The Market for Real
Estate Knowledge
Chapter 1
1
Real Estate - land and things
attached to it

The real estate body of
knowledge consists of four
broad collections of concepts:
 legal analysis concepts
 market analysis concepts
 real estate service industry
concepts
 financial and investment
analysis concepts.
2
Legal analysis concepts
include:






property rights
restrictions on property
rights (public and private)
deeds
leases
contracts
title transfer issues
3
Market analysis concepts
include:

real estate market
dynamics




real estate space market
real estate asset market
real estate development
industry
urban growth models
4
Real estate service industry
concepts include:



real estate brokerage
real estate appraisal
property management
5
Financial and investment
analysis concepts include:





financing methods
time value of money
concepts
mortgage mechanics
investment property
analysis
development project
analysis
6
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
7
Industry Trends and
Statistics


Figure 1.2 on page 7
shows number of
individuals employed in
the real estate industry
from 1972 though 2001
Table 1.1 on page 8 shows
typical earnings for
brokers, salespersons,
appraisers, title
examiners, and property
managers in 1998 and
1999.
8
Property Rights and
Legal Descriptions
Chapter 2
9
Real vs. Personal Property






Real estate
Property
Real property
Personal property
Deeds
Leases
10
Fixture


A personal property item
that has become a part of
the real property is called
a fixture.
Tests for fixture status
include:



Intent of parties
Test of attachment
Test of adaptability
11
Mineral and Air Rights


Mineral 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.
12
Water Rights

Water 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
water
riparian rights doctrine
 prior appropriation doctrine

13
Estates in Land

Freehold estates



Present interests
 Fee simple absolute estate
 Qualified fee estate
 Life estate
Future interests include:
 Reversion interest
 Remainder interest
Leasehold estates




Tenancy
Tenancy
Tenancy
Tenancy
for a stated period
from period to period
at will
at sufferance
14
Concurrent Estates




Tenancy in common
Joint tenancy
Tenancy by the entirety
Community property
15
Other forms of joint
ownership



Condominium
Cooperative
Timeshare


Fee interests
Right to use
16
Legal Description
Methods



Metes and Bounds
Rectangular Survey
Recorded Plats
17
Metes and Bounds

start 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.
18
Rectangular Survey







Principal meridians are
north-south lines
Base lines are east-west
lines
Range lines
Township lines
Townships
Sections
Divisions of section
19
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.”
20
Private Restrictions on
Ownership
Chapter 3
21
Encumbrances

Restrictions or limitations
on the owner’s ability to
use a property.
22
Liens

Lien – a financial security
interest in a property.

Mortgage – a pledge of real
property as collateral for a
debt or other obligation
Mortgagor-borrower
 Mortgagee-lender
 Foreclosure


Mechanic’s lien
23
Easement


right to use a property in a
specified manner.
Types of Easements



Creation of Easements by:




Easement Appurtenant
Easement in gross
Express grant or reservation
Implication
Prescription
Termination of Easements by:



Agreement
Merger
Abandonment
24
Licenses and Profits


License – a revocable
personal privilege to use
land for a particular
purpose
Profit - profit a prende – a
non-possessory interest
that permits the holder to
remove specified
resources from the land
25
Adverse Possession


Process 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 possession






Actual and exclusive
Open and notorious
Hostile
Continuous
Under a claim of right
Statutory period
26
Other issues




Encroachment – 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.
27
Public Restrictions on
Ownership Rights
Chapter 4
28
Four Basic Powers of
Government Over Real
Estate




Taxation
Escheat
Eminent domain
Police power
29
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
multiplied by Assessment Ratio
equals Assessed Value
minus Exemptions (if any)
equals Taxable Value
divided by 1000
times Millage Rate
equals Property Tax
$120,000
x .40
$48,000
-$2,500
$45,500
1000
x 25
$1,137.50
30
Administering the
Property Tax


First step, identify all properties and
estimate their values
Second 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.
31
Power of Escheat

Government’s right to
acquire ownership of land
when the landowner dies
without an heir or a valid
will
32
Power of Eminent
Domain




right of the government to
take private property for
public use upon the
payment of just
compensation
Use must be a valid public
use.
Property owner must be
compensated fairly.
Inverse condemnation
33
Police Power



Power to regulate use of private
property to protect public health,
safety, morals and general welfare
Land uses are interdependent,
meaning that the way one property
is used affects other nearby
properties.
Comprehensive general plan





projected economic development
transportation plan to provide for
necessary circulation
public-facilities plan that identifies
such needed facilities as schools,
parks, civic centers, water and
sewage disposal plants
land-use plan
official map
34
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 uses


Type of use – residential,
commercial, industrial categories
Intensity of use - developmental
density
 Height and bulk limitations
 Bulk regulations
 Floor-area ratio
 Minimum lot size and setback
regulations
35
Zoning Changes





Legislative relief
Administrative relief
Variances
Special use permits
Judicial relief
36
Other Issues:



Nonconforming Uses
Building Codes
Subdivision Regulations




Subdivision Approval Process
Mandatory Dedication
Impact Fees
Innovative Land-use Control
Methods




Planned unit development
Performance zoning
Incentive zoning
Transfer of development rights
37
Deeds and Leases
Chapter 5
38
Deeds


Written document that
transfers title (ownership)
to real estate from the
grantor to the grantee
Necessary Elements of a
Deed





Designation of the parties
Consideration given by
grantee
Legal description
Specific interest conveyed
Signature of the grantor
and witnesses
39
Additional Deed Elements





Covenant against
encumbrances
Covenant of seisin
Covenant of quiet
enjoyment
Covenant of further
assurances
Warranty forever
40
Types of Deeds





General warranty deed
Special warranty deed
Bargain and sale deed
Quitclaim deed
Deeds for special uses
41
Leases


Agreement between a
property owner and tenant
that transfers the rights of use
and possession
Requirements of a Properly
Prepared Lease







Names of the lessor and lessee
Conveyance of the premises
Description of the premises
Term or duration of the lease
Amount of rent and manner of
payment
Duties and obligations of parties
Signatures of the parties
42
Classification of Leases
Duration of term





for stated period
from period to period
at will
at sufferance
Type of Use




Tenancy
Tenancy
Tenancy
Tenancy
Ground Lease
Residential lease
Commercial lease
Methods of Payment









Gross lease
Net lease
Net net lease
Net net net lease
Fixed-rent lease
Graduated-rent lease
Reappraisal lease
Percentage lease
Index lease
43
Issues in the LandlordTenant Relationship


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




Renewal option
Expense stops
Assignment and subleasing
Security deposits
Improvements
Covenant of quiet enjoyment
Implied warranty of
habitability
Maintenance of common areas
Protection against criminal
acts
44
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 www.nolo.com on the
World Wide Web.
45
Contracts in Real
Estate Transactions
Chapter 6
46
Contracts


An exchange of promises
between parties,
conditioned on certain
events and enforceable by
law.
Necessary Elements of a
Contract





Offer and acceptance
Consideration
Capacity of parties
Lawful purpose
Writing requirement
(Statute of Frauds)
47
Contract Issues




Oral Contracts
Specific Performance
Partial Performance
Breach of Contract
48
Contract Contingencies




Specified conditions in a
contract that relieve the
parties of their promises
to perform
financing contingency
title contingency
inspection and repair
contingency
49
Common Real Estate
Contracts



Real Estate Sales Contract
Option-to-Buy Contract
Contract for Deed
50
Title Examination and
the Closing Process
Chapter 7
51
Title Examination

the process of verifying
the ownership rights being
offered by the seller of a
property



marketable title
insurable title
title perfect of record
52
Title Search





Detailed examination of
all public records that
reveals the ownership
history of a property
recording requirement
grantor and grantee
indexes
tax records search
lien search
53
Other Title Issues



Title abstract
Title Opinion
Title insurance




paid for in full at the time
the policy is issued
not transferable
protects only against past
events that were in
existence, but undiscovered
at the time the policy was
issued
Torrens system
54
Title Closing


the final step in the process of
transferring title from grantor
to grantee
Buyer’s responsibilities before
closing






obtaining financing
examining the title evidence
having the property surveyed
obtaining property insurance
having the property inspected
Seller’s responsibilities before
closing



prepare the deed
remove encumbrances
cooperate with inspectors
55
Closing Costs

Costs generally paid by the buyer at
the closing










loan origination fee
loan discount points
appraisal fee
credit report fee
lender’s inspection fee
mortgage insurance premium
attorney fees
hazard insurance premium
recording fees for the mortgage
Costs generally paid by the seller at
the closing




real estate brokerage commission
attorney fees
documentary stamp taxes, where
required
recording fees for the satisfaction of
the seller’s mortgage
56
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 $37,243.28 to the
closing and the seller will leave the
closing with $58,548.96.
57
Understanding Real
Estate Markets
Chapter 8
58
Market

the mechanism or
arrangements through
which goods and services
are traded between
market participants
59
Real Estate Space
Markets




Mechanism or arrangements for
trading the rights to use land and
buildings
people, 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 use






Office space markets
Retail space markets
Industrial space markets
Agricultural space markets
Lodging space market
Residential space market
60
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.
61
Real Estate Asset Market


mechanism or arrangements for trading
the rights to cash flows generated by
land and buildings
the real estate asset market is part of
the larger capital market, which includes





publicly 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 capital
growth expectations
risk
62
The Real Estate System





consists of real estate space markets,
the real estate asset market, and the
development industry
See 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.
63
Market Analysis







examination of the supply and demand
sides of a real estate space market and
the balance (equilibrium) between them
Inputs to market analysis
Vacancy rate – higher vacancy rate
indicates less demand relative to supply
and vice versa
Rent or price level – trends in rents and
prices indicate changes in the balance
between supply and demand
Quantity of new construction started –
indicates new supply that will be coming
into the market
Quantity of new construction completed
– indicates new supply that is just
arriving into the market
Absorption of new space – indicates the
rate at which new supply is becoming
occupied in the market
64
“Months Supply”




Using “Months Supply” to look
forward in a real estate market
analysis
Months supply = (vacant space +
space in construction)/net
absorption per month
If 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 demand
If 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.
65
Key Drivers for Real
Estate Space Markets






Office: employment in office
occupations
Lodging: air passenger volume,
highway traffic counts, tourism
receipts, number of visitors
Retail: per capital income,
aggregate income, wealth measures
Industrial: manufacturing
employment, transportation
employment, shipping volume
Apartments: population, household
formation, local housing
affordability, employment growth
(blue and white collar)
Owner-occupied residential:
population, household formation,
interest rates, employment growth,
income growth
66
Urban and Regional
Economics
Chapter 9
67
Determinants of a City’s
Comparative Advantage







Transportation facilities
Educational facilities
Created environment
Natural resources
Climate
Labor force
Leadership
68
Economic Base

Export activities


Agriculture, manufacturing,
mining, and wholesale trade
Population serving
activities

Construction, public
utilities, retail trade
69
Analyzing Local Demand

Short-run demand issues





Current supply of real estate
improvements
Current industrial structure
Recent changes in the local
economy
Likely economic changes in the
near future
Long-run demand issues



Long-run economic prospects for
the local economy
National & regional trends likely
to affect the local economy
Likelihood of new firms coming
into the area
70
Bid Rent Curves and
Highest and Best Use





land rent – the return that a
particular parcel of land will bring in
the open market
highest and best use – the use of
land that results in the highest land
rent
each parcel of land has a highest
and best use
Bid-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
71
Urban Growth Models

Concentric Circle growth (Figure 9.2)



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)


Land use patterns are defined as concentric
circles around a Central Business District
As 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.
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
72
Dynamics of
Neighborhood Change


What is a neighborhood?
Neighborhood Life Cycle
Stages





Gestation, Youth, and
Maturity
Incipient Decline
Clear Decline
Accelerating Decline and
Abandonment
Neighborhood stabilization
and rehabilitation
73
Real Estate Brokerage
Chapter 10
74
The Real Estate Sales
Process





listing agreement
marketing the property
and qualifying buyers
presentation and
negotiations
contracts
settlement or closing
75
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 commission
Real estate salesperson are
individuals licensed by state
governments to arrange real estate
sale or lease transactions under the
supervision of a real estate broker
76
Legal Aspects of BrokerClient 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
77
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 buyer
Exclusive 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 commission
Exclusive 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
broker
Buyer representation agreements
establish the agency relationship
between buyers and brokers. (Figure
10.5, page 210)
78
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.
79
Termination of Agency
Relationships







when a transaction occurs
when the agreement expires
when the parties agree to
terminate
when one party breaches the
agreement
when one party becomes
contractually incapacitated
the listing property is
destroyed
the listing property is
condemned
80
Other Brokerage Issues




Franchises
Desk Fee Arrangements
Multiple-Listing Services
Broker and Salesperson
Compensation



usually calculated as a
percentage of the transaction
amount
broker and salesperson often
have an agreed upon “split”
between themselves
cooperating brokers (through the
MLS) often split any commissions
paid by agreement
81
Real Estate Appraisal
Chapter 11
82
Appraisal Regulation





FIRREA of 1989
State requirements
Licensed appraisers
Certified residential
appraisers
Certified general
appraisers
83
What is Value?

Market value (page 225)









Typically motivated parties
Well informed parties
Market exposure
Payment in cash
No special circumstances
Investment value – worth to a
particular investor based on that
investor’s personal standards of
investment acceptability
Price versus market value
Market value versus cost of
production
Other types of value


Assessed value
Insurable value
84
Key Appraisal Principles




Anticipation
Change
Substitution
Contribution
85
The Appraisal Process

Definition of the problem





Data selection and collection







As though vacant
As improved
Application of the three approaches
to valuation


General market analysis
Specific property analysis
Highest and best use analysis


Type of value-purpose
Description of property
Specific property rights
Effective date
Sales comparison approach
Cost approach
Income approach
Reconciliation of value indications
Report of defined value
86
Sales Comparison
Approach



Comparable sales data
selection
Adjustment of sales data
Elements of comparison







Property rights conveyed
Conditions of sale
Financing terms
Market conditions
Locational characteristics
Physical characteristics
Applying the sales comparison
approach – See Table 11.1,
page 237.
87
Cost Approach


Estimating site value
Estimating production cost



Estimating accrued
depreciation




Reproduction cost
Replacement cost
Physical deterioration
Functional obsolescence
Economic obsolescence
Applying the cost
approach – See Table
11.2, page 241.
88
Income Approach

Gross income multiplier


Net income capitalization


GIM = Value/Gross Income
Capitalization Rate = Net
Income/Value
Discounted cash flow –
see Table 11.3, page 244
89
Applying the Appraisal
Process: Single-Family
Home Case Study

pages 245-249.
90
Property Management
Chapter 12
91
Property Management

The 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
92
Management Agreement


establishes the relationship between
the owner and the manager. (Figure
12.1, pages 258-260)
The agreement should address the
powers of the manager relating to






Rent setting
Lease signings
Rent collections
Power to spend money on behalf of
the property
Authority to hire, fire, and supervise
personnel
The agree should specify the
compensation to the manager




Percentage of gross income
Fixed amount
Fee schedule for certain tasks
Hourly rate
93
Functions of a Property
Manager









administration
marketing and advertising
tenant selection
lease negotiation
move-in inspections
property maintenance
rent collection
move-out inspections
security deposit
management.
94
Real Estate Today
Feature


“Green Acres Shopping
Center – A Property
Management Success
Story”
page 265.
95
Corporate Real Estate
Asset Managers

The functions of an asset
manager include:




facilities management
acquisition of additional
space for the firm’s
operations
financing decisions relating
to needed space
disposition of corporate real
estate assets.
96
Residential and
Commercial Property
Financing
Chapter 13
97
Understanding the
Mortgage Concept





secured vs. unsecured
debt
mortgage
hypothecation
title theory
lien theory
98
Promissory Note




a written promise to repay
a debt that usually
accompanies a mortgage
document
prepayment clause
acceleration clause
due-on-sale clause
99
Foreclosure




the process of seizing
control of the collateral for
a loan and using the
proceeds from its sale to
satisfy a defaulted debt
judicial foreclosure
Nonjudicial foreclosure
Strict foreclosure
100
Alternative Security
Instruments


Trust Deeds
Land Contracts
101
Other Issues:



“Subject to”
Assumption
Deed in lieu of foreclosure
102
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.
103
Federal Housing
Administration (FHA)




Created in 1934 to help restore
confidence to the nation’s housing
finance system
Helped developed lending standards
that reduced lenders’ risk exposure
Promoted the use of long-term, fully
amortizing loans
Established a mortgage insurance
program to cover losses to lenders


Borrowers pay a fee to purchase an
insurance policy that protects the
lender from the risk of loss due to
default by the borrower
In return, lenders are more willing to
lend money at favorable rates with
relatively small down payment
requirements.
104
Private Mortgage
Insurance




Competes with government
loan insurance and guarantee
programs
Borrowers pay a fee to
purchase an insurance policy
that limits the risk of loss
faced by lenders in the event
of default by the borrower
In return, lenders are willing
to lend money at favorable
rates with relatively small
down payment requirements
Usually less expensive than
FHA insurance, but requires a
larger down payment amount
than FHA insured loans
105
Federal National Mortgage
Association (Fannie Mae)



Created as a government
agency in 1938 to buy FHAinsured 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.
106
VA-guaranteed Loans



As 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.
107
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.
108
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.
109
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 by






Commercial banks
Savings institutions
Life insurance companies
Federal agencies
Mortgage pools and trusts
Individuals and others
110
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 pages 290292.
The 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
111
Federal Legislation Related
to Loan Applications





Equal Credit Opportunity
Act
Consumer Credit
Protection Act
Real Estate Settlement
Procedures Act
Flood Disaster Protection
Act
Fair Credit Report Act
112
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.
113
Sources of Commercial
Mortgage Market Capital






Individual Investors
Life Insurance Companies
Pension Funds
Real Estate Investment
Trusts
Commercial Banks
Commercial mortgage
backed securities (CMBS)
114
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-tovalue ratios for commercial loans. 70%
LTV is common as a maximum LTV.
115
Risk, Return, and the
Time Value of Money
Chapter 14
116
Relationship Between
Risk and Return



return – profit as a
percentage of total
investment
risk – uncertainty about
the actual rate of return
over an investment period
risk and return are
directly related (investors
require greater returns for
greater risk)
117
Types of Risk




Business risk – uncertainty arising
from changing economic conditions
that affect an investment’s ability to
generate returns
Financial risk – uncertainty
associated with the possibility of
defaulting on borrowed funds used
to finance an investment
Purchasing 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
118
Time Value of Money
Principle

Money in hand today is
worth more than money
to be received in the
future
119
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 amount
Compounding – the process of
determining future value
Example: What is the future
value of $70,000 compounded
at 10% annual interest over 3
years?
Calculator keystrokes shown
on page 315.
120
Present Value of a Lump
Sum



Discounting – the process
of determining present
value
Example: What is the
present value of $93,170
discounted at 10% annual
interest for 3 years?
Calculator keystrokes
shown on page 316.
121
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.
122
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%?
123
Sinking Fund Payments

Example: 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?
124
Mortgage Payments

Example: What annual
payment would be
necessary to amortize a
loan for $100,000 over
ten years at 10%
interest?
125
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 dollars




NPV = present value of cash inflows
minus present value of cash outflows
NPV Decision Rule: If the NPV is equal to
or greater than zero, we choose to invest
Calculator keystrokes shown on page
325.
Internal Rate of Return (IRR) - the
discount rate that makes the NPV equal
to zero




IRR = the rate of return on the
investment
IRR Decision Rule: If the IRR is greater
than or equal to our required rate of
return, we choose to invest
IRR for above example = 12.06%
Calculator keystrokes shown on page
325.
126
Mortgage Mechanics
Chapter 15
127
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
128
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.
129
Amortization Schedule
Total
Year
Payment
PMT
Interest
It
Principal
Pt
Amount
Outstanding
AOt
0
-
-
-
100,000.00
1
$16,274.54
10,000.00
6,274.54
93,725.46
2
$16,274.54
9,372.55
6,901.99
86,823.47
3
$16,274.54
8,682.35
7,592.19
79,231.28
4
$16,274.54
7,923.13
8,351.41
70,879.87
5
$16,274.54
7,087.99
9,186.55
61,693.32
6
$16,274.54
6,169.33
10,105.21
51,588.11
7
$16,274.54
5,158.81
11,115.73
40,472.38
8
$16,274.54
4,047.24
12,227.30
28,245.08
9
$16,274.54
2,824.51
13,450.03
14,795.05
10
$16,274.54
1,479.51
14,795.05
0.00
$162,745.40
$62,745.40
$100,000.00
130
To Construct an
Amortization Schedule











Begin by calculating the periodic payment required
to amortize the loan using the mortgage payment
formula
Proceed 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 balance
The 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 One
It = AOt-1 x i = 10,000 = 100,000 x .10
Pt = PMT – It= 6,274.54 = 16,274.54 - 10,000
AOt = AOt-1 – Pt = 93,725.46 = 100,000 6,274.54
Amortization: Period Two
It = AOt-1 x i = 9,372.55 = 93,725.46 x .10
Pt = PMT – It = 6,901.99 = 16,274.54 - 9,372.55
AOt = AOt-1 – Pt = 86,823.47 = 93,725.46 6,901.99
131
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 payments
Example: a loan with an original
loan amount of $133,000 for 30
years at 7.5% annual interest would
require monthly payments of
$929.96. At the end of the fifth
year of this loan (60 months), the
amount outstanding of the original
principal amount is $125,841.19.
Calculator keystrokes shown on
page 336.
132
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
$125,841.19 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 $810.80
Or, the borrower could refinance the loan at
6% interest but keep the monthly payments at
$929.96 and reduce the number of months
needed to amortize the debt from 300 to 227.
Calculator keystrokes shown on page 338.
133
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 $725.07. 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 7.9275%
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.
134
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 $682.18 and the effective
interest rate if the loan is held to
maturity is 7.6123%. If the loan is
prepaid at the end of the 60th month,
however, the effective interest rate
increase to 8.1252%
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.
135
Alternatives to the Fixedrate 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 year
Adjustable rate mortgages
– loans in which the
interest rate is adjusted at
the end of each year to
match current market
rates
136
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?
$659.51
What is the monthly payment during
the last 23 years of this loan?
$840.68
Calculator keystrokes given on page
343 & 344.
137
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.
138
Analyzing IncomeProducing Properties
Chapter 17
139
Advantages of Real
Estate Investment




Cash Flow from
Operations (After Tax
Cash Flow – ATCF)
Appreciation (After Tax
Equity Reversion – ATER)
Portfolio Diversification
Financial Leverage
140
Disadvantages of Real
Estate Investment


large capital requirements
risk




business risk
financial risk
purchasing power risk
liquidity risk
141
The Wealth Maximization
Objective




investment can be defined as
present sacrifice in anticipation of
future benefit
investment decision making involves
comparison of the expected future
benefits with the costs of the
investment
investors’ ultimate goal is to
maximize their wealth by choosing
investments that are worth more
than they cost
the NPV decision rule employs the
wealth maximization concept

If 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.
142
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 taxes
ATER = gross sale price minus
selling expenses minus loan
payoff minus taxes
Initial equity = purchase price
minus loan amount
i = the investor’s required rate
of return
143
Example of the DCF
Model
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




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
144
Residential Land Uses
Chapter 17
145
Types of Residential
Development


single-family detached houses
single-family attached houses





multifamily residences





row houses
townhouses
plexes
patio or zero-lot-line houses
garden apartments
mid-rise apartments
high-rise apartments
manufactured homes
second homes
146
Market and Feasibility
Analysis



delineation of the market area
analysis of recent economic
trends in the local market area
analysis of demand factors






employment
disposable income
population
household characteristics
absorption rate
analysis of supply, including
other possible competing
projects
147
Millford Hills Subdivision
Case Study





Summary in Real Estate
Today feature beginning
on page 381
Location Map in Figure
17.1
Competing project sales
figures in Table 17.1
Projected cash flow
statement in Table 17.2
Pro Forma Profit and Loss
Statement, Table 17.3
148
Commercial and
Industrial Development
Chapter 18
149
Shopping Center Types
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
neighborhood shopping
center
community shopping
center
regional shopping center
superregional shopping
center
other shopping centers
150
Shopping Center
Development

Market and Feasibility
Analysis





Primary and secondary
trade areas
Market size
Competitive survey
Site Location
Tenant Selection
151
Willow Springs Center
Case Study
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



Summary in Real Estate
Today feature beginning
on page 399
Expense forecast, Table
18.2
Income statement, Table
18.3
Trade area map, Figure
18.3
Site map, Figure 18.4
152
Office Buildings

Location


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
Central business districts
Secondary office nodes
Office parks
Single vs. multi-tenant
buildings
153
Industrial and Distribution
Facilities




manufacturing
warehousing
distribution
analysis technique




determine existing and
potential supply
forecast demand
estimate absorption rate
compare competitiveness
with other projects
154
Lodging Facilities



commercial hotels
highway or airport hotels
and motels
resort hotels
155
Principles of Real
Property Insurance
Chapter 19
156
Risks of Property
Ownership




Loss of property due to fire,
wind, water, vandalism or
other hazards
Loss of use
Liability loss resulting from
negligence in the use of the
property
Financial loss, particularly the
inability to make mortgage
payments, as a result of
disability or death of a wage
earner
157
Homeowners Policy



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
Items covered
Replacement cost
coverage
Personal articles floater
policies
Credit card forgery and
counterfeit money losses
Factors influencing rates
Coinsurance
158
Renter and Condo Owner
Policies

Cover only personal
property and personal
liability
159
Protection from Specific
Risks






Earthquake insurance
Making an inventory and a
photographic record
Liability insurance
The personal excess
liability policy
Flood insurance
Mortgage life insurance
160
Home Purchase
Decisions
Chapter 20
161
Rent or Buy Decisions





Tax consequences of rent
versus mortgage
payments
Alternative investments
Inflation and home prices
Impact of mortgage
interest rates
Period of ownership
162
How Much House Can
You Afford?




Income
Expenses
Qualifying ratios
Down payment
163
Choosing a Property

Choosing an area






Property taxes and quality of public
services
Recreational facilities
Quality of school system
Crime statistics
Overall quality of the community
Evaluating the individual home






Attic
Walls, ceilings and floors
Roof
Basement or crawl space
Electrical system
Mechanical systems


Heating and cooling systems
Water supply and waste disposal
164
Making and Closing the
Deal




Real estate agents
Negotiating the price
Dealing with the lender
Closing attorneys and
escrow agents
165