REAL ESTATE FINANCING 9/11/2018 Dr.P.S, MBFS, V Unit

Major Topics Mortgage Terms and Clauses Sources of Real Estate Finance Mortgage Money in the Context of the Capital Market Primary and Secondary Mortgage Markets Commercial Mortgage Backed Securities Economic of Interest Rates Impact of the Federal Reserve Trends in Real Estate Finance 9/11/2018 Dr.P.S, MBFS, V Unit

Introduction Real estate finance is traditionally the process of borrowing or lending, most often involving a third party that is neither the buyer nor seller of the property in question From the borrower’s point of view a loan is a debt and liability, while from the lender’s point of view a loan is an investment and an asset with the property serving as collateral for the loan Financing a real estate transaction involves significant risk to both the owner of the real estate (the borrower) and to the lender 9/11/2018 Dr.P.S, MBFS, V Unit

Important to have relationship documented What is a Mortgage Loan? The combination of Equity and Debt used to buy a property is known as the capital structure of the property When debt involves real estate as collateral security for the loan it is referred to as a Mortgage A mortgage loan is a contractual agreement between the mortgagor and the mortgagee Important to have relationship documented 9/11/2018 Dr.P.S, MBFS, V Unit

Promissory Note A promissory note is a written document containing the contract terms between the borrower and the lender Legally, the promissory note provides evidence of the debt between borrower and lender since a mortgage cannot be enforced unless the mortgagor owes a debt to the mortgagee Practically, the promissory note documents the agreement between the borrower and the lender and contains the financial and legal details of the transaction 9/11/2018 Dr.P.S, MBFS, V Unit

Clauses contained in “the note” Loan Amount Method of Repayment Interest Rate Term Acceleration Clause Prepayment Provisions Late Payment Provisions Due on Sale Clause Escrow for Property Taxes/ Insurance Maintenance of Property Default Loan Guarantees 9/11/2018 Dr.P.S, MBFS, V Unit

Mortgage Markets and the Role of Intermediaries Financial Markets bring together savers who have surplus income to invest and borrowers who have a need for funds beyond their current cash holdings Financial Intermediaries bring together those who use borrowed funds and those who have surplus funds to lend or invest Play an extremely important role in financial markets because they absorb many of the risks associated with lending by and provide important services to both savers and borrowers 9/11/2018 Dr.P.S, MBFS, V Unit

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Uses of Mortgage Money 9/11/2018 Dr.P.S, MBFS, V Unit

Primary Sources of Mortgage Money Single Family Housing Dominant secondary market players, Freddie Mac and Fannie Mae Multifamily Mortgage Loans Commercial banks followed by Federally related agencies, Fannie Mae, Ginnie Mae etc. Commercial Mortgages For office and industrial property, commercial banks, followed far behind by life insurance companies and the larger savings and loan associations Commercial mortgage backed securities market (CMBS) becoming important 9/11/2018 Dr.P.S, MBFS, V Unit

CMBS 9/11/2018 Dr.P.S, MBFS, V Unit

Primary Suppliers of Mortgage Funds Savings and Loans Commercial Banks Mortgage Bankers/ Mortgage Companies Life Insurance Companies Pension Funds Individuals 9/11/2018 Dr.P.S, MBFS, V Unit

Other Sources of Debt Capital Mortgage and Hybrid REITS (Real Estate Investment Trusts) Credit Unions Companies and Private Personal Finance Agencies especially important for home equity second mortgages. Investment Banking Firms through Commercial Mortgage Backed Securities or Direct Placements of larger loans ($100 million plus). The Government Agencies such as the Farmers Home Administration Bank Trust Departments 9/11/2018 Dr.P.S, MBFS, V Unit

Impact of the RTC RTC had to establish standard procedures and rating criteria in order to dispose of much of the real estate held by the failed institutions As a result, these procedures have been used by investment bankers as a way of structuring commercial financing transactions on performing properties that can be securitized and sold in the secondary markets 9/11/2018 Dr.P.S, MBFS, V Unit

Impact of the CRA CRA requires that each insured depository institution's record to meet credit needs of its entire community be evaluated periodically As a result of CRA more loans are made to disadvantaged areas, often at below market rates, as part of the community oriented policies of local financial institutions 9/11/2018 Dr.P.S, MBFS, V Unit

Influences on Mortgage Interest Rates Generally, the interest rate on any investment consists of several components: The real risk free rate of interest Expected inflation over a given term A risk premium for interest rate risk and liquidity concerns, Risk premiums for default and loss of principal risk Other risk premiums such as political risks, currency risks, or other factors that may influence investment return volatility or safety 9/11/2018 Dr.P.S, MBFS, V Unit

Yield Curves All real estate loans are affected by yields on Treasury securities These yields on Treasury securities are used by economists and financial market reporters to construct what is called a term structure Yield Curve Most yield curves are upward sloping Tend to flatten out or even become downward sloping just before and during economic recessions 9/11/2018 Dr.P.S, MBFS, V Unit

Yield Curves 9/11/2018 Dr.P.S, MBFS, V Unit

The Real Risk Free Rate of Interest and Expected Inflation Levels Nominal risk free returns were theorized to have a real component and expected inflation component by Ernest Fisher: nominal rate = (1+ real rate)(1+ expected inflation) – 1 Using this same relationship, if we know expected inflation and nominal rates, we can estimate real rates: real rate = (nominal rate + 1)/(1 + expected inflation) – 1 The level of expected inflation also has an important influence on fixed rate mortgage payments through the tilt effect 9/11/2018 Dr.P.S, MBFS, V Unit

Yield Curve (Contd.) Real risk free rates in the United States have run about .5% to 1.5% for short term investments and 1.5% to 4% for longer term investments over the last few decades 9/11/2018 Dr.P.S, MBFS, V Unit

Impact of Global Capital Markets on Mortgage Rates Real interest rates are ultimately driven by the opportunity costs of capital, not just domestically but globally If sufficient mechanisms evolve for foreign capital investment in rapid growth countries in Asia, Eastern Europe etc., they will be able to pay greater real rates of return than anything provided in more developed countries 9/11/2018 Dr.P.S, MBFS, V Unit

Impact of Federal Reserve The overall mission of the Federal Reserve is to keep the economy stable by balancing the total amount of money available in the economy with the economy’s growth and productivity The three tools that the Federal Reserve uses to accomplish this goal are as follows: Open-market Operations Discount Rate Reserve Requirements 9/11/2018 Dr.P.S, MBFS, V Unit

Other Risk Premia added on Mortgages Default Risk Prepayment and Interest Risk Liquidity Risk 9/11/2018 Dr.P.S, MBFS, V Unit

Trends in Real Estate Finance The days of purely relationship borrowing are gone, although many commercial banks still rely heavily on relationship based marketing Today we continue to see an increasing prevalence of securitizing all types of mortgages Securitization is the process of converting an individual mortgage into a security, often is pooled form where many similar mortgages are combined, that is then sold to investors in secondary markets 9/11/2018 Dr.P.S, MBFS, V Unit

THANK YOU 9/11/2018 Dr.P.S, MBFS, V Unit