1. An Introduction to Real Estate Finance Holger Sieg University of Pennsylvania

2. Housing Consumption In all of our models that we have considered thus far, we have treated as an ordinary consumption good that can be purchased (rented) in a competitive, frictionless market. If that were the case, the U.S. economy would be in much better shape right now! There a number of idiosyncratic aspects of housing consumption that arise from the fact that houses not only provide consumption flows, but are also durable assets. As a matter of fact, for the waste majority of American households, real estate investments are the only significant assets held in a portfolio once one controls for mandatory retirement savings. Recall that most Americans do not save enough for retirement.

3. The Moral Hazard of Renting Renting a house creates a serious moral hazard problem for the owner since the renter has little incentives to maintain the house. Renting also creates a monitoring and screening problem since it is difficult and costly to evict a renter that has defaulted on rental payments. Owner occupied housing solves both problems, but creates a financing problem. Most owners cannot afford to buy a house without receiving a loan or some sort of financing from a bank. Home financing creates additional complications.

4. Mortgages A mortgage is a secured, nonrecourse loan. A secured loan is a loan in which the borrower pledges some asset (the house) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan, i.e. the debt is secured against the collateral. In the event that the borrower defaults, the creditor takes possession of the house used as collateral. The creditor may sell it to regain some or all of the amount originally lent to the borrower (foreclosure of a home). A nonrecourse loan is a secured loan where the collateral is the only security or claim the creditor has against the borrower. The creditor has no further recourse against the borrower for any deficiency remaining after foreclosure against the property. If you default on a mortgage you do not have to declare personal bankruptcy!

5. Call Options The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The price of a call option is difficult to compute since it depends on the expectations about the future price of the asset. Even if the call is out of the money, i.e. if the current price of the asset is below the strike price, the call option still has a positive value, since it is possible that the price of the asset will rise over the strike price before the expiration date of the option. In a decent advanced finance course, you will learn how to use continuous time stochastic processes to model asset prices and then use stochastic calculus to price derivatives such as options.

7. Mortgage-financed Purchases of Houses and Call Options To understand a transaction in which an individual buys a home using a large mortgage, it is useful to think about it in terms of buying a call option. The bank owns the house and rents the house to the owner. The owner can buy the house back from the bank at any time by paying off the mortgage (purchase option). Effectively, the owner does not own the house until he has paid off the mortgage, but owns a call option. The initial down-payment is the price of the call option. The monthly interest payments are the rental payments. The strike price is the remaining principal. Each monthly payments reduces the strike price of the call.

8. An Example Suppose you want to buy a house that costs $500,000, putting 10 percent down. The bank provides a 30 year mortgage of $450,000 with a 5 percent interest rate. Your monthly payment is $2,415.70. Property taxes can add another $500-1,000 to your monthly payment. Home owners insurance will add another $100. The good news is that you can deduct local taxes and mortgage interest payment from your taxable income when you compute federal income tax payments as long as you do not have to pay AMT. Over the course of the 30 years, you will pay $419,651 in interest payments and $450,000 in principal payments. As a rule of thumb, the home-value-to-income ratio should be approximately 3 to 1. Hence, you need to make $167,000 in annual household income. Your after-tax monthly income is approximately $10,000. You monthly payments are $3,000 which means you spend 30 percent of your after-tax income on your home.

9. Primary Mortgage Market How do you get a loan to purchase a house? In a traditional loan, a (local) commercial bank lends money to an individual to buy a house using funds deposited with that bank. The credit or default risk is entirely born by the local bank. The main advantage of this arrangement is that there is little moral hazard since the local bank has strong incentives not to make bad loans. This arrangement has three disadvantages: (1) small or growing markets may not have enough liquidity; (2) borrowing may shut down if local banks are in trouble; (3) local banks hold an undiversified portfolio and are thus exposed to risk that could be diversified.

10. Secondary Market The secondary mortgage market is the market for the sale of securities or bonds collateralized by the value of mortgage loans. Intermediaries buy loans from local banks and repackage loans for resale via mortgage-backed securities (MBS). Investors can buy and hold a diversified portfolio of mortgage backed securities. The local banks can pass the mortgage or default risks to the investors in the secondary market. The main players in the secondary market are government sponsored enterprises.

12. Fannie Mae and Freddie Mac To create additional demand in the secondary market, the federal government created two agencies which were later converted into publically traded companies. These are also known as government-sponsored enterprises (GSEs). Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, was founded as a government agency in 1938 as part of Franklin Delano Roosevelt's New Deal to provide liquidity to the mortgage market. The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, was created in 1970 to expand the secondary market for mortgages and create competition to Fannie Mae. Fannie Mae and Freddie Mac are the leading buyer in the U.S. secondary mortgage market. Currently, Fannie and Freddie hold or guarantee about 50% of the nations outstanding home mortgages.

13. Private Mortgage Insurance If you cannot make a sufficient down payment, lenders need to insure themselves of the default risk and require borrowers to pay for this insurance. Private Mortgage Insurance is insurance payable to a lender for a security that may be required when taking out a mortgage loan. Historically all home purchasers that bought a house with a down- payment less than 20 percent were required to buy PMI. PMI is expensive: typical rates are $55/month per $100,000 financed. In our example, suppose you buy the $500,000 with no down- payment, you will have to pay an additional $275 to your monthly payment. Moreover, there is no guarantee that you will be approved by the insurance company to qualify for PMI. In that case, you will not obtain the mortgage and you will not be able to buy the house.

14. Public Mortgage Insurance Since Private Mortgage Insurance is expensive and hard to get for low income households, the federal, the federal government also offers public mortgage insurance. To obtain public mortgage insurance from the Federal Housing Administration of the United States, you must pay a mortgage insurance premium (MIP) equal to 1 percent of the loan amount at closing. Fannie Mae then essentially makes up any missed payments to the bondholder that the borrower misses. It also makes up for any loss for the loan not being fully repaid either by the borrower or from the sale of the house. The risk of a downturn in housing markets is shifted to the taxpayers that guarantee the GSEs. If the federal government guarantees the loans of the GSEs then it is shifted to the tax payers.

15. Potential Problems GSEs hold a large fraction of the undiversified risk in the housing market. The other fraction is held by international investors. Local banks have few incentives to screen mortgage applicants since they no longer bear the risk, they just make commissions from selling mortgages. Investors of MBS have often little knowledge about the exact type of mortgages that they are holding. As a consequence they have a hard time evaluating the risk associated with the investments, Credit Rating Agencies may not be of much help and may provide bad incentives if they misclassify investments. As long as housing prices keep on rising, none of this matters!

16. Measuring Housing Prices It is difficult to compute housing price indexes since only a small fraction of all houses is sold each period. We thus do not have transaction prices for the vast majority of houses at each point of time. The indices are calculated from data on repeat sales of single-family homes, an approach developed by economists Karl Case, Robert Shiller and Allan Weiss. To construct a repeat sales index you need to observe housing two transaction. Of course, housing transactions are not random events and this methodology is especially problematic during a housing market crisis in which the sample of houses that are transacted are clearly not a random sample of the underlying housing stock. Of course, the main competitor of the repeat sales index is one that is based on median housing prices. That is even worse!

18. Some Advice Follow the 3 to 1 rule to determine whether you can afford to buy a house or a condo. If you buy a house, remember that there will come a day when you will have to sell again. (You buy to sell!) If you want to speculate in real estate, dont do it with your own house. Instead you should invest into real estate investment trusts (REIT). These are mutual funds that focus on real estate investments and are offered by many different companies. Leave the investment decisions to professional real estate managers! If you still want to gamble in real estate, get an MBA in Real Estate Finance from Wharton or any other decent Business School. Then try to make a career out of it.