2 Real Estate - land and things attached to it The real estate body of knowledge consists of four broad collections of concepts:legal analysis conceptsmarket analysis conceptsreal estate service industry conceptsfinancial and investment analysis concepts.
3 Legal analysis concepts include: property rightsrestrictions on property rights (public and private)deedsleasescontractstitle transfer issues
4 Market analysis concepts include: real estate market dynamicsreal estate space marketreal estate asset marketreal estate development industryurban growth models
5 Real estate service industry concepts include: real estate brokeragereal estate appraisalproperty management
6 Financial and investment analysis concepts include: financing methodstime value of money conceptsmortgage mechanicsinvestment property analysisdevelopment project analysis
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 2001Table 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 estatePropertyReal propertyPersonal propertyDeedsLeases
11 FixtureA personal property item that has become a part of the real property is called a fixture.Tests for fixture status include:Intent of partiesTest of attachmentTest of adaptability
12 Mineral and Air RightsMineral 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 RightsWater 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 waterriparian rights doctrineprior appropriation doctrine
14 Estates in Land Freehold estates Leasehold estates Present interests Fee simple absolute estateQualified fee estateLife estateFuture interests include:Reversion interestRemainder interestLeasehold estatesTenancy for a stated periodTenancy from period to periodTenancy at willTenancy at sufferance
15 Concurrent Estates Tenancy in common Joint tenancy Tenancy by the entiretyCommunity property
16 Other forms of joint ownership CondominiumCooperativeTimeshareFee interestsRight to use
17 Legal Description Methods Metes and BoundsRectangular SurveyRecorded Plats
18 Metes and Boundsstart 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 linesRange linesTownship linesTownshipsSectionsDivisions 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.”
22 EncumbrancesRestrictions 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 obligationMortgagor-borrowerMortgagee-lenderForeclosureMechanic’s lien
24 Easement right to use a property in a specified manner. Types of EasementsEasement AppurtenantEasement in grossCreation of Easements by:Express grant or reservationImplicationPrescriptionTermination of Easements by:AgreementMergerAbandonment
25 Licenses and ProfitsLicense – a revocable personal privilege to use land for a particular purposeProfit - profit a prende – a non-possessory interest that permits the holder to remove specified resources from the land
26 Adverse PossessionProcess 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 possessionActual and exclusiveOpen and notoriousHostileContinuousUnder a claim of rightStatutory period
27 Other issuesEncroachment – 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 TaxationEscheatEminent domainPolice 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 1000times Millage Rate x 25equals Property Tax $1,137.50
31 Administering the Property Tax First step, identify all properties and estimate their valuesSecond 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 EscheatGovernment’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 compensationUse must be a valid public use.Property owner must be compensated fairly.Inverse condemnation
34 Police PowerPower to regulate use of private property to protect public health, safety, morals and general welfareLand uses are interdependent, meaning that the way one property is used affects other nearby properties.Comprehensive general planprojected economic developmenttransportation plan to provide for necessary circulationpublic-facilities plan that identifies such needed facilities as schools, parks, civic centers, water and sewage disposal plantsland-use planofficial 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 usesType of use – residential, commercial, industrial categoriesIntensity of use - developmental densityHeight and bulk limitationsBulk regulationsFloor-area ratioMinimum lot size and setback regulations
36 Zoning Changes Legislative relief Administrative relief Variances Special use permitsJudicial relief
37 Other Issues: Nonconforming Uses Building Codes Subdivision RegulationsSubdivision Approval ProcessMandatory DedicationImpact FeesInnovative Land-use Control MethodsPlanned unit developmentPerformance zoningIncentive zoningTransfer of development rights
39 DeedsWritten document that transfers title (ownership) to real estate from the grantor to the granteeNecessary Elements of a DeedDesignation of the partiesConsideration given by granteeLegal descriptionSpecific interest conveyedSignature of the grantor and witnesses
40 Additional Deed Elements Covenant against encumbrancesCovenant of seisinCovenant of quiet enjoymentCovenant of further assurancesWarranty forever
41 Types of Deeds General warranty deed Special warranty deed Bargain and sale deedQuitclaim deedDeeds for special uses
42 LeasesAgreement between a property owner and tenant that transfers the rights of use and possessionRequirements of a Properly Prepared LeaseNames of the lessor and lesseeConveyance of the premisesDescription of the premisesTerm or duration of the leaseAmount of rent and manner of paymentDuties and obligations of partiesSignatures of the parties
43 Classification of Leases Duration of termTenancy for stated periodTenancy from period to periodTenancy at willTenancy at sufferanceType of UseGround LeaseResidential leaseCommercial leaseMethods of PaymentGross leaseNet leaseNet net leaseNet net net leaseFixed-rent leaseGraduated-rent leaseReappraisal leasePercentage leaseIndex lease
44 Issues in the Landlord-Tenant Relationship Renewal optionExpense stopsAssignment and subleasingSecurity depositsImprovementsCovenant of quiet enjoymentImplied warranty of habitabilityMaintenance of common areasProtection 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 on the World Wide Web.
46 Contracts in Real Estate Transactions Chapter 6
47 ContractsAn exchange of promises between parties, conditioned on certain events and enforceable by law.Necessary Elements of a ContractOffer and acceptanceConsiderationCapacity of partiesLawful purposeWriting requirement (Statute of Frauds)
48 Contract Issues Oral Contracts Specific Performance Partial PerformanceBreach of Contract
49 Contract Contingencies Specified conditions in a contract that relieve the parties of their promises to performfinancing contingencytitle contingencyinspection and repair contingency
50 Common Real Estate Contracts Real Estate Sales ContractOption-to-Buy ContractContract for Deed
51 Title Examination and the Closing Process Chapter 7
52 Title Examinationthe process of verifying the ownership rights being offered by the seller of a propertymarketable titleinsurable titletitle perfect of record
53 Title SearchDetailed examination of all public records that reveals the ownership history of a propertyrecording requirementgrantor and grantee indexestax records searchlien search
54 Other Title Issues Title abstract Title Opinion Title insurance paid for in full at the time the policy is issuednot transferableprotects only against past events that were in existence, but undiscovered at the time the policy was issuedTorrens system
55 Title Closingthe final step in the process of transferring title from grantor to granteeBuyer’s responsibilities before closingobtaining financingexamining the title evidencehaving the property surveyedobtaining property insurancehaving the property inspectedSeller’s responsibilities before closingprepare the deedremove encumbrancescooperate with inspectors
56 Closing Costs Costs generally paid by the buyer at the closing loan origination feeloan discount pointsappraisal feecredit report feelender’s inspection feemortgage insurance premiumattorney feeshazard insurance premiumrecording fees for the mortgageCosts generally paid by the seller at the closingreal estate brokerage commissiondocumentary stamp taxes, where requiredrecording 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, to the closing and the seller will leave the closing with $58,
59 Marketthe 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 buildingspeople, 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 useOffice space marketsRetail space marketsIndustrial space marketsAgricultural space marketsLodging space marketResidential 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 buildingsthe real estate asset market is part of the larger capital market, which includespublicly 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 capitalgrowth expectationsrisk
63 The Real Estate Systemconsists of real estate space markets, the real estate asset market, and the development industrySee 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 Analysisexamination of the supply and demand sides of a real estate space market and the balance (equilibrium) between themInputs to market analysisVacancy rate – higher vacancy rate indicates less demand relative to supply and vice versaRent or price level – trends in rents and prices indicate changes in the balance between supply and demandQuantity of new construction started – indicates new supply that will be coming into the marketQuantity of new construction completed – indicates new supply that is just arriving into the marketAbsorption 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 analysisMonths supply = (vacant space + space in construction)/net absorption per monthIf 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 demandIf 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 occupationsLodging: air passenger volume, highway traffic counts, tourism receipts, number of visitorsRetail: per capital income, aggregate income, wealth measuresIndustrial: manufacturing employment, transportation employment, shipping volumeApartments: population, household formation, local housing affordability, employment growth (blue and white collar)Owner-occupied residential: population, household formation, interest rates, employment growth, income growth
68 Determinants of a City’s Comparative Advantage Transportation facilitiesEducational facilitiesCreated environmentNatural resourcesClimateLabor forceLeadership
69 Economic Base Export activities Population serving activities Agriculture, manufacturing, mining, and wholesale tradePopulation serving activitiesConstruction, public utilities, retail trade
70 Analyzing Local Demand Short-run demand issuesCurrent supply of real estate improvementsCurrent industrial structureRecent changes in the local economyLikely economic changes in the near futureLong-run demand issuesLong-run economic prospects for the local economyNational & regional trends likely to affect the local economyLikelihood 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 markethighest and best use – the use of land that results in the highest land renteach parcel of land has a highest and best useBid-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 DistrictAs 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 StagesGestation, Youth, and MaturityIncipient DeclineClear DeclineAccelerating Decline and AbandonmentNeighborhood stabilization and rehabilitation
75 The Real Estate Sales Process listing agreementmarketing the property and qualifying buyerspresentation and negotiationscontractssettlement 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 commissionReal 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 buyerExclusive 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 commissionExclusive 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 brokerBuyer 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 occurswhen the agreement expireswhen the parties agree to terminatewhen one party breaches the agreementwhen one party becomes contractually incapacitatedthe listing property is destroyedthe listing property is condemned
81 Other Brokerage Issues FranchisesDesk Fee ArrangementsMultiple-Listing ServicesBroker and Salesperson Compensationusually calculated as a percentage of the transaction amountbroker and salesperson often have an agreed upon “split” between themselvescooperating brokers (through the MLS) often split any commissions paid by agreement
83 Appraisal Regulation FIRREA of 1989 State requirements Licensed appraisersCertified residential appraisersCertified general appraisers
84 What is Value? Market value (page 225) Typically motivated partiesWell informed partiesMarket exposurePayment in cashNo special circumstancesInvestment value – worth to a particular investor based on that investor’s personal standards of investment acceptabilityPrice versus market valueMarket value versus cost of productionOther types of valueAssessed valueInsurable value
86 The Appraisal Process Definition of the problem Type of value-purposeDescription of propertySpecific property rightsEffective dateData selection and collectionGeneral market analysisSpecific property analysisHighest and best use analysisAs though vacantAs improvedApplication of the three approaches to valuationSales comparison approachCost approachIncome approachReconciliation of value indicationsReport of defined value
87 Sales Comparison Approach Comparable sales data selectionAdjustment of sales dataElements of comparisonProperty rights conveyedConditions of saleFinancing termsMarket conditionsLocational characteristicsPhysical characteristicsApplying the sales comparison approach – See Table 11.1, page 237.
88 Cost Approach Estimating site value Estimating production cost Reproduction costReplacement costEstimating accrued depreciationPhysical deteriorationFunctional obsolescenceEconomic obsolescenceApplying the cost approach – See Table 11.2, page 241.
89 Income Approach Gross income multiplier Net income capitalization GIM = Value/Gross IncomeNet income capitalizationCapitalization Rate = Net Income/ValueDiscounted cash flow – see Table 11.3, page 244
90 Applying the Appraisal Process: Single-Family Home Case Study pages
92 Property ManagementThe 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 Agreementestablishes the relationship between the owner and the manager. (Figure 12.1, pages )The agreement should address the powers of the manager relating toRent settingLease signingsRent collectionsPower to spend money on behalf of the propertyAuthority to hire, fire, and supervise personnelThe agree should specify the compensation to the managerPercentage of gross incomeFixed amountFee schedule for certain tasksHourly rate
94 Functions of a Property Manager administrationmarketing and advertisingtenant selectionlease negotiationmove-in inspectionsproperty maintenancerent collectionmove-out inspectionssecurity 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 managementacquisition of additional space for the firm’s operationsfinancing decisions relating to needed spacedisposition of corporate real estate assets.
97 Residential and Commercial Property Financing Chapter 13
98 Understanding the Mortgage Concept secured vs. unsecured debtmortgagehypothecationtitle theorylien theory
99 Promissory Notea written promise to repay a debt that usually accompanies a mortgage documentprepayment clauseacceleration clausedue-on-sale clause
100 Foreclosurethe process of seizing control of the collateral for a loan and using the proceeds from its sale to satisfy a defaulted debtjudicial foreclosureNonjudicial foreclosureStrict foreclosure
101 Alternative Security Instruments Trust DeedsLand Contracts
102 Other Issues:“Subject to”AssumptionDeed 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 systemHelped developed lending standards that reduced lenders’ risk exposurePromoted the use of long-term, fully amortizing loansEstablished a mortgage insurance program to cover losses to lendersBorrowers pay a fee to purchase an insurance policy that protects the lender from the risk of loss due to default by the borrowerIn 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 programsBorrowers pay a fee to purchase an insurance policy that limits the risk of loss faced by lenders in the event of default by the borrowerIn return, lenders are willing to lend money at favorable rates with relatively small down payment requirementsUsually 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 LoansAs 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 byCommercial banksSavings institutionsLife insurance companiesFederal agenciesMortgage pools and trustsIndividuals 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 pagesThe 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 ActConsumer Credit Protection ActReal Estate Settlement Procedures ActFlood Disaster Protection ActFair 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 InvestorsLife Insurance CompaniesPension FundsReal Estate Investment TrustsCommercial BanksCommercial 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 investmentrisk – uncertainty about the actual rate of return over an investment periodrisk and return are directly related (investors require greater returns for greater risk)
118 Types of RiskBusiness risk – uncertainty arising from changing economic conditions that affect an investment’s ability to generate returnsFinancial risk – uncertainty associated with the possibility of defaulting on borrowed funds used to finance an investmentPurchasing 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 amountCompounding – the process of determining future valueExample: 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 valueExample: What is the present value of $93,170 discounted at 10% annual interest for 3 years?Calculator keystrokes shown on page 316.
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 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 PaymentsExample: 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 PaymentsExample: 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 dollarsNPV = present value of cash inflows minus present value of cash outflowsNPV Decision Rule: If the NPV is equal to or greater than zero, we choose to investCalculator keystrokes shown on page 325.Internal Rate of Return (IRR) - the discount rate that makes the NPV equal to zeroIRR = the rate of return on the investmentIRR Decision Rule: If the IRR is greater than or equal to our required rate of return, we choose to investIRR for above example = 12.06%
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.
131 To Construct an Amortization Schedule Begin by calculating the periodic payment required to amortize the loan using the mortgage payment formulaProceed 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 balanceThe 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 OneIt = AOt-1 x i = 10,000 = 100,000 x .10Pt = PMT – It= 6, = 16, ,000AOt = AOt-1 – Pt = 93, = 100, ,274.54Amortization: Period TwoIt = AOt-1 x i = 9, = 93, x .10Pt = PMT – It = 6, = 16, ,372.55AOt = AOt-1 – Pt = 86, = 93, ,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 paymentsExample: 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 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 $810.80Or, 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 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 $ 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 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 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 yearAdjustable 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? $659.51What is the monthly payment during the last 23 years of this loan? $840.68Calculator 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.
140 Advantages of Real Estate Investment Cash Flow from Operations (After Tax Cash Flow – ATCF)Appreciation (After Tax Equity Reversion – ATER)Portfolio DiversificationFinancial Leverage
141 Disadvantages of Real Estate Investment large capital requirementsriskbusiness riskfinancial riskpurchasing power riskliquidity risk
142 The Wealth Maximization Objective investment can be defined as present sacrifice in anticipation of future benefitinvestment decision making involves comparison of the expected future benefits with the costs of the investmentinvestors’ ultimate goal is to maximize their wealth by choosing investments that are worth more than they costthe NPV decision rule employs the wealth maximization conceptIf 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 taxesATER = gross sale price minus selling expenses minus loan payoff minus taxesInitial equity = purchase price minus loan amounti = 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
146 Types of Residential Development single-family detached housessingle-family attached housesrow housestownhousesplexespatio or zero-lot-line housesmultifamily residencesgarden apartmentsmid-rise apartmentshigh-rise apartmentsmanufactured homessecond homes
147 Market and Feasibility Analysis delineation of the market areaanalysis of recent economic trends in the local market areaanalysis of demand factorsemploymentdisposable incomepopulationhousehold characteristicsabsorption rateanalysis of supply, including other possible competing projects
148 Millford Hills Subdivision Case Study Summary in Real Estate Today feature beginning on page 381Location Map in Figure 17.1Competing project sales figures in Table 17.1Projected cash flow statement in Table 17.2Pro Forma Profit and Loss Statement, Table 17.3
149 Commercial and Industrial Development Chapter 18
150 Shopping Center Types neighborhood shopping center community shopping centerregional shopping centersuperregional shopping centerother shopping centers
151 Shopping Center Development Market and Feasibility AnalysisPrimary and secondary trade areasMarket sizeCompetitive surveySite LocationTenant Selection
152 Willow Springs Center Case Study Summary in Real Estate Today feature beginning on page 399Expense forecast, Table 18.2Income statement, Table 18.3Trade area map, Figure 18.3Site map, Figure 18.4
153 Office Buildings Location Single vs. multi-tenant buildings Central business districtsSecondary office nodesOffice parksSingle vs. multi-tenant buildings
154 Industrial and Distribution Facilities manufacturingwarehousingdistributionanalysis techniquedetermine existing and potential supplyforecast demandestimate absorption ratecompare competitiveness with other projects
155 Lodging Facilities commercial hotels highway or airport hotels and motelsresort 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 hazardsLoss of useLiability loss resulting from negligence in the use of the propertyFinancial 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 policiesCredit card forgery and counterfeit money lossesFactors influencing ratesCoinsurance
159 Renter and Condo Owner Policies Cover only personal property and personal liability
160 Protection from Specific Risks Earthquake insuranceMaking an inventory and a photographic recordLiability insuranceThe personal excess liability policyFlood insuranceMortgage life insurance
162 Rent or Buy DecisionsTax consequences of rent versus mortgage paymentsAlternative investmentsInflation and home pricesImpact of mortgage interest ratesPeriod of ownership
163 How Much House Can You Afford? IncomeExpensesQualifying ratiosDown payment
164 Choosing a Property Choosing an area Evaluating the individual home Property taxes and quality of public servicesRecreational facilitiesQuality of school systemCrime statisticsOverall quality of the communityEvaluating the individual homeAtticWalls, ceilings and floorsRoofBasement or crawl spaceElectrical systemMechanical systemsHeating and cooling systemsWater supply and waste disposal
165 Making and Closing the Deal Real estate agentsNegotiating the priceDealing with the lenderClosing attorneys and escrow agents