agency relationship between sellers and brokers.

Open Listing (Figure 10.1, page 206) – seller may hire several brokers to search for a buyer and only be obligated to pay the broker who finds the actual buyer

Exclusive Agency Listing (Figure 10.2, page 207) – seller agrees to hire only one broker to search for a buyer, but reserves the right to sell the property without the assistance of the broker and thus avoid paying a commission

Exclusive Right to Sell Listing (Figure 10.3, page 207) – seller aggress to hire only one broker and to pay that broker a commission even if the seller locates a buyer without the assistance of the broker

Buyer representation agreements establish the agency relationship between buyers and brokers. (Figure 10.5, page 210)

79

Brokers as Fiduciaries

A fiduciary is a person who occupies a position of trust and confidence in relation to another person or his or her property. Fiduciaries must act in the best interest of their client at all times.

Fraud occurs when a fiduciary, with the intention to mislead, makes a false statement material to a transaction that is justifiably relied on by the client, resulting in injury to the client.

Misrepresentation is the same as fraud except the intention to mislead is not present.

80

Termination of Agency Relationships

when a transaction occurs when the agreement expires when the parties agree to

terminate when one party breaches the

agreement when one party becomes

contractually incapacitated the listing property is

destroyed the listing property is

condemned

81

Other Brokerage Issues

Franchises Desk Fee Arrangements Multiple-Listing Services Broker and Salesperson

Compensation usually calculated as a

percentage of the transaction amount

broker and salesperson often have an agreed upon “split” between themselves

cooperating brokers (through the MLS) often split any commissions paid by agreement

82

Real Estate Appraisal

Chapter 11

83

Appraisal Regulation

FIRREA of 1989 State requirements Licensed appraisers Certified residential

appraisers Certified general

appraisers

84

What is Value?

Market value (page 225) Typically motivated parties Well informed parties Market exposure Payment in cash No special circumstances

Investment value – worth to a particular investor based on that investor’s personal standards of investment acceptability

Price versus market value Market value versus cost of

production Other types of value

Assessed value Insurable value

85

Key Appraisal Principles

Anticipation Change Substitution Contribution

86

The Appraisal Process

Definition of the problem Type of value-purpose Description of property Specific property rights Effective date

Data selection and collection General market analysis Specific property analysis

Highest and best use analysis As though vacant As improved

Application of the three approaches to valuation Sales comparison approach Cost approach Income approach

Reconciliation of value indications Report of defined value

87

Sales Comparison Approach

Comparable sales data selection

Adjustment of sales data Elements of comparison

Property rights conveyed Conditions of sale Financing terms Market conditions Locational characteristics Physical characteristics

Applying the sales comparison approach – See Table 11.1, page 237.

88

Cost Approach

Estimating site value Estimating production cost

Reproduction cost Replacement cost

Estimating accrued depreciation Physical deterioration Functional obsolescence Economic obsolescence

Applying the cost approach – See Table 11.2, page 241.

89

Income Approach

Gross income multiplier GIM = Value/Gross Income

Net income capitalization Capitalization Rate = Net

Income/Value Discounted cash flow –

see Table 11.3, page 244

90

Applying the Appraisal Process: Single-Family Home Case Study

pages 245-249.

91

Property Management

Chapter 12

92

Property Management

The role of the property manager is to manage the property with the objective of securing the highest net return for the property owner over the property’s useful life

93

Management Agreement

establishes the relationship between the owner and the manager. (Figure 12.1, pages 258-260)

The agreement should address the powers of the manager relating to Rent setting Lease signings Rent collections Power to spend money on behalf of

the property Authority to hire, fire, and supervise

personnel The agree should specify the

compensation to the manager Percentage of gross income Fixed amount Fee schedule for certain tasks Hourly rate

94

Functions of a Property Manager

administration marketing and advertising tenant selection lease negotiation move-in inspections property maintenance rent collection move-out inspections security deposit

management.

95

Real Estate Today Feature

“Green Acres Shopping Center – A Property Management Success Story”

page 265.

96

Corporate Real Estate Asset Managers

The functions of an asset manager include: facilities management acquisition of additional

space for the firm’s operations

financing decisions relating to needed space

disposition of corporate real estate assets.

97

Residential and Commercial Property Financing

Chapter 13

98

Understanding the Mortgage Concept

secured vs. unsecured debt

mortgage hypothecation title theory lien theory

99

Promissory Note

a written promise to repay a debt that usually accompanies a mortgage document

prepayment clause acceleration clause due-on-sale clause

100

Foreclosure

the process of seizing control of the collateral for a loan and using the proceeds from its sale to satisfy a defaulted debt

judicial foreclosure Nonjudicial foreclosure Strict foreclosure

101

Alternative Security Instruments

Trust Deeds Land Contracts

102

Other Issues:

“Subject to” Assumption Deed in lieu of foreclosure

103

Structure of the U.S. Housing Finance System

The process of creating a new loan agreement between a borrower and lender is known as loan origination.

Loan originations occur in the primary mortgage market.

The secondary mortgage market consists of transactions involving existing loans being sold from originators to investors or from one investor to another.

104

Federal Housing Administration (FHA)

Created in 1934 to help restore confidence to the nation’s housing finance system

Helped developed lending standards that reduced lenders’ risk exposure

Promoted the use of long-term, fully amortizing loans

Established a mortgage insurance program to cover losses to lenders Borrowers pay a fee to purchase an

insurance policy that protects the lender from the risk of loss due to default by the borrower

In return, lenders are more willing to lend money at favorable rates with relatively small down payment requirements.

105

Private Mortgage Insurance

Competes with government loan insurance and guarantee programs

Borrowers pay a fee to purchase an insurance policy that limits the risk of loss faced by lenders in the event of default by the borrower

In return, lenders are willing to lend money at favorable rates with relatively small down payment requirements

Usually less expensive than FHA insurance, but requires a larger down payment amount than FHA insured loans

106

Federal National Mortgage Association (Fannie Mae)

Created as a government agency in 1938 to buy FHA-insured mortgages originated by lenders and to sell securities backed by these mortgages to investors, thus providing a secondary market for mortgage loans.

Converted to a private company in 1968.

Continues today to purchase mortgage loans from originators and repackage these loans into mortgage backed securities that are sold to investors.

107

VA-guaranteed Loans

As part of the “GI Bill of Rights,” veterans are able to obtain mortgage loans with little or no down payment and low interest rates.

Private lenders are protected from risk of default by a guarantee from the Department of Veteran Affairs that assures repayment of the loan in the event the borrowing veteran defaults on the debt.

Note that these loans are guaranteed (not insured), so no premium is charged to the borrower for the guarantee.

108

Government National Mortgage Association (Ginnie Mae)

Created in 1968 as a federal agency, GNMA was anticipated to provide subsidized loans to borrowers.

In 1970, GNMA introduced a program that guarantees the timely payment of principal and interest on FHA and VA mortgages. This guarantee made “mortgage backed securities” more attractive in the secondary market.

109

Federal Home Loan Mortgage Corporation (Freddie Mac)

Created in 1970 to create and operate a secondary mortgage market for “conventional mortgages” (loans with privately mortgage insurance or with no insurance).

Competes today with FNMA in the market for all types of mortgages and mortgage backed securities.

110

Mortgage Market Participants

As of the second quarter of 2000, mortgage debt outstanding in the U.S. exceeded $6.6 trillion, with about 75% of this amount secured by one- to four-family structures.

As shown in Table 13.1 on page 287, mortgage debt is held by Commercial banks Savings institutions Life insurance companies Federal agencies Mortgage pools and trusts Individuals and others

111

Uniform Residential Loan Application

Most lenders use a standardized loan application form that complies with the requirements imposed on lenders by the secondary market powerhouses, Fannie Mae and Freddie Mac.

The application is shown in Figure 13.3 on pages 290-292.

The application collects information about the borrower’s income, other debts, other assets, employment history, etc. that is used by the lender to evaluate lending risk

112

Federal Legislation Related to Loan Applications

Equal Credit Opportunity Act

Consumer Credit Protection Act

Real Estate Settlement Procedures Act

Flood Disaster Protection Act

Fair Credit Report Act

113

Residential Mortgage Underwriting

The process of evaluating the risk of an applicant and the property being pledged as collateral and deciding whether or not to approve the loan.

Properties are evaluated by obtaining an independent appraisal of the market value of the property.

Applicants are evaluated on the basis of their willingness to repay his or her debts using a residential mortgage credit report or a credit score.

Lenders consider the amount and source of down payment funds the borrower intends to use in the transaction. Lower “loan-to-value” ratios imply lower risk.

Lenders also evaluate risk by comparing the borrower’s income to the debt obligations.

Mortgage Debt Ratio: most lenders recognize that principal, interest, taxes and insurance (PITI) obligations should be no more than 28% of the borrower’s gross monthly income for a conventional mortgage or 29% for a FHA-insured mortgage.

Total Debt Ratio: most lenders recognize that PITI and other monthly debt obligations should be no more than 36% of the borrower’s gross monthly income for a conventional mortgage or 41% for a FHA-insured mortgage.

Successful applicants must qualify under both ratios simultaneously.

114

Sources of Commercial Mortgage Market Capital

Individual Investors Life Insurance Companies Pension Funds Real Estate Investment

Trusts Commercial Banks Commercial mortgage

backed securities (CMBS)

115

Commercial Underwriting Criteria

Commercial loan underwriters are more concerned with the property’s ability to generate income to repay the debt than they are concerned with the borrower’s income.

Lenders typically require that a property’s net operating income exceed the debt service requirement by 15 to 20 percent. By definition, the debt coverage ratio is calculated by dividing the net operating income by the debt service payments. A lender who requires a DCR of 1.2 is requiring that the property’s net operating income exceed the amount of the debt payments by 20%.

Lenders also set maximum loan-to-value ratios for commercial loans. 70% LTV is common as a maximum LTV.

116

Risk, Return, and the Time Value of Money

Chapter 14

117

Relationship Between Risk and Return

return – profit as a percentage of total investment

risk – uncertainty about the actual rate of return over an investment period

risk and return are directly related (investors require greater returns for greater risk)

118

Types of Risk

Business risk – uncertainty arising from changing economic conditions that affect an investment’s ability to generate returns

Financial risk – uncertainty associated with the possibility of defaulting on borrowed funds used to finance an investment

Purchasing power risk – uncertainty arising from the possibility that the amount of goods and services that can be acquired with a given amount of money will decline over time (inflation)

Liquidity risk – possibility of loss resulting from not being able to convert an asset into cash quickly should the need arise

119

Time Value of Money Principle

Money in hand today is worth more than money to be received in the future

120

Future Value of a Lump Sum

Compound interest – during any given period, interest is earned not only on the original principal amount, but also on any interest previously earned by the principal amount

Compounding – the process of determining future value

Example: What is the future value of $70,000 compounded at 10% annual interest over 3 years?

Calculator keystrokes shown on page 315.

121

Present Value of a Lump Sum

Discounting – the process of determining present value

Example: What is the present value of $93,170 discounted at 10% annual interest for 3 years?


122

Present Value of an Annuity

Example: What is the present value of a series of three payments of $1,000 received at the end of each year if the discount rate is 10%?


123

Future Value of an Annuity

Example: What is the future value of a series of five payments of $100 received at the end of each year if the compound interest rate is 10%?

124

Sinking Fund Payments

Example: What is the amount of money that must be deposited into an account each year that earns 10% for five years in order to accumulate $20,000?

125

Mortgage Payments

Example: What annual payment would be necessary to amortize a loan for $100,000 over ten years at 10% interest?

126

Financial Decision Rules

Net Present Value (NPV) - difference between how much an investment costs and how much it is worth to an investor in present value dollars

NPV = present value of cash inflows minus present value of cash outflows

NPV Decision Rule: If the NPV is equal to or greater than zero, we choose to invest


Internal Rate of Return (IRR) - the discount rate that makes the NPV equal to zero

IRR = the rate of return on the investment

IRR Decision Rule: If the IRR is greater than or equal to our required rate of return, we choose to invest

IRR for above example = 12.06% Calculator keystrokes shown on page

325.

127

Mortgage Mechanics

Chapter 15

128

Interest-Only vs. Amortizing Loans

In interest-only loans, the borrower makes periodic payments of interest, then pays the loan balance in full at the end of the loan in a lump sum payment.

In an amortizing loan, the borrower makes periodic payments of both interest and principal so the loan balance declines gradually over the life of the loan

129

Understanding the Amortization Process

With a level, constant payment, the portions of each payment going to interest and principal vary greatly over time.

The interest portion of each payment decreases over time.

The principal portion of each payment increases over time.

The amount outstanding declines to zero at the end of the loan term.

130

Amortization Schedule

Year PaymentPMT

InterestIt

PrincipalPt

Amount OutstandingAOt

0 - - - 100,000.00

1 $16,274.54 10,000.00 6,274.54 93,725.46

2 $16,274.54 9,372.55 6,901.99 86,823.47

3 $16,274.54 8,682.35 7,592.19 79,231.28

4 $16,274.54 7,923.13 8,351.41 70,879.87

5 $16,274.54 7,087.99 9,186.55 61,693.32

6 $16,274.54 6,169.33 10,105.21 51,588.11

7 $16,274.54 5,158.81 11,115.73 40,472.38

8 $16,274.54 4,047.24 12,227.30 28,245.08

9 $16,274.54 2,824.51 13,450.03 14,795.05

10 $16,274.54 1,479.51 14,795.05 0.00

Total $162,745.40 $62,745.40 $100,000.00

131

To Construct an Amortization Schedule

Begin by calculating the periodic payment required to amortize the loan using the mortgage payment formula

Proceed down the rows of the table, one row at a time, by calculating the interest due, subtracting interest from the payment to get principal for the period, and then subtracting the principal paid in the period from the previous years balance to get the new balance

The following notation will prove useful: PMT = mortgage payment, It = interest due in period t, i = periodic interest rate, Pt = principal paid in period t, and AOt = amount outstanding at the end of period t.

Amortization: Period One It = AOt-1 x i = 10,000 = 100,000 x .10 Pt = PMT – It= 6,274.54 = 16,274.54 - 10,000 AOt = AOt-1 – Pt = 93,725.46 = 100,000 -

6,274.54 Amortization: Period Two It = AOt-1 x i = 9,372.55 = 93,725.46 x .10 Pt = PMT – It = 6,901.99 = 16,274.54 - 9,372.55 AOt = AOt-1 – Pt = 86,823.47 = 93,725.46 -

6,901.99

132

Understanding Prepayment

To find the amount needed to prepay (repay before the full term of the loan expires) a loan, use the present value of an annuity formula to find the present value of the remaining payments

Example: a loan with an original loan amount of $133,000 for 30 years at 7.5% annual interest would require monthly payments of $929.96. At the end of the fifth year of this loan (60 months), the amount outstanding of the original principal amount is $125,841.19.


133

Understanding Refinancing

Borrowers can take advantage of declining mortgage interest rates by refinancing existing loans at the prevailing market rate. Refinancing the loan at the lower rate reduces borrowing cost by either reducing the payment amount or reducing the number of payments required to amortize the loan.

Example: Suppose a borrower has an outstanding mortgage loan with a balance of $125,841.19 with 25 years of monthly payments remaining at 7.5% interest. Further suppose that the current interest rate available in the market is 6%.

The borrower could refinance the loan for 25 years at 6% and reduce the monthly payment to $810.80

Or, the borrower could refinance the loan at 6% interest but keep the monthly payments at $929.96 and reduce the number of months needed to amortize the debt from 300 to 227.


134

Understanding Discount Points and Effective Interest Rates

Many lenders charge discount points and/or origination fees to increase their yield on mortgage loans.

One discount point equals 1% of the loan amount. Points and fees are paid at origination of the loan. From the borrower’s perspective, points and fees

increase the effective interest rate on the loan. Example: Consider a 30-year, fixed rate loan for

$100,000 at 7.875% and a “one-half point” due at origination. The monthly payment necessary to amortize this loan is $725.07. Because the borrower must pay $500 at origination, the effective interest rate is actually higher than the stated rate. Solving for the internal rate of return for the cash flow stream gives an effective interest rate of 7.9275%

Calculator keystrokes are shown on page 340. Repeating this analysis for other loans with

different interest rate and discount point combinations allows comparison of the effective interest rates being charged in each loan.

135

Effective Interest Rates with Discount Points and Prepayment

When a borrower expects to prepay a loan before it is due (as most borrowers do), discount points paid at origination may have a dramatic impact on the effective interest rate of the loan.

Example: Suppose a borrower is considering a 30-year loan for $100,000 at 7.25% and 3.5 discount points. The monthly payment necessary to amortize this debt is $682.18 and the effective interest rate if the loan is held to maturity is 7.6123%. If the loan is prepaid at the end of the 60th month, however, the effective interest rate increase to 8.1252%

Calculator keystrokes are shown on page 341.

The earlier a loan with discount points is prepaid, the greater the effective interest rate for the loan.

136

Alternatives to the Fixed-rate Mortgage

Two-step mortgages – loans in which the interest rate is adjusted to match current market rates at the end of the fifth or seventh year

Adjustable rate mortgages – loans in which the interest rate is adjusted at the end of each year to match current market rates

137

Two-Step Mortgage Example

Consider a 30-year mortgage for $110,000. The initial interest rate on this loan is 6%, but the loan contract calls for an interest rate adjustment at the end of year seven to 2% above the ten-year U.S. Treasury Bond yield at that time. Assuming that the Treasury yield is 6.9%, the new interest rate for the remaining 23 years of this loan will be 8.9%.

What is the monthly payment during the first seven years of this loan? $659.51

What is the monthly payment during the last 23 years of this loan? $840.68

Calculator keystrokes given on page 343 & 344.

138

Adjustable Rate Mortgage Example

Consider a 30-year mortgage for $110,000 that is indexed to the one-year U.S. Treasury Bill yield with a margin of 2%. Further assume that adjustments to the contract rate are limited to 2% annual and 5% over the life of the loan and that the lender offers a teaser of 1% for the first year.

Calculator keystrokes are shown on pages 345 & 346.

139

Analyzing Income- Producing Properties

Chapter 17

140

Advantages of Real Estate Investment

Cash Flow from Operations (After Tax Cash Flow – ATCF)

Appreciation (After Tax Equity Reversion – ATER)

Portfolio Diversification Financial Leverage

141

Disadvantages of Real Estate Investment

large capital requirements risk

business risk financial risk purchasing power risk liquidity risk

142

The Wealth Maximization Objective

investment can be defined as present sacrifice in anticipation of future benefit

investment decision making involves comparison of the expected future benefits with the costs of the investment

investors’ ultimate goal is to maximize their wealth by choosing investments that are worth more than they cost

the NPV decision rule employs the wealth maximization concept If faced with two competing projects,

one that offers an NPV of $1,501 and another that offers a NPV of $703, the investor would prefer the one with the largest NPV.

143

The Discounted Cash Flow Model

To apply the NPV rule in practice, real estate investors may use the following discounted cash flow model.

ATCF = potential gross income minus vacancy and collect losses minus operating expenses minus debt service minus taxes

ATER = gross sale price minus selling expenses minus loan payoff minus taxes

Initial equity = purchase price minus loan amount

i = the investor’s required rate of return

144

Example of the DCF Model

Consider a four-unit apartment complex that is offered for sale at $255,000.

The units are expected to rent for $725 per month in the first year (increasing at 5% per year) with an annual vacancy rate of 4%.

The property is expected to have operating expenses of $9,900 in the first year (increases at 3% per year).

A loan is available at 70% of the purchase price for 9% interest with monthly payments over 25 years.

The investor believes property value will increase at the annual rate of 5% per year.

The investor faces a tax rate of 28%. The investor expects a five year holding

period. Is this a good deal based on the NPV rule at a

required rate of return of 16%? See cash flow calculations in Tables 16.3 and

16.4

145

Residential Land Uses

Chapter 17

146

Types of Residential Development

single-family detached houses single-family attached houses

row houses townhouses plexes patio or zero-lot-line houses

multifamily residences garden apartments mid-rise apartments high-rise apartments

manufactured homes second homes

147

Market and Feasibility Analysis

delineation of the market area analysis of recent economic

trends in the local market area analysis of demand factors

employment disposable income population household characteristics absorption rate

analysis of supply, including other possible competing projects

148

Millford Hills Subdivision Case Study

Summary in Real Estate Today feature beginning on page 381

Location Map in Figure 17.1

Competing project sales figures in Table 17.1

Projected cash flow statement in Table 17.2

Pro Forma Profit and Loss Statement, Table 17.3

149

Commercial and Industrial Development

Chapter 18

150

Shopping Center Types

neighborhood shopping center

community shopping center

regional shopping center superregional shopping

center other shopping centers

151

Shopping Center Development

Market and Feasibility Analysis Primary and secondary

trade areas Market size Competitive survey

Site Location Tenant Selection

152

Willow Springs Center Case Study

Summary in Real Estate Today feature beginning on page 399

Expense forecast, Table 18.2

Income statement, Table 18.3

Trade area map, Figure 18.3

Site map, Figure 18.4

153

Office Buildings

Location Central business districts Secondary office nodes Office parks

Single vs. multi-tenant buildings

154

Industrial and Distribution Facilities

manufacturing warehousing distribution analysis technique

determine existing and potential supply

forecast demand estimate absorption rate compare competitiveness

with other projects

155

Lodging Facilities

commercial hotels highway or airport hotels

and motels resort hotels

156

Principles of Real Property Insurance

Chapter 19

157

Risks of Property Ownership

Loss of property due to fire, wind, water, vandalism or other hazards

Loss of use Liability loss resulting from

negligence in the use of the property

Financial loss, particularly the inability to make mortgage payments, as a result of disability or death of a wage earner

158

Homeowners Policy

Items covered Replacement cost

coverage Personal articles floater

policies Credit card forgery and

counterfeit money losses Factors influencing rates Coinsurance

159

Renter and Condo Owner Policies

Cover only personal property and personal liability

160

Protection from Specific Risks

Earthquake insurance Making an inventory and a

photographic record Liability insurance The personal excess

liability policy Flood insurance Mortgage life insurance

161

Home Purchase Decisions

Chapter 20

162

Rent or Buy Decisions

Tax consequences of rent versus mortgage payments

Alternative investments Inflation and home prices Impact of mortgage

interest rates Period of ownership

163

How Much House Can You Afford?

Income Expenses Qualifying ratios Down payment

164

Choosing a Property

Choosing an area Property taxes and quality of public

services Recreational facilities Quality of school system Crime statistics Overall quality of the community

Evaluating the individual home Attic Walls, ceilings and floors Roof Basement or crawl space Electrical system Mechanical systems

Heating and cooling systems Water supply and waste disposal

165

Making and Closing the Deal

Real estate agents Negotiating the price Dealing with the lender Closing attorneys and

escrow agents

Documents

The Market for Real Estate Knowledge