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1 The Market for Real Estate Knowledge Chapter 1.

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1 1 The Market for Real Estate Knowledge Chapter 1

2 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 3 property rights restrictions on property rights (public and private) deeds leases contracts title transfer issues Legal analysis concepts include:

4 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 5 real estate brokerage real estate appraisal property management Real estate service industry concepts include:

6 6 financing methods time value of money concepts mortgage mechanics investment property analysis development project analysis Financial and investment analysis concepts include:

7 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 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 9 Property Rights and Legal Descriptions Chapter 2

10 10 Real vs. Personal Property Real estate Property Real property Personal property Deeds Leases

11 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 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 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 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 15 Concurrent Estates Tenancy in common Joint tenancy Tenancy by the entirety Community property

16 16 Other forms of joint ownership Condominium Cooperative Timeshare Fee interests Right to use

17 17 Legal Description Methods Metes and Bounds Rectangular Survey Recorded Plats

18 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 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 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 21 Private Restrictions on Ownership Chapter 3

22 22 Encumbrances Restrictions or limitations on the owners ability to use a property.

23 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 Mechanics lien

24 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 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 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 27 Other issues Encroachment – an unauthorized invasion or intrusion of a fixture, building or other improvement onto another owners 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 28 Public Restrictions on Ownership Rights Chapter 4

29 29 Four Basic Powers of Government Over Real Estate Taxation Escheat Eminent domain Police power

30 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 propertys market value and permits a exemption of $2,500 for this type of property is calculated as follows: Market Value$120,000 multiplied by Assessment Ratiox.40 equals Assessed Value$48,000 minus Exemptions (if any)-$2,500 equals Taxable Value$45,500 divided by times Millage Ratex 25 equals Property Tax$1,137.50

31 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 32 Power of Escheat Governments right to acquire ownership of land when the landowner dies without an heir or a valid will

33 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 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 35 Implementing Comprehensive General Plan Zoning – division of a communitys 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 36 Zoning Changes Legislative relief Administrative relief Variances Special use permits Judicial relief

37 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 38 Deeds and Leases Chapter 5

39 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 40 Additional Deed Elements Covenant against encumbrances Covenant of seisin Covenant of quiet enjoyment Covenant of further assurances Warranty forever

41 41 Types of Deeds General warranty deed Special warranty deed Bargain and sale deed Quitclaim deed Deeds for special uses

42 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 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 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 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 on the World Wide Web.www.nolo.com

46 46 Contracts in Real Estate Transactions Chapter 6

47 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 48 Contract Issues Oral Contracts Specific Performance Partial Performance Breach of Contract

49 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 50 Common Real Estate Contracts Real Estate Sales Contract Option-to-Buy Contract Contract for Deed

51 51 Title Examination and the Closing Process Chapter 7

52 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 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 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 55 Title Closing the final step in the process of transferring title from grantor to grantee Buyers responsibilities before closing obtaining financing examining the title evidence having the property surveyed obtaining property insurance having the property inspected Sellers responsibilities before closing prepare the deed remove encumbrances cooperate with inspectors

56 56 Closing Costs Costs generally paid by the buyer at the closing loan origination fee loan discount points appraisal fee credit report fee lenders 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 sellers mortgage

57 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, to the closing and the seller will leave the closing with $58,

58 58 Understanding Real Estate Markets Chapter 8

59 59 Market the mechanism or arrangements through which goods and services are traded between market participants

60 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 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 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 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 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 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 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 67 Urban and Regional Economics Chapter 9

68 68 Determinants of a Citys Comparative Advantage Transportation facilities Educational facilities Created environment Natural resources Climate Labor force Leadership

69 69 Economic Base Export activities Agriculture, manufacturing, mining, and wholesale trade Population serving activities Construction, public utilities, retail trade

70 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 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 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 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 74 Real Estate Brokerage Chapter 10

75 75 The Real Estate Sales Process listing agreement marketing the property and qualifying buyers presentation and negotiations contracts settlement or closing

76 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 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 principals best interest. Dual Agency

78 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 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 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 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 82 Real Estate Appraisal Chapter 11

83 83 Appraisal Regulation FIRREA of 1989 State requirements Licensed appraisers Certified residential appraisers Certified general appraisers

84 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 investors personal standards of investment acceptability Price versus market value Market value versus cost of production Other types of value Assessed value Insurable value

85 85 Key Appraisal Principles Anticipation Change Substitution Contribution

86 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 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 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 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 90 Applying the Appraisal Process: Single-Family Home Case Study pages

91 91 Property Management Chapter 12

92 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 propertys useful life

93 93 Management Agreement establishes the relationship between the owner and the manager. (Figure 12.1, pages ) 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 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 95 Real Estate Today Feature Green Acres Shopping Center – A Property Management Success Story page 265.

96 96 Corporate Real Estate Asset Managers The functions of an asset manager include: facilities management acquisition of additional space for the firms operations financing decisions relating to needed space disposition of corporate real estate assets.

97 97 Residential and Commercial Property Financing Chapter 13

98 98 Understanding the Mortgage Concept secured vs. unsecured debt mortgage hypothecation title theory lien theory

99 99 Promissory Note a written promise to repay a debt that usually accompanies a mortgage document prepayment clause acceleration clause due-on-sale clause

100 100 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

101 101 Alternative Security Instruments Trust Deeds Land Contracts

102 102 Other Issues: Subject to Assumption Deed in lieu of foreclosure

103 103 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.

104 104 Federal Housing Administration (FHA) Created in 1934 to help restore confidence to the nations 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.

105 105 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

106 106 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 Continues today to purchase mortgage loans from originators and repackage these loans into mortgage backed securities that are sold to investors.

107 107 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.

108 108 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.

109 109 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.

110 110 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

111 111 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 The application collects information about the borrowers income, other debts, other assets, employment history, etc. that is used by the lender to evaluate lending risk

112 112 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

113 113 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 borrowers 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 borrowers 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 borrowers gross monthly income for a conventional mortgage or 41% for a FHA-insured mortgage. Successful applicants must qualify under both ratios simultaneously.

114 114 Sources of Commercial Mortgage Market Capital Individual Investors Life Insurance Companies Pension Funds Real Estate Investment Trusts Commercial Banks Commercial mortgage backed securities (CMBS)

115 115 Commercial Underwriting Criteria Commercial loan underwriters are more concerned with the propertys ability to generate income to repay the debt than they are concerned with the borrowers income. Lenders typically require that a propertys 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 propertys 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.

116 116 Risk, Return, and the Time Value of Money Chapter 14

117 117 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)

118 118 Types of Risk Business risk – uncertainty arising from changing economic conditions that affect an investments 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

119 119 Time Value of Money Principle Money in hand today is worth more than money to be received in the future

120 120 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.

121 121 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? Calculator keystrokes shown on page 316.

122 122 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%? Calculator keystrokes shown on page 318.

123 123 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%?

124 124 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?

125 125 Mortgage Payments Example: What annual payment would be necessary to amortize a loan for $100,000 over ten years at 10% interest?

126 126 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 Calculator keystrokes shown on page 325. 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.

127 127 Mortgage Mechanics Chapter 15

128 128 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

129 129 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.

130 130 Amortization Schedule YearPayment PMT Interest I t Principal P t Amount Outstanding AO t , $16, , , , $16, , , , $16, , , , $16, , , , $16, , , , $16, , , , $16, , , , $16, , , , $16, , , , $16, , , Total $162, $62, $100,000.00

131 131 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, = 16, ,000 AOt = AOt-1 – Pt = 93, = 100, , Amortization: Period Two It = AOt-1 x i = 9, = 93, x.10 Pt = PMT – It = 6, = 16, , AOt = AOt-1 – Pt = 86, = 93, ,901.99

132 132 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 $ At the end of the fifth year of this loan (60 months), the amount outstanding of the original principal amount is $125, Calculator keystrokes shown on page 336.

133 133 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, 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 $ Or, the borrower could refinance the loan at 6% interest but keep the monthly payments at $ and reduce the number of months needed to amortize the debt from 300 to 227. Calculator keystrokes shown on page 338.

134 134 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 borrowers 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 $ 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 % 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.

135 135 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 $ and the effective interest rate if the loan is held to maturity is %. If the loan is prepaid at the end of the 60th month, however, the effective interest rate increase to % 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.

136 136 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

137 137 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? $ What is the monthly payment during the last 23 years of this loan? $ Calculator keystrokes given on page 343 & 344.

138 138 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.

139 139 Analyzing Income- Producing Properties Chapter 17

140 140 Advantages of Real Estate Investment Cash Flow from Operations (After Tax Cash Flow – ATCF) Appreciation (After Tax Equity Reversion – ATER) Portfolio Diversification Financial Leverage

141 141 Disadvantages of Real Estate Investment large capital requirements risk business risk financial risk purchasing power risk liquidity risk

142 142 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.

143 143 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 investors required rate of return

144 144 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

145 145 Residential Land Uses Chapter 17

146 146 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

147 147 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

148 148 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

149 149 Commercial and Industrial Development Chapter 18

150 150 Shopping Center Types neighborhood shopping center community shopping center regional shopping center superregional shopping center other shopping centers

151 151 Shopping Center Development Market and Feasibility Analysis Primary and secondary trade areas Market size Competitive survey Site Location Tenant Selection

152 152 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

153 153 Office Buildings Location Central business districts Secondary office nodes Office parks Single vs. multi-tenant buildings

154 154 Industrial and Distribution Facilities manufacturing warehousing distribution analysis technique determine existing and potential supply forecast demand estimate absorption rate compare competitiveness with other projects

155 155 Lodging Facilities commercial hotels highway or airport hotels and motels resort hotels

156 156 Principles of Real Property Insurance Chapter 19

157 157 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

158 158 Homeowners Policy Items covered Replacement cost coverage Personal articles floater policies Credit card forgery and counterfeit money losses Factors influencing rates Coinsurance

159 159 Renter and Condo Owner Policies Cover only personal property and personal liability

160 160 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

161 161 Home Purchase Decisions Chapter 20

162 162 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

163 163 How Much House Can You Afford? Income Expenses Qualifying ratios Down payment

164 164 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

165 165 Making and Closing the Deal Real estate agents Negotiating the price Dealing with the lender Closing attorneys and escrow agents


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