Lecture slides from week 2 PDF

Preview

Summary

This file is the Lecture slides from week 2...

Description

Real Estate Finance Lecture 2

Associate Professor Kristle Romero Cortés

1

2

Three fundamental Risks in Real Estate: 1. Interest Rate Shock 2. Unemployment Increase 3. Vacancies Increase

Typical Mortgage Payment

Mortgage Payment Patterns • Interest paid in the first month – (.12/12) x $60,000 = $600 • Principal paid in the first month – $617.17 - $600 = $17.17 • Every month, interest portion decreases • Every month, principal portion increases • Interest paid in the last month – (.12/12) x $611.06 = $6.11 • Principal paid in the last month – $617.17 - $6.11 = $611.06

Monthly Payment, Principal, Interest, and Loan Balances for a Fully Amortizing, Constant Payment Mortgage

Monthly Payments for Shorter Maturities

• Typically loans run for 30 years • Other loan maturities could be 10, 15, 50 years for example

Monthly Payments for Shorter Maturities

• Typically loans run for 30 years • Other loan maturities could be 10, 15, 50 years for example • Question: do you pay the same amount with a shorter maturity?

Monthly Payments for Shorter Maturities

Monthly Payment, Principal, Interest, and Loan Balances for a Fully Amortizing, Constant Payment Mortgage

Computing a Loan Balance Essentially “removing” the interest that was built into the payment. • Compute the present value of the remaining payments.

Present Value of an annuity • Number of periods: the years remaining until maturity*period per year • PV=$617.17*PVIFA(12%/12, 15*12)=$51,424

Variable Payment Patterns Fixed Rate Mortgages vs Adjustable or Floating Rate Mortgages

Fixed Rate Mortgages • Rate stays the same over a period of time • Pros? • Cons? • Normal usage in Australia

Fixed Rate Mortgages A fully amortizing mortgage loan is made for $80,000 at 6% interest for 25 years. Payments are monthly. Calculate: • Monthly payments. • Interest and principal payments during month 1. • Total principal and total interest paid over 25 years • The outstanding loan balance if the loan is repaid at the end of year 10. • Total monthly interest and principal payments through year 10.

Loan Closing Costs Loan Closing Costs Additional Finance Charges • Loan Origination Fees – Cover origination expenses • Loan Discount Fees – “Points” – Used to raise the yield on the loan – Borrower trade-off: points vs. contract rate – 1 Point = 1% of the loan amount

Loan Closing Costs Why Points? • “Sticky” mortgage rates • It’s a way to price in the risk of a borrower. • Early repayment of a loan does not allow recovery of origination costs. It’s a way to cover the lender for the overhead of running its business. • Earn a profit on loans sold to investors at a yield equal to the loan interest rate.

Loan Fees and Borrowing Costs Calculating the effective interest cost Example: • $250,000 home • 80% LTV Loan • Mortgage =200,000 • 8% Interest • 4 Points (1 point = 1%) • 30 Years

Loan Fees and Borrowing Costs Step 1: Compute payment using the face value of the loan. PV = $200,000

n = 360 i

=8

PMT = $1,467.53 But, with points paid up front, the borrower actually receives less than the face value.

Loan Fees and Borrowing Costs Step 2: Loan Amount = $200,000 - Points Paid = (.04 x $200,000) Amount Received = $192,000

Compute effective interest cost, using the Amount Received from Step 2 & Payment from Step 1.

Loan Fees and Borrowing Costs Compute effective interest cost:

PV

= $192,000

PMT

= 360

n

= $1467.53

= 8.44%

CPT

i

Other FRM Loan Patterns Constant Amortization Mortgages • Monthly payments decrease over time since amortization amount remains constant

Basic Issues with Adjustable Rate Mortgages ARMs do not eliminate interest rate risk The longer the adjustment interval, the more interest rate risk the lender will take on As the lender assumes less interest rate risk by putting it onto the borrower, the lender should expect to receive a lower rate of interest than it would otherwise receive with a fixed rate mortgage.

Adjustable Rate Mortgages

A new loan payment is computed at each reset date •

Composite Rate = index + margin

•

Index – Interest rate that the lender does not control » Treasury securities » Cost Of Funds Index (COFI) » London Interbank Offered Rate (LIBOR)

•

Margin (or spread) – Premium added to the index

Adjustable Rate Mortgages Index Margin Composite Rate Reset Date • When mortgage payment is readjusted

Negative Amortization • Payment does not cover the interest due

Caps Floors Discount Points Prepayment Conversion Option

Adjustable Rate Mortgages Hybrid Loans • Longer initial reset period, 3/1, 5/1, and 7/1 Interest Only ARM and Floating Rate • Interest only (“i.o.”) for initial period • Then, depending on what has been negotiated – Pay interest only – Pay interest & some principal – Sometimes negative amortization – Fully amortizing payments required in future

Adjustable Rate Mortgages

For residential loans, the teaser rate is important • Initial rate below market composite rate • Market Competition • Accrual Rate • Negative Amortization • Payment Shock • It is not clear whether all residential borrowers comprehend or appropriately price the inherent risks in adjustable rate mortgages.

Adjustable Rate Mortgages • It is not clear whether all residential borrowers comprehend or appropriately price the inherent risks in adjustable rate mortgages.

Agenda Covered today:

Next Week

•

Amortization schedules

•

Adjustable rate loan calculations (chp 4)

•

Fixed rate loan calculations (chpt 3)

•

Reverse Mortgages

•

Adjustable rate considerations (chpt 4)

Recommended Questions Review 1-5 Name the three general methods of title assurance and briefly describe each. Which would you recommend to a friend purchasing a home? Why?

Recommended Questions Review 2-19 What are the risks to the lender if a borrower declares bankruptcy?

Recommended Questions Review Problem 3-6

Suppose you have the opportunity to make an investment in a real estate venture that expects to pay investors $750 at the end of each month for the next eight years. You believe that a reasonable return on your investment should be an annual rate of 15 percent compounded monthly

Recommended Questions Review Problem 3-6 a)

How much should you pay for the investment

b)

What will be the total sum of cash you will receive over the next eight years

c)

What do we call the difference between a) and b)?

Introduction of two topics •

Individual take-home residential real estate investment class project

•

In-class commercial real estate investment case...