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GEK2013 – REAL ESTATE FINANCE
Chapter 1: Overview of Real Estate Finance
Definitions:
Real Estate
Land and all natural part of the land and attachments to the land e.g. buildings, etc
Real Property
All rights, interests and benefits related to ownership of real estate
Real Estate
Finance
The study of the institutions, markets and instruments used to transfer money and credit for
purpose of developing or acquiring real property
Contract results in mutual benefits
Inherent risks to one/both parties
Air Rights
Surface Rights
Land
Characteristics (Read notes):
Physical
Institutional
Economic
Real Estate
(physical)
Mineral
Rights
Fixtures
To-the-land
Improvements
Right to Use
Real Property
Ownership
rights (legal)
On-the-land
Right to
Possess
Right to
exclude ppl
Right to
dispose
See Notes for Overview of Capital
Market
Real Estate Market
Space Market (Tangible)
Asset Market (Intangible)
Supply: Property Owners
Demand: Property Users
Supply: Investors willing to sell
Demand: Investors willing to buy
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GEK2013 – REAL ESTATE FINANCE
Chapter 2: Institutions & Instruments of Financial Markets
Financial Assets
Legal claim to future cash flow
Financial Market
Forum for trading funds where suppliers and demanders of funds interact to transact business
Money Market
Arena for trading short-term funds e.g. marketable securities
Capital Market
Forum for trading in equity and long term debts e.g. long-term securities
Real Estate
Financial Market
Financial Assets
Forum for trading legal claims to future cash from real estate assets
Properties of Financial Assets: See Notes for full explanation
-
Moneyness
Convertibility
-
Divisibility
Currency
-
Reversibility
Cash flow & Return
Predictability
-
Term to maturity
Complexity
-
Liquidity
Tax Status
Role of Financial Assets
-
Transfer funds from those with surplus to invest on those who needs funds.
Redistribute risk generated by tangible assets among seekers and providers of funds
Financial Markets
Major Institutions in financial markets
-
Households
Depository institutions (banks)
Investment banks
-
Governments
Insurance companies
Non-profit organizations
-
Nonfinancial Corporations
Asset management firms
Foreign investors
Service Provided by Financial Institutions
-
Transform financial assets into a different, and more widely preferable type of asset
Exchange financial assets both for customers and own account
Assist in creation of financial assets for customers and selling these assets
Provide investment advice and manage portfolio of other market participants
Instruments of Financial Markets (Asset Class)
-
Common Stock
-
Bonds
o
o
o
Residential MBS
Commercial MBS
CDOs
Derivatives (Value depends on
assets)
Financial Intermediaries
Role of Financial Intermediaries
-
Flow of funds for Financial Institutions & Markets
Transform less desirable financial assets into other financial assets preferred by public by: (See Notes)
o Maturity Intermediation
o Risk reduction via diversification (doesn’t work, only redistribute but not reduce risk)
o Reducing costs of contracting the information processing
o Providing payment mechanism
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GEK2013 – REAL ESTATE FINANCE
Chapter 5: Mortgage Markets I
Mortgage
Special form of debt that uses real estate as a security for the loan
Gives lender a lien on the property
If property is sold, owner not entitled to cash proceeds until loan amount and interest
accrued have been paid off
Owner’s interest subordinate to lender’s interest
Mortgage
document
Pledges the property as collateral for the loan
Promissory Note
Written document of agreement detailing financial and legal details of transaction
See Notes for its contents
Mortgage Loan
A contractual document that protects mortgagee’s interest w.r.t. 3rd party claims on collateral
Clarify purposes and proof of borrower’s and lender’s intent
Mortgagor – Borrower
Mortgagee – Lender
Default and Foreclosure
Lien
A charge upon the property for the discharge of a debt
Lien status – Indicates loan’s seniority in the event of a foreclosure
Delinquency
Non-payment of a mortgage payment due
Default
-
Acceleration
Clause
Provision that enables lender to demand payment of entire outstanding when first monthly
payment is missed
Due-on-sale Clause
Provision allowing lender to demand full repayment if borrower sells property
Foreclosure
-
Occurs when borrower fails to perform one or more duties under terms of note
Occurs when borrower missed 90 days’ installment
Judicial foreclosure: Obtain court order to sell
Non-judicial foreclosure: trustee sale without court order
Notice of foreclosure
Public auction followed by private sale if property wasn’t sold
Loan Terminology
Loan-to-value ratio
𝐿𝑇𝑉 =
𝐿𝑜𝑎𝑛
min⁡(𝑀𝑎𝑟𝑘𝑒𝑡⁡𝑉𝑎𝑙𝑢𝑒⁡𝑜𝑓⁡𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦, 𝑆𝑒𝑙𝑙𝑖𝑛𝑔⁡𝑃𝑟𝑖𝑐𝑒⁡𝑜𝑓⁡𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦)
Loan Principal
-
Amount actually borrowed
Remaining Balance of loan
Debt Service
Periodic payments for interest and principal
Interest Rate
Rate charged for use of money
Market i/r
Rate that clears the market for loanable funds
Contracted i/r
Rate specified in contract for purpose of calculating interest charges
Nominal i/r
Rate stated in a particular currency
Real i/r
Rate in purchasing power
Loan Duration
Time given to borrower to repay loan
Loan Amortization
Regular, periodic repayment of principal
Mortgage Interest Rate (See Notes for Demand VS Supply)
𝑖𝑡 = 𝑟1 + 𝑝1 + 𝑓1
𝑟1 , Real rate of Interest
𝑓1 , Inflation Expectation
𝑝1 , Risk Premiums
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Amortization Scheme
Constant Payment Mortgage: Loan is fully amortized with level payments
Graduated Payment Mortgage: Loan is fully amortized with rising payments
Constant Amortization Mortgage: Loan balance reduced by a constant amount each period
Borrower took on a $500,000 loan at 5% interest for 30years
Constant Payment Mortgage
Constant Amortization Mortgage
1) Compute Monthly Debt Service
2)
3)
4)
5)
1) Compute constant amortization amount
500,000
5%
𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 =
𝑃𝑉 = 500,000⁡; 𝑛 = 360; 𝑖 =
; 𝐹𝑉 = 0
360
12
𝑃𝑀𝑇 = $2,684.11
= $1,388.89
Compute Loan Outstanding End of Month1
2) Compute monthly interest on loan balance
5%
5%
𝑃𝑀𝑇 = 2,684.11; 𝑛 = 359; 𝑖 =
; 𝐹𝑉 = 0
𝑖𝑚𝑜𝑛𝑡ℎ1 = 500,000 ×
12
12
𝑃𝑉 = 499,399.23
= $2,083.33
5%
Difference between PV is the Principal Paid
𝑖𝑚𝑜𝑛𝑡ℎ2 = 498,611.11 ×
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙⁡𝑃𝑎𝑖𝑑 = $600.77
12
= $2,077.55
Difference between principal payment and PMT
3) Compute Total Month’s Payment
is Interest Payment
𝑀1 = 1388.89 + 2083.33
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡⁡𝑃𝑎𝑖𝑑 = $2,083.33
= $3,472.22
Repeat for all 360 months
4) Repeat for all 360 months
$60,000 loan for 30years at 12% interest. 3% origination fee and 3% prepayment penalty on outstanding
balance.
Loan Fees and Borrowing Costs
1) Compute monthly loan payments
12%
; 𝐹𝑉 = 0
12
𝑃𝑀𝑇 = $617.17
2) Calculate net cash disbursed (Loan amount – Origination fee / Discount points = Net disbursed)
𝑁𝑒𝑡⁡𝑐𝑎𝑠ℎ⁡𝑑𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑑 = 60,000 × (1 − 3%)
= 58,200
3) Compute effective i/r
𝑃𝑉 = −58,200; 𝑛 = 360; 𝑃𝑀𝑇 = 617.17
Monthly
𝑖 = 1.034%
𝑃𝑉 = 60,000⁡; 𝑛 = 360; 𝑖 =
Early repayments and Prepayment Penalty
-
Simple
Loan Balance EOY5 = $58,597.93
Outstanding + Prepayment Penalty = 1.03% × $58,597.93 = $60,355.87
Monthly Debt Service = $617.17
Net Cash Disbursed = $58,200
Holding period = 5 years
𝑃𝑉 = −58,200; 𝐹𝑉 = 60,355.87, 𝑃𝑀𝑇 = 617.17; 𝑛 = 60
𝑖 = 1.1043%
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GEK2013 – REAL ESTATE FINANCE
Chapter 6: Alternative Mortgage Instruments
Type
Adjustable-Rate
Mortgage
See Notes for ARM
Variables and Index
Graduated-Payment
Mortgage
Price-Level Adjusted
Mortgage
Usage
Allows lender to adjust contract i/r to reflect
changes in market i/r. Change in rate reflected by
change in monthly payment
𝑖𝑛 = min⁡(𝐼𝑛𝑑𝑒𝑥 + 𝑀𝑎𝑟𝑔𝑖𝑛, 𝑖𝑛−1 + 𝐶𝑎𝑝)
Mathematics
Loan Amount = $100,000
Index = 1 year
Margin = 2.50
See Notes for computation
Term = 30 years
2/6 i/r caps
Teaser Rate = 5%
Graduated Payment Mortgage designed to offset tilt effect by lowering payments on an FRM early on and increasing over time
Solves tilt problem and interest rate risk by
separating real rate of return and inflation rate:
𝑖 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡⁡𝑟𝑜𝑟 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛⁡𝑟𝑎𝑡𝑒
$100,000
30years, 6%
interest
PMT in Year 1
4% inflation
Year 2
4% inflation
Year 3
-3% inflation
Year 4
2% inflation
Year 5-30
0% inflation
Shared Appreciation
Mortgage
Reverse Annuity
Mortgage
Pledged Account
Mortgage / Flexible
Loan Insurance
Program
𝑃𝑉 = 100,000; 𝑛 = 360; 𝑖 =
𝑃𝑀𝑇 = $599.55
6%
12
𝑃𝑉 = 98,772 × 1.04; 𝑛 = 348; 𝑖 =
𝑃𝑀𝑇 = $625.53
6%
12
𝑃𝑉 = 101,366 × 0.97; 𝑛 = 336; 𝑖 =
𝑃𝑀𝑇 = $604.83
𝑃𝑉 = 96,929 × 1.02; 𝑛 = 324; 𝑖 =
𝑃𝑀𝑇 = $616.92
𝑃𝑉 = 98,868; 𝑛 = 312; 𝑖 =
𝑃𝑀𝑇 = $612.92
6%
12
6%
12
6%
12
Low initial contract rate with inflation collected in a Appreciation amt. computed when house is sold or appraised in future
𝑉−𝛽
lump sum based on house price appreciation
𝑎=
, 𝑎: 𝑠ℎ𝑎𝑟𝑒⁡𝑜𝑓⁡𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛, 𝑉: 𝐿𝑇𝑉, 𝛽:⁡𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛⁡𝑖𝑛⁡𝑙𝑜𝑎𝑛⁡𝑖𝑛𝑡⁡
1−𝑡
𝑡:⁡𝑙𝑒𝑛𝑑𝑒𝑟 ′ 𝑠⁡𝑡𝑎𝑥⁡𝑟𝑎𝑡𝑒
Borrower receives a series of payments and repays $200,000 at 9% for 5 years, annual payments
in a lump sum at some future time i.e. Reverse
𝑛 = 5; 𝑖 = 9%; 𝐹𝑉 = 200,000
𝑃𝑀𝑇 = $33,418.49
Mortgage
Combines a deposit with lender and fixed rate loan to form a graduated-payment structure
Deposit in pledged as collateral
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Type
Fixed Rate
Mortgage
Adjustable-Rate
Mortgage
Advantages
Price-Level
Adjusted Mortgage
Future housing costs are known with relative certainty
-
Young households with lower incomes may not qualify for loans
with the different ratios in play / Interest rates will be higher for
those on mortgages with unstable payments
-
Default rates are generally low, simplicity and standardization
encourage securitization, easier to police
Default rates are lower because payment shocks are avoided
If interest rates are expected to fall in the future, good for
borrowers
Provides lower initial rate and payment than FRMs
Allows lenders with short-term liabilities to manage interest rate
risk
Future housing costs are known with relative certainty
Easier to qualify for lower income households to take advantage of
future earning power
Lower monthly payments early in mortgage
Default rates are lower because payment shocks are avoided
Solves tilt effect
While borrowers may face large payments at end of mortgage, its
actual buying power is similar to initial payment  if real income
increases, then burden is reduced
-
Exposes lenders with short-term liabilities to severe interest rate
risk
-
Greater uncertainty about future mortgage payments
Difficult to understand. Subject to possible large increases in future
payment
Default rates are higher than on FRMs. Diversity discourages
securitization
Interests larger than fixed rate mortgage to make up for the risk of
rising mortgage outstanding
Payments will be higher in later stages of the loan (must be
confident that income will rise)
Long duration makes management of interest rate risk difficult
Negative amortization
Interest rates changes doesn’t reflect changes in income levels
Mortgage balance increases faster than price appreciation
Lenders are protected against sudden inflation and enjoy relatively
constant rates of returns
Solves tilt effect and interest rate risks
Relatively low interest rate and monthly payments
-
Sudden inflation would result in large payments, increasing default
risk
-
Not feasible in regions with declining home values
Buyer may not be able to buy out lender when specified payoff
time arrives; buyer would be forced to refinance or sell the house
Way to access home equity without having burden of repayment
Creates income
Owners enjoy tax-free annuities
Continue to live in the house and benefit from appreciation and
property deductions
May result in lower payments for borrower and thus greater
affordability and lower risk for default
Future payments are known in advance
Rate increases do not cause payment problems for borrowers
resulting in defaults
-
Reduces value of estate (accumulating debt)
Home must be sold after death to repay mortgage if liquid assets
not sufficient
Annuities may place owners above certain welfare schemes
-
Initial payment is higher. Payoff period is uncertain
Loan duration is not known in advance
-
-
-
Shared
Appreciation
Mortgage
Reverse Annuity
Mortgage
Flexible Loan
Insurance Program
Flexible Maturity
Adjustable Rate
Mortgages
Disadvantages
-
GraduatedPayment Mortgage
GEK2013 – REAL ESTATE FINANCE
-
-
-
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GEK2013 – REAL ESTATE FINANCE
Chapter 7: Financing Decisions
House Value = $100,000
80% LTV, 12% i/r, 25 years
90% LTV, 13% i/r, 25 years
Down payment= 20% × 100,000 = 20,000
Down payment= 10% × 100,000 = 10,000
𝑃𝑉 = 80,000; 𝑛 = 300; 𝑖 = 12%⁄12
𝑃𝑉 = 90,000; 𝑛 = 300; 𝑖 = 13%⁄12
𝑃𝑀𝑇 = $842.58
𝑃𝑀𝑇 = $1,015.05
Compute internal rate of return, irr
Borrow $10,000 more but pay $172.47 more per month
𝑃𝑉 = 10,000; 𝑛 = 300; 𝑃𝑀𝑇 = 172.47
𝑖 = 1.7142 × 12 = 20.570%
Evaluate this percentage. Would you pay 20.57% interest just to borrow an extra $10,000?
Assume borrower relocates after 5 years
Loan Outstanding EOY5= 76,522.56
Loan Outstanding EOY5= 86,639.88
Difference in loan outstanding= 86,639.88 − 76,522.56 = 10,117.32
𝑃𝑉 = 10,000; ⁡𝐹𝑉 = 10,117.32;⁡
𝑖 = 1.73596 × 12 = 20.832%
With 2% origination fee
𝑛 = 60; 𝑃𝑀𝑇 = 172.47
Loan disbursement= 98% × 80,000
Loan disbursement= 98% × 90,000
= $78,400
= $88,200
Difference at time zero= $88,200 − $78,400 = $9,800
Borrow $10,000 more but pay $172.47 more per month
𝑃𝑉 = 9,800; 𝑛 = 300; 𝑃𝑀𝑇 = 172.47
𝑖 = 1.750 × 12 = 21.00%
Assume Alternative #2 changed to 30 years
80% LTV, 12% i/r, 25 years
90% LTV, 13% i/r, 30 years
Down payment= 20% × 100,000 = 20,000
Down payment= 10% × 100,000 = 10,000
𝑃𝑉 = 80,000; 𝑛 = 300; 𝑖 = 12%⁄12
𝑃𝑉 = 90,000; 𝑛 = 360; 𝑖 = 13%⁄12
𝑃𝑀𝑇 = $842.58
𝑃𝑀𝑇 = $995.58
Difference at time zero= $10,000
Difference in monthly payment: First 300 months: $153.00; Final 60 months: $995.58
irr(−10,000, {153, 995.58}, {300, 60}) = 1.5720 × 12 = 18.864%
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Loan Refinancing
$80,000 loan at 15% for 30 years 5 years ago
Stick
Switch
Refinance at 14% for 25 years, 2% prepayment
penalty and upfront fee payable to $2,525
𝑃𝑉 = 80,000; 𝑛 = 360; 𝑖 = 15%⁄12
𝑃𝑀𝑇 = $1011.56
Year 0 – EOY5
Loan outstanding EOY5= $78,976.50
𝑃𝑉 = 78,976.50; 𝑛 = 300; 𝑖 = 14%⁄12
𝑃𝑀𝑇 = $950.69
∴ new⁡monthly⁡payment = $950.69
Returns from Refinancing Investment
Cost⁡to⁡refinance = Prepayment⁡Penalty + Upfront⁡Costs
= 2% × $78,976.50 + 2,525 = $4,104.53
Benefit⁡from⁡refinancing = Initial⁡Monthly⁡Payment − New⁡Monthly⁡Payment
= $60.87
𝑃𝑉 = 4,104.53; 𝑛 = 300; 𝑃𝑀𝑇 = 60.87
𝑖 = 1.464 × 12 = 𝟏𝟕. 𝟓𝟔𝟗% > 14%⁡cost⁡of⁡new⁡borrowing
Effective Cost of Refinancing
𝑃𝑉 = 78,976.50 − 4,105.53 = $74,871; 𝑛 = 300; 𝑃𝑀𝑇 = 950.69
𝑖 = 1.238 × 12 = 𝟏𝟒. 𝟖𝟓𝟕% < 15%⁡cost⁡of⁡original⁡loan
Buyer plans to relocate after 10 years of refinancing or not refinancing
Loan Outstanding EOY10= $72,275.26
Loan Outstanding EOY10= $71,386.86
Difference in loan outstanding= $888.4
𝑃𝑉 = 4,105; 𝐹𝑉 = 888.4; 𝑛 = 120, 𝑃𝑀𝑇 = 60.87
𝑖 = 1.1842 × 12 = 𝟏𝟒. 𝟐𝟏% < 17.569%⁡irr⁡if⁡stay⁡all⁡the⁡way
Two or more Loans
Financial Package
Individual Loans
Payment of individual loans
$100,000 at 7%, 30 years
𝑃𝑀𝑇 = $665.30
𝑃𝑀𝑇 = $1,611.19
$200,000 at 7.5%, 20 years
𝑃𝑀𝑇 = $2,426.55
$200,000 at 8%, 10 years
irr(−500,000, {4703.04, 2276.49, 665.30}, {120, 120, 120}) = 0.6239 × 12 = 7.4873%
$500,000:
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GEK2013 – REAL ESTATE FINANCE
Chapter 9: Controlling Default Risk
Loan Underwriting: Process of determining and controlling default risk, evaluate borrower’s loan request in
terms of profitability and risk
See Notes for Underwriting Process
Type
Loan-to-Value
(LTV)
Payment to
Income Ratio
-ORMortgage
Servicing Ratio
Formula
Example
Property⁡Value = $500,000
Loan = $400,000
𝐿𝑇𝑉 = 0.8
𝑇𝑜𝑡𝑎𝑙⁡𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒⁡𝐸𝑥𝑝𝑒𝑛𝑠𝑒 Jack’s gross income is $5,500
𝑃𝐼𝑅⁄𝑀𝑆𝑅 =
Monthly loan payment is $4,540
𝐺𝑟𝑜𝑠𝑠⁡𝑀𝑜𝑛𝑡ℎ𝑙𝑦⁡𝐼𝑛𝑐𝑜𝑚𝑒
4540
𝑃𝐼𝑅 =
= 0.8255 > 𝑇𝐷𝑆𝑅
𝐶𝑎𝑠ℎ⁡𝑇𝑜𝑝𝑢𝑝⁡(𝑜𝑣𝑒𝑟⁡𝐶𝑃𝐹)
5500
𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛:
⁡
𝐿𝑇𝑉 =
𝐿𝑜𝑎𝑛
𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦⁡𝑉𝑎𝑙𝑢𝑒
𝐷𝑒𝑏𝑡⁡𝑆𝑒𝑟𝑣𝑖𝑐𝑒
See Notes for variation in this ratio
𝑁𝑒𝑡⁡𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔⁡𝐼𝑛𝑐𝑜𝑚𝑒
𝐷𝑒𝑏𝑡⁡𝑆𝑒𝑟𝑣𝑖𝑐𝑒
𝐷𝑒𝑏𝑡⁡𝑆𝑒𝑟𝑣𝑖𝑐𝑒 + 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔⁡𝐸𝑥𝑝𝑒𝑛𝑠𝑒
Breakeven
Ratio
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒⁡𝐺𝑟𝑜𝑠𝑠⁡𝐼𝑛𝑐𝑜𝑚𝑒
How much can a buyer finance?
Gross household monthly income
$7870
Car Loan
$1500
Car Insurance
250
Credit Card
700
Personal Loan
500
Property tax & Insurance
300
Bank to grant 25-year 80% LTV at 3.5% p.a. with monthly payments subject to HEIR 30% and TDSR 60%
Debt Coverage
Ratio
HousingExpense to
Income Ratio
Total Debt
Service Ratio
𝐷𝐶𝑅 =
Gross Monthly Income
Times: HEIR
Max Permissible long term obligations
Less: Property tax & insurance
Max Principal & interest payment
𝑃𝑀𝑇 = 2061; 𝑛 = 300; 𝑖 = 3.5%⁄12
𝑃𝑉 = $411,687
∴ max⁡loan = $411,687
Gross Monthly Income
Times: TDSR
Max Permissible long term obligations
Less: Property tax & insurance
Less: Payments on long-term debt
Max Principal & interest payment
𝑃𝑀𝑇 = 1472; 𝑛 = 300; 𝑖 = 3.5%⁄12
𝑃𝑉 = $294,033
∴ max⁡loan = $294,033
$7,780
0.30
$2,361
300
$2,061
$7,780
0.60
$4,722
300
2950
3,250
$1,472
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Chapter 11: Asset-Backed Securities
Securitization
Process by which assets are packaged into securities sold on organized exchanges
Asset-backed
A security created by pooling loans
Security
Bankruptcy
A bankruptcy remote company is a company within a corporate group whose
Remote
bankruptcy has as little economic impact as possible on other entities within the group
Two types of assets used as collateral – existing and future
Securitization Structure
Amortizing Assets (Self-liquidating Structure)
Periodic payments consisting if principal & interest
Amortization schedule on a pool/loan level
Non Amortizing Assets (Revolving Structure)
- No amortizing schedule
- Lockout/revolving period
No fixed period, only minimum payment, e.g. credit
See Notes for further explanation
card
Fixed Rate
Floating Rate
Possibility of mismatch between cash flow characteristics of underlying asset and liabilities. Interest rate
derivatives are used to mitigate the risk
Asset Classification
Asset Backed
Security
Mortgage Backed
Security
Others
- Customer loans
- RMBS
- Credit Card
Receivables
- CMBS (income
producing)
- Leasing
Receivables
Collateralized Debt
Obligation
- Collateralized Loan
Obligation
- Collateralized Bond
Obligation
-Future cash flows
-
Asset Risk
Underlying borrower’s ability
to pay and service loans
Experience of originators
Concentration of loans: a
single huge loan borrower?
Assessment of most likely
lost via weighted average loss
& variability of loss
Credit Risks
Structural Risk
Can Cash Flow satisfy all obligations?
- Loss allocation
- Cash flow allocation
- Interest rate spread
- Potential of occurrence of trigger events
- Changes in credit enhancement
Third-Party Providers
- Credit guarantors
(bond insurers)
- Servicer
- Trustee
- Lawyer
See Notes for Subordination Principle & Cash Flow
Waterfall
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GEK2013 – REAL ESTATE FINANCE
Credit Enhancement (See Notes for Credit Enhancement)
Senior
Subordinated
Structure+
Internal
Excess Spread
Credit
Enhancement
Overcollateralization
Monoline
Insurance*
External
*Monoline Insurance: An insurance company that provides guarantees to issuers to enhance the credit of
the issuer. Issuers will often go to monoline insurance companies to either boost the rating of one of their
debt issues or to ensure a debt issue does not become downgraded.
+
Main motivation is to maintain ratio of senior-subordinate: Redirect prepayments disproportionately from
subordinate to senior to ensure no deterioration of credit protection for senior bond class
Residential Mortgage Backed Securities
Prepayment Risk
Conditional Prepayment Rate –
Single-Monthly Mortality rate (SMM)
1
𝑆𝑀𝑀 = 1 − (1 − 𝐶𝑃𝑅)12
𝑀𝑜𝑛𝑡ℎ𝑙𝑦⁡𝑃𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡
= 𝑆𝑀𝑀 × (𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔⁡𝑏𝑎𝑙⁡𝑓𝑜𝑟⁡𝑚𝑜𝑛𝑡ℎ⁡𝑡
− 𝑠𝑐ℎ𝑒𝑑𝑢𝑙𝑒𝑑⁡𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙⁡𝑝𝑎𝑦𝑚𝑒𝑛𝑡⁡𝑓𝑜𝑟⁡𝑚𝑜𝑛𝑡ℎ⁡𝑡)
Default Risk
1) Conditional Default Risk (CDR)
Annualized value of unpaid principal balance of newly defaulted loans in a month as percentage of unpaid
balance of pool
𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑒𝑑⁡𝑙𝑜𝑎𝑛⁡𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝐶𝐷𝑅𝑀 =
𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔⁡𝑏𝑎𝑙⁡𝑓𝑜𝑟⁡𝑚𝑜𝑛𝑡ℎ⁡𝑡 − 𝑠𝑐ℎ𝑒𝑑𝑢𝑙𝑒𝑑⁡𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙⁡𝑝𝑎𝑦𝑚𝑒𝑛𝑡⁡𝑖𝑛⁡𝑚𝑜𝑛𝑡ℎ⁡𝑡
𝐶𝐷𝑅𝑌 = 1 − (1 − 𝐶𝐷𝑅𝑀 )12
2) Cumulative Default Rate
Commercial Mortgage Backed Securities
-
Prepayment terms
Role of servicer: transference of loan to special servicer when borrower is in default, imminent default,
or in violation of covenants
Role of buyers: junior bond buyers
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GEK2013 – REAL ESTATE FINANCE
Special Purpose Vehicle
A Special purpose vehicle is a legal entity created to fulfil a Specific or temporary objective. SPVs are typically
used by companies to isolate the firm from financial risk. They are also commonly used to hide debt, hide
ownership, and obscure relationships between different entities which are in fact related to each other
Some of the reasons for creating Special purpose entities are as follow:
-
-
Securitization: SPVs are commonly used to securitise loans. For example, a bank may wish to issue a
mortgage-backed security whose payments come from a pool of loans. However, to ensure that the
holders of the mortgage-back securities have the first priority right to receive payments on the loans,
these loans need to be legally separated from the other obligations of the bank. This is done by creating
an SPV, and then transferring the loans from the bank to the SPV.
Risk sharing: Corporates may use SPVs to legally isolate a high risk project/asset from the parent
company and to allow other investors to take a share of the risk.
Finance: Multi-tiered SPVs allow multiple tiers of investment and debt.
Asset transfer: Many permits required to operate certain assets (such as power plants) are either nontransferable or difficult to transfer. By having an SPV own the asset and all the permits, the SPV can be
sold as a self-contained package, rather than attempting to assign over numerous permits
Asset-Backed Securities
When a consumer takes out a loan, their debt becomes an asset on the balance sheet of the lender,
collecting principal and interest payments from borrowers. The lender can then sell these assets to a trust or
“special purpose vehicle,” which packages them into an asset backed security (ABS) that can be sold in the
public market. The interest and principal payments made by consumers “pass through” to the investors that
own the asset backed securities.
ABS benefit lenders because they can be removed from the balance sheet, allowing lenders to acquire
additional funding as well as greater flexibility to pursue new business. 1) Investors of ABS and MBS are
usually institutional investors and they use ABS to obtain higher yields than comparable-maturity U.S.
Treasury securities among triple-A rated assets, as well as to provide a way to diversify their portfolios and
augment their portfolio diversification. 2) ABS are one of the most secure investment vehicles from a credit
standpoint. Predictable cash flow. The certainty and predictability of cash flow for many types and classes of
ABS are well established. Investors can buy these securities with considerable confidence that the timing of
payments will occur as expected. (Prepayment uncertainty). 3) Because ABS are secured by underlying
assets, they offer significant protection against event-risk downgrades, particularly in contrast to corporate
bonds. A major concern investors have about unsecured corporate bonds, no matter how highly rated, is
that the rating agencies will downgrade them because of some disruptive event affecting the issuer. Such
events include mergers, takeovers, restructurings and recapitalizations, which are often undertaken by
corporate managers trying to boost shareholder value.
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Name
Simple Interest
Formula
𝑖 = Principal × 𝑖/𝑟
Usage
Interest earned on principal
amount only
Compute compound interest
𝐹𝑉 = 𝑃𝑉 ∙ 𝜃
Future Value
Present Value
𝑃𝑉 = 𝐹𝑉 ∙
1
𝜃
Value of an investment in
today’s money
Future Value
Annuity
𝐹𝑉𝐴 = 𝑃𝑀𝑇 ∙
𝜃−1
𝑖
Future value of a series of
constant payments
Sinking Fund
Factor (“PMT”)
𝑃𝑀𝑇 = 𝐹𝑉𝐴 ∙
𝑖
𝜃−1
Amount set aside to be
invested in order to accumulate
desired future amount
Present Value
Annuity
Mortgage
Constant
Arrears
1
1−
1 − 𝑃𝑉
𝜃
𝑃𝑉𝐴 = 𝑃𝑀𝑇 ∙
= 𝑃𝑀𝑇 ∙
𝑖
𝑖
Advance
1
1−
𝜃
𝑃𝑉𝐴 = 𝑃𝑀𝑇 ∙ (1 + 𝑖) ∙
𝑖
𝑖
𝑃𝑀𝑇 = 𝑃𝑉𝐴 ∙
1
1−
𝜃
How much to pay for an
investment that hands out
constant payments
Debt service necessary to
amortize a present mortgage
loan amount
Loan Outstanding
Effective Rates
VS
Nominal Rates
𝐸𝐴𝑅 = (1 +
𝑖 𝑚
) −1
𝑚
Future⁡Value⁡Factor, θ = (1 + i)n ; ⁡Discount⁡rate =
Convert nominal quotes to
effective rates
1
1+𝑟
GEK2013 – REAL ESTATE FINANCE
Example
Total amount accumulated EOY2 if $1,000 invested at 10% simple interest:
Total⁡amount = 1,000 + 2 × 10% × 1,000 = $1,200
Total amount accumulated EOY2 if $1,000 invested at 7% interest
𝐹𝑉 = 1,000 ∙ (1 + 0.07)2 = $1144.90
Present value of obtaining $105,000 EOY1 at 7% interest
1
𝑃𝑉 = 105,000 ∙
= $98,130.84
(1 + 0.07)1
Investor pays $200 per month for 5 years at 8% interest p.a.
8% 5∙12
(1 +
)
−1
12
𝐹𝑉𝐴 = 100 ∙
= $14,695.37
8%
12
Compute PMT to accumulate $33,100 EOY3 at 10% interest p.a.
10%
12
𝑃𝑀𝑇 = 33,100 ∙
= $792.21
10% 3∙12
(1 +
)
−1
12
Investment pays out $300 each month over 6 months at 8% interest p.a., how much to
pay?
1
1−
8% 6
(1 +
)
12
𝑃𝑉𝐴 = 300 ∙
8%
12
= $1,758.74
You raised a mortgage of $100,000. Loan is for 15years, interest at 7% p.a.
7%
𝑃𝑀𝑇 = 100,000 ∙
1
1−
(1 + 7%)15
= $10,979.46
𝑛 = 𝑦𝑒𝑎𝑟𝑠⁡𝑙𝑒𝑓𝑡
Loan Outstanding EOY1
𝑆𝑎𝑚𝑒⁡𝑃𝑀𝑇
1
1−
(1 + 7%)14
𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔⁡𝑚𝑜𝑟𝑡𝑔𝑎𝑔𝑒⁡𝐿𝑜𝑎𝑛 = 10,979.46 ∙
= $96,020.52
7%
Effective annual rate of 1% i/r per month
Simple interest rate of 1% per month=12% p.a.
12% 12
𝐸𝐴𝑅 = (1 +
) − 1 = 0.126825
12
13