Real Estate Investment Chapter 10 Financing Real Estate Investments © 2011 Cengage Learning

Key Terms Add-on interest Amortization Annuity Balloon note Cap rate (CR) Commercial loan Compound interest Construction loans Conventional loan Debt coverage ratio Debt service Discount Equity participation Foreclosure Loan discount Loan-to-value (LTV)

© 2011 Cengage Learning Key Terms Mezzanine loans Mortgage loan amortization Non-recourse loan Origination fee Primary mortgage market Refinance Residential loans Secondary mortgage market Simple interest Underwriting standards Wrap-around mortgage

© 2011 Cengage Learning Risk and the Impact of Leverage How borrowing can increase returns What are the disadvantages? Too much leverage Loss of major tenants Greater equity requirements

© 2011 Cengage Learning Risks Facing Real Estate Lenders Default risk Interest rate risk Reinvestment risk

© 2011 Cengage Learning Primary Mortgage Market Where loans are originated It is the market where borrowers negotiate with lenders, discussing the cost of a loan Interest rate Discount points

© 2011 Cengage Learning Secondary Mortgage Market Where loans are sold to investors, hence making more money available to lend. At its beginning, the secondary mortgage market consisted of the Federal National Mortgage Association (FNMA or Fannie Mae). The Emergency Home Finance Act of 1970 created the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). FIRREA in 1989 made regulation of Fannie Mae and Freddie Mac consistent.

© 2011 Cengage Learning The Secondary Market Following the “thrift crisis” of the late 1980s, the General Accounting Office and the Department of Treasury were instructed to conduct studies of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. These studies laid the foundation for comprehensive regulatory modernization for both Fannie Mae and Freddie Mac in 1992.

© 2011 Cengage Learning The Secondary Market The Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac It created the Office of Federal Housing Enterprise Oversight (OFHEO) as a new regulatory office within HUD. OFHEO did not achieve this primary objective, with the failures of Fannie and Freddie.

© 2011 Cengage Learning The Secondary Market Adjacent to the collapse of Fannie and Freddie and under the auspices of the Housing and Economic Recovery Act (HERA) of 2008, OFHEO and the Federal Housing Finance Board were combined to form the new Federal Housing Finance Agency.

© 2011 Cengage Learning The Secondary Market HERA was passed to strengthen governmental oversight of Fannie Mae and Freddie Mac Established the Federal Housing Finance Agency replacing OFHEO and HUD as Fannie Mae’s safety and soundness and mission regulator.

© 2011 Cengage Learning Evaluating the Commercial Loan Somewhat similar to evaluating a residential loan Lender is primarily concerned with the source of the funds that will be used to make the loan payments. With a residential loan the lender will look at the income of the borrower. The funds used to pay the debt service on a commercial loan come from the property rather than the borrower. The major focus of the commercial lender is to evaluate the property, both for its ability to generate sufficient income and also its adequacy as collateral for the loan.

© 2011 Cengage Learning Using the Debt Coverage Ratio Method The debt coverage ratio is not based on any specific standards The lender will look at the type of property, the experience of the developer, the risks involved, the strength and quality of the property’s income, and other variables. Typically the ratio will vary between 1.2 and 1.4 for most properties. The debt coverage ratio is DCR = NOI/DS In other words, the ratio equals the net operating income divided by the debt service.

© 2011 Cengage Learning Evaluating the Property Most lenders will require an appraisal of the property that is to be pledged as collateral for the loan. For a property that is basically an income producing property, the appraiser will rely heavily on the income approach to establish value. The appraiser will develop a Pro Forma based on market data Like many commercial. The appraisal is frequently for a property to be built.

© 2011 Cengage Learning Using the Loan to Value (LTV) Method Once a value is established, the lender will then establish the loan amount for the project being considered. In previous times lenders would make loans based entirely upon the appraised value. In recent times the lender will require that the borrower have a large verifiable equity in the property. There is no standard but a 75 % LTV is probably about the highest that can be arranged unless there are extenuating circumstances. A 60 % to 65 % LTV, or lower, is more common

© 2011 Cengage Learning Lender Criteria No rigid standards for setting lender criteria. Vary from month to month, from lender to lender, and from property type to property type. A borrower must determine the criteria that are currently being used by several different lenders before attempting to establish the feasibility of a proposed development. A project that may be feasible under certain assumptions may instantly become infeasible under different criteria.

© 2011 Cengage Learning Effects of Underwriting on Commercial Borrowers Much of the credit demand for residential mortgage money has shifted from savings deposits and insurance company reserves to the financial markets. The historic participation of institutional lenders in residential loans in lending for their own portfolios can now be more focused on commercial loans. Mortgage companies have expanded their market share of commercial loans. Also, there is a growing effort by private lenders, such as large commercial banks, to pool blocks of commercial loans for the issuance of mortgage- backed securities.

© 2011 Cengage Learning Why Borrow Money? To increase the return, or yield Impact of mortgage loans on investment returns ROR ROE Internal Rate of Return (IRR) Manager’s Rate of Return (MRR)

© 2011 Cengage Learning Positive and Negative Leverage If ROE > ROR, there is positive leverage If ROR > ROE, there is negative leverage Also, If ROR > K, there is positive leverage If ROR < K, there is negative leverage Where K is the mortgage constant

© 2011 Cengage Learning Participation by Mortgage Lenders A way to seek some risk protection is for the lender to participate in the mortgaged project Income participation Equity participation

© 2011 Cengage Learning Financing Costs Simple Interest Compound Interest Add-On Interest Application of an Interest Rate Loan Discount

© 2011 Cengage Learning Other Loan Fees Application Fee Origination Fee Commitment Fee Stand-By Commitment Fee

© 2011 Cengage Learning Other Finance Charges Funding fee Renewal fee Assumption fee Warehouse fee

© 2011 Cengage Learning Mortgage Loan Amortization Straight mortgage loan Partially amortized loan Fully amortized loan Calculation of Amortized Payments Pmt = Loan Amount x K Where K is the loan constant

© 2011 Cengage Learning Mortgage Repayment Plans Fixed-Rate Mortgage Adjustable-Rate Mortgage Prime Rate Loan Construction Loans Mezzanine Loan

© 2011 Cengage Learning Mortgage Variations Shorter-Term Loans Biweekly Payment Plan A Negative View on Early Pay-off Shared-Equity Mortgage Junior Mortgage Wrap-Around Mortgage