Lecture 12: Real Estate
Real Estate: an Important Asset
Class
• Until recent stock market boom, single family
homes value in US approximated value of entire
stock market.
• Home mortgages 1999: $4.62 trillion Consumer
credit is only 1.46 trillion. US National debt held
by public is only $3 trillion
(Source: FRB, Balance Sheets for US Economy)
Real Estate Partnerships as the
Major Example of a DPP
• Real estate limited partnerships represent the most
important example of a Direct Participation Program
(DPP), a class of investments that also includes oil and gas
exploration programs and equipment leasing programs
• “Direct participation:” DPPs are “flow-throw vehicles” and
investors can deduct program losses on personal taxes
• “Tax shelters” until the Tax Reform Act of 1986: losses
used to offset “passive income.” Now, genuine businesses.
• DPPs escape the corporate profits tax
• IRS requirements, notably limitation of life
Limited Partnership Structure
• General partner runs the business, does not have
limited liability
• General partner must own at least 1%
• Limited Partners are passive investors, with
limited liability, rights to vote, can replace general
partner
• General partner or associate usually runs the
offering to sell units to investors
• Give additional performance-oriented
compensation to the general partner
Accredited Investors
• Regulation D: Accredited investors include
individuals with net worth in excess of $1
million or with income in excess of
$200,000 ($300,000 joint income) in each
of the last two years
• National Association of Securities Dealers
(NASD) requires suitability files and
suitability tests for DPPs
REITs
• Real Estate Investment Trusts (REITs) were
created by US Congress in 1960 to allow small
investors access to real estate investments.
• Before 1960, public companies that owned real
estate would be considered businesses, for which
their earnings would be subject to corporate
profits tax. So, until 1960, real estate was typically
owned by partnerships, not suitable for small
investors.
• Today, institutions invest in REITs too.
Restrictions on REITs
• 75% of assets must be in real estate or cash
• 75% of income must be from real estate
• 90% of their income must be from real estate,
dividend, interest & capital gains
• 95% of income must be paid out
• No more than 30% of income from sale of
properties held less than four years
– These prevent regular businesses from being REITS
The 3 REIT Booms
• First boom: Late 1960s: interest rates rose above
deposit rate ceilings at banks, depositors fled to
mortgage REITs. But, with recession of 1974,
many REITs defaulted. Economic Recovery Tax
Act of 1981 favored partnerships.
• Second boom: Tax Reform Act of 1986 eliminated
advantages of partnerships, so investors switched
to REITs.
• Third boom: Starting 1992, many private real
estate companies found it advantageous to go
public as REITs, specialized REITs developed.
History of Mortgages
• In 1920s, 5-year term loans common,
balloon payment due in five years, or
refinance or sell house.
• In 1930s, decline in nominal home prices
and rise in unemployment caused massive
defaults
• Mortgage lending industry turned to longterm annuities
Kinds of Mortgages
• Conventional, fixed rate mortgage
• Adjustable rate mortgage (ARM)
• Price level adjusted mortgage (PLAM) payment
adjusted to inflation so constant in real terms
• Dual rate mortgages (DRAMs) same as PLAM but
interest rate floats
• Shared appreciation mortgages (SAMs)
• First mortgages: on purchase of home
• Home equity loans
Conventional Mortgages
• Homeowners’ fixed rate mortgage: an
annuity whose present value equals the
initial loan.
• Traditionally, payments are monthly and
compounding is monthly. With maturity m
years and mortgage rate r we have:
 1

1
Mortgage balance  monthly payment  

12 M 
 r / 12 r / 12(1  r / 12) 
New Haven Savings Bank
• Founded in 1838 as part of the “Savings Bank
Movement” that began in UK at begin of 19th
century. A major mortgage lender
• Philanthropic mission to protect small savers.
Charter requires conservative investments
• No savings bank went bankrupt during great
depression
• Savings banks accumulate huge piles of assets,
tempting takeover
Statement from NHSB Directors
•
•
•
•
In NHSB's case, formidable business risks have been steadily emerging over the last
several years.
The Board has a fiduciary responsibility to make sure that NHSB is successful, and it is
clear to us that the Bank has to grow if it is to break out of its current stagnation. If
NHSB were to rely just on its history and goodwill in the community, it would risk the
very real possibility of becoming obsolete over time.
These are unique challenges, and they call for outstanding leadership. NHSB is fortunate
to have just that in its President and CEO, Peyton R. Patterson, and her executive
management team. The Board brought Ms. Patterson to NHSB based upon her history of
being able to jumpstart momentum at financial institutions, and her strong belief in
community banking. Our confidence in her and her team has been confirmed in
numerous ways, but most notably with the pending acquisitions of Savings Bank of
Manchester and Tolland Bank, and the proposed plans to convert the Bank to public
ownership.
We are aiming to put more money back into the community -- NHSB is more than
quadrupling the size of its Foundation, by allotting to it $30 million of the stock raised
through a public offering.
CT Banking Commissioner John P. Burke,
Approval of Conversion Jan 2004
• The New Haven Saving Bank (NHSB) submitted an
application on September 30, 2003 for the conversion from
a mutual saving bank to a capital stock bank and for the
acquisition of and subsequent merger of the Savings Bank
of Manchester and Tolland Bank with and into NHSB. The
combined entities will operate under the name
NewAlliance Bank.
• To address the comments received on the concern the new
institution would be sold in the near future, the approved
plan of conversion restricts the acquisition of more than
10% of any security of the Holding Company without the
prior approval of the Commissioner for a period of 5 years
following completion of the conversion.
NHSB Conversion Plan
• As part of the Plan of Conversion, New Haven Savings Bank will
conduct a subscription offering of common stock to eligible depositors,
in accordance with applicable conversion rules. Pursuant to governing
regulations, the common stock is being offered for sale in a
subscription offering, in descending order of priority, to 1) New Haven
Savings Bank account holders with a balance of at least $50 or more
on June 30, 2002; 2) New Haven Savings Bank's tax qualified
employee stock benefit plans, including the employee stock ownership
plan; 3) account holders with $50 or more on deposit as of the quarter
end before receiving approval; 4) New Haven Savings Bank Directors,
officers and employees and 5) New Haven Savings Bank Corporators.
“NHSB Shares Likely to Soar”
• NHSB sent prospectus to its depositors on Feb 19,
2004
• Price per share $10, maximum order $70,000
shares
• Deadline to order shares March 11, 2004
• As many as 102.5 million shares may be sold
• SNL Financial report Feb 20, 2004: “the stock
price will most likely jump 40 percent to 50% on
the day the company goes public”
Fannie Mae
• Federal National Mortgage Association, created by
Congress in 1938 to create a secondary market for
FHA approved mortgages. Borrows money, buys
& holds mortgages.
• 1944 allowed to buy VA (Veteran Admin. Loans)
• 1954 Congress makes Fannie Mae a “mixed
ownership corp., with private owners
• 1968 Pres. Johnson signs bill making Fannie a
fully private corporation
• 1976 Conventional loans outnumber FHA & VA
• Still does not do jumbo loans (above $275000)
Freddie Mac
• Federal Home Loan Mortgage Corporation
(Freddie Mac) created by Congress in 1970.
• From beginning, it securitized mortgages:
sold pools of mortgages, called a
participation certificate (PC) to investors.
• In 1981, Fannie began to compete with
Freddie in pooling mortgages, with its
mortgage backed securities (MBS)
Implicit Govt Guarantee of GSEs
• Complaints that the Government Sponsored
Enterprises have unfair advantage
• Richard Baker, Chairman of House Banking
Committee, has introduced a bill to regulate
GSEs and limit their business
• Stiff opposition
Private Mortgage Insurance
(PMI)
• Companies, such as MGIC, insure Fannie &
Freddie against losses on their mortgages
• Both Fannie & Freddie require that mortgagors
buy mortgage insurance if down payment is less
than 20%.
• Controversy: with recent real estate price
increases, LTV has declined below 80% for many
homeowners still paying for mortgage insurance.
The PMIs don’t notify them.
• Impossibility of PMIs insuring GSEs in a major
downturn is another issue.
Collateralized Mortgage
Obligations (CMOs)
• CMOs divide the cash flow of a mortgage
pass-through security into a number of
tranches in terms of prepayment risk.
• Sequential-pay CMOs (first created 1983):
First tranche receives first principal
payments, after it is paid off the second
tranche receives principal payments.
Behavior of Single Family Home
Prices
• Not a random walk, substantial inertia
• Occasional booms and busts
• Shared movements over wide regions of
country, but not shared over entire country
• Boom of late 1980s infected many of largest
cities of world
Characteristics of Real Estate
Booms
• Case Shiller Surveys of Homeowners 1988,
2003
• Surveyed recent homebuyers in Anaheim
CA (boom), Milwaukee WI (no boom) and
Boston MA (post-boom)
• Nearly 1000 responses each survey
Figure 5 Los Angeles Real Home Price Index and Employment
120
9000000
8000000
100
7000000
80
6000000
5000000
Real Price
60
employment
4000000
40
3000000
2000000
20
1000000
0
1970
1975
1980
1985
1990
1995
2000
0
2005
Figure 8 Milwaukee Real Home Price Index and Employment
200.0
900000.0
180.0
800000.0
160.0
700000.0
140.0
600000.0
120.0
500000.0
Price
100.0
Employment
400000.0
80.0
300000.0
60.0
200000.0
40.0
100000.0
20.0
0.0
1975
1980
1985
1990
1995
2000
0.0
2005
Long-Term Expectations
“On average over the next ten years, how
much do you expect the value of your home
to change each year?”
Los Angeles
Milwaukee
1988 2003
1988 2003
14.3% 13.1%
7.3% 11.7%
Fears of Being Left Out
“Housing prices are booming. Unless I buy
now, I won’t be able to afford a house in the
future.”
Los Angeles
Milwaukee
1988 2003
1988 2003
Agree
79.5% 48.8% 27.8% 36.4%
Disagree 20.5% 51.2% 72.2% 63.6%
Perceptions of Excitement
“There has been a good deal of excitement
surrounding recent housing price changes. I
Sometimes I think I may have been
influenced by it.”
Los Angeles
Milwaukee
1988 2003
1988 2003
Yes
54.3% 46.1% 21.5% 34.8%
No
45.7% 53.9% 78.5% 65.2%
Word-of-Mouth Communication
“In conversations with friends and associates
over the last few months, conditions in the
housing market were discussed.”
Los Angeles
Milwaukee
1988 2003
1988 2003
Frequently 52.9% 32.9% 20.0% 27.6%
“Stock Market is Best Investment”
“The stock market is the best investment for long-term holders, who can
just buy and hold through the ups and downs of the market.”
1996
1999
2000
Oct 2001
-Feb 2002
1. Strongly agree
69%
76%
63%
60%
2. Agree somewhat
25%
20%
34%
31%
3. Neutral
2%
2%
2%
3%
4. Disagree somewhat 2%
1%
1%
5%
5. Strongly disagree 1%
1%
0%
1%
(U. S. Individual investors; numbers for 2000 are mid-year, after
peak of market.)
“Real Estate is Best Investment”
“Real estate is the best investment for long-term holders, who can just buy
and hold through the ups and downs of the market.”
Los Angeles
Milwaukee
2003
2003
1. Strongly agree
53.7%
31.3%
2. Agree somewhat
33.1%
45.9%
3. Neutral
10.3%
11.3%
4. Disagree somewhat
2.7%
9.1%
5. Strongly disagree
0.0%
2.1%
Effects of Real Estate Booms &
Crashes on Financial Institutions
• Default rate on mortgages is function of
loan to value ratio, which declines as prices
rise, rises as prices fall.
• Mortgage insurance companies suffered
massive losses in 1980s with decline of real
estate prices in Texas. MGIC in great
trouble then.
Real Estate Market Today
• Late 1990s have shown solid price increases in
many cities
• San Francisco increased 28% 1999 III to 2000 III,
fell 4.5% between 2001-I and 2001-IV .
• More low downpayment loans today
• Risk of stock market decline harming real estate
market, thereby the PMIs, and mortgage lenders