Chapter 14-22 Chapter questions

Question 19-11 Name five important characteristics of mortgage pools. Tell why each is important

(1) Guarantee against default on mortgages by both private mortgage insurers and government agencies reduces the inherent risk of such securities. (2) Mortgages are grouped according to payment patterns, maturity and security which helps investors predict with some confidence the cash flow pattern that they can expect to receive. (3) A mixture of interest rates enables a faster accumulation of larger pools for securitization. The coupon rate promised to investors purchasing securities is generally based on the lowest interest rate on any mortgage in the pool, less servicing and guarantee fees. This means that for two security issues bearing the same coupon rate, expected cash flows to investors in the pool containing mortgages with different rates will be less variable than cash flows from the pool with the same interest rates. (4) The risk of default is usually greatest in the early years of the life of a mortgage. Inclusion of seasoned mortgages in pools tends to reduce the possibility of prepayment because of default. (5) Geographic diversity of the mortgages in the pool is important because it may affect the likelihood of prepayment and default. Certain regions of the country may be affected more by economic downturns and resulting unemployment than others and, hence, may have higher default rates. A mortgage pool with more geographic diversity tends to insulate investors from cash flow irregularities.

Question 20-17 In what ways is a CMBS structure different from a CMO backed by residential mortgages? Why is default risk in a CMBS offering given more attention?

A CMBS is subject to default risk because there are no government agencies that insure the mortgages against default or guarantee the payments as in the case of a CMO backed by residential mortgages. Default risk is borne first by the lower rated trances in the CMBS. Because there are typically prepayment penalties and "lockout" provisions associated with commercial mortgages, prepayment risk is not a significant concern for CMBS.

Question 20-4 What is a CMO? Explain why a CMO has been called as much of a marketing innovation as a financial innovation.

A CMO is a type of mortgage-backed security where a pool of mortgages is used as collateral for several different classes of securities. Each class has different investment characteristics which would appeal to different types of investors. The CMO is a marketing innovation as well as a financial innovation because the different classes of securities can be marketed to a variety of investors with different investment goals.

Question 18 - 15 What is the main difference between organizing a real estate venture as a corporation versus a general partnership? How does a limited partnership have some of the characteristics of both?

A corporation provides limited liability to shareholders whereas the general partners in a general partnership have liability. But a corporation is taxed at the entity level and dividends paid to shareholders may also be subject to taxation. Partnerships are not taxed at the partnership level. Taxable income and losses flow to the partner's tax return. If there are tax losses, this also flows to the partner's tax return which can offset other taxable income whereas with a corporation the tax losses cannot be passed through to the shareholders. A limited partnership is taxed like a general partnership but the limited partners do not have any personal liability. The liability is incurred by the general partner in the limited partnership.

Question 20-5 What is meant by a derivative investment?

A derivative security derives its value from another security, index, or financial claim. Because the value of mortgage-backed securities (MBS), such as MPTs and CMOs, are based on pools of mortgages, both are referred to as derivatives. IOs and POs are also examples of derivatives.

Question 20-13 What are "floater" and "inverse-floater" tranches in a CMO offering?

A floater is a CMO tranche that has a variable interest rate. It is supported by an inverse-floater that is structured so that the sum of interest on the floater and inverse floater sum to a fixed interest amount.

Question 17-4 In land development projects, why do lenders insist on loan repayment rates in excess of sales revenue? What is a release price?

A lender doesn't want to wait until the last parcel sells for the development loan to be completely repaid. Thus, a lender will normally insist on a loan repayment rate that is greater than the rate for which parcels are expected to sell. The release price is the dollar amount of the loan that must be repaid when a lot is sold. Release prices may vary with different types of lots. Typically, the release price is set at an amount that results in the loan being repaid by the time a certain percentage, e.g. 80 percent, of the lots are sold. Note, this does not mean that the developer must pay back an amount that is greater than the sale price of the lot.

Question 21-7 What is a mortgage REIT?

A mortgage REIT is a REIT that primarily invests in mortgages and mortgage backed securities rather than property ownership.

Question 19-5 Why was the formation of FHLMC so important?

A period of intermittent rate volatility, particularly during the mid- and late 1960s, was also causing liquidity problems that plagued thrifts. The Federal Home Loan Mortgage Corporation (FHLMC) was established to provide a secondary market and, hence, liquidity for conventional mortgage originators.

Question 16-5 A presale agreement is said to be equivalent to a take-out commitment. What will the construction lender be concerned about if the developer plans to use such an agreement in lieu of a take-out?

A presale agreement differs from a take-out commitment in that proceeds from the sale of a property are used to repay the construction loan rather than the permanent loan. The construction lender must be sure that the agreement requires the buyer to purchase the property at an amount that is at least sufficient to pay off the construction loan and that there will be no contingencies in the agreement that allow the purchaser to cancel the agreement.

Question 20-14 What is the role of the "scaler" in structuring an (F) and (IF) structure?

A scaler is used to adjust the ratio of the relative composition of interest to be received by the F (floater) and IF (inverse floater) tranches.

Question 16-4 What is a standby commitment? When and why is it used?

A standby commitment is an agreement by a lender to provide permanent financing for a property once construction is complete. It is used by a developer to obtain construction financing, because construction lenders typically require the commitment of a permanent lender before a construction loan will be made. The permanent lender may receive a fee for making the commitment to provide permanent financing, if necessary. A standby commitment is often used by developers who are still shopping for permanent financing, but need a commitment in order to obtain the construction loan. Thus, the standby commitment is like an option that the developer can use as a source of financing, but may choose not to if a better alternative is found.

Question 20-16 What are (IO) and (PO) strips? Which tends to be more volatile in price? Why?

An IO strip receives only the interest from a pool of mortgages. A PO strip receives only the principal. An IO tends to be more volatile because it only receives interest from mortgages that have not been prepaid. Prepayment causes investors in a PO to get repaid sooner, but they still receive all of the principal from the entire pool of mortgages.

Question 14-2 Why might the actual holding period for a property be different from the holding period that was anticipated when the property was purchased?

An investor purchases a real estate investment based on the benefits expected to be received over an anticipated holding period. That is, the investor computes the various measures of investment performance based on expectations at the time the property is purchased. After the property is purchased, however, many things can change that affect the actual performance of the property. These same factors may affect the investor's decision as to whether the property continues to meet his investment objectives. For example, market rents may not be increasing as fast as expected, thus reducing the investor's cash flow. Tax laws may have changed, as they did in 1986, thus changing the benefit for some investors more than others. The point is that a periodic evaluation should be made to determine whether properties should be sold.

Question 14-16 Why would an investor consider doing an exchange or an installment sale?

Both an exchange and an installment sale are ways of deferring capital gain taxes so that they are recognized in the future rather than at the time of sale.

Question 15-9 Why is the cost of financing with a sale-leaseback essentially the same as the return from continuing to own?

Both of these calculations use the same marginal cash flows. The difference is just in how the return is interpreted.

Question 16-2 What are two development strategies that many developers follow?

Business strategies used by developers can be categorized in three general ways: 1) owning and managing projects for many years, 2) selling projects after the lease-up phase, and 3) developing land and buildings for lease in a master-planned development or "build to suite" for single tenants. Following a particular strategy allows the developer to have a balance between use of external contractors, architects, real estate brokers, leasing agents, and property managers and having this expertise within the firm.

Question 20-8 Why are CMOs overcollateralized?

CMOs are overcollateralized to provide additional interest income as a cushion to meet contractual payments on the securities. This cushion is especially important when a decrease in interest rates leads to accelerated prepayment. Mortgages that pay the highest interest rates are prepaid first, whereas securities with the lowest coupon (i.e., the class A) receive additional principal from prepayment.

Question 20-7 What is the major difference between a CMO and the other types of mortgage-related securities?

CMOs differ because there are different classes or tranches of securities that are issued. The classes vary in terms of their priority of receipt of principal and interest, including prepayment; they hence differ in terms of maturity and risk.

Question 20-10 Which tranches in a CMO issue are least subject to price variances related to changes in market interest rates? Why?

Changes in market interest rates affect the market value of a tranche. Tranches with the greatest duration (timeweighted maturity) are affected most by changes in interest rates. This will be the lowest priority tranches, e.g., the C tranche has a longer duration than the A tranche. Note that even though a change in interest rates may have a greater impact on the duration of the A tranche than the C tranche, the C tranche still has a longer duration, which is what affects a security's sensitivity to changes in interest rates.

Question 16-3 What contingencies are commonly found in permanent or take-out loan commitments? Why are they used? What happens if they are not met by the developer?

Contingencies commonly found in permanent or take-out loan commitments include: 1) a maximum amount of time to obtain a construction loan commitment, 2) a date for completion of construction, 3) minimum rent-up (leasing) requirements and an approval of major leases, 4) an expiration date of the permanent loan commitment and any provisions for extensions, and 5) an approval by the permanent lender of design changes and substitution of any building materials.

Question 18-5 What is the main difference between the way a partnership is taxed versus the way a corporation is taxed?

Corporations cannot allocate losses to shareholders. Also, corporations are taxed at the corporate level and shareholders are taxed on dividends they receive. Partnerships are not taxed at the partnership level.

Question 15-10 Why might it be argued that corporations do not have a comparative advantage when investing in real estate as a means of diversification from their core business?

Corporations do not typically hold real estate in a large number of geographic areas and may not hold a variety of different types of properties. Thus, they cannot diversify their real estate holdings as much as a large institutional investor that holds a much larger and more diversified portfolio.

Question 20-18 How do CDOs differ from CMBS?

Difference between CDO and CMBS is that CMBS is a subset of CDO. In CMBS the underlying assets are commercial based mortgages but in CDO the underlying asset can be Real Estate ABS, Non-Real Estate ABS, Leveraged Loans, Middle Market Leveraged Loans, Trust preferred securities, CMBS or any combination of these asset classes. So CDO adds another level of complexity to the securitization process.

Question 21-4 What is the difference between earnings per share (EPS), funds from operations (FFO), adjusted funds from operations (AFFO), and dividends per share?

Earnings per share (EPS) is based on accounting income which is reduced by any depreciation and amortization which are non-cash deductions. EPS is calculated as GAAP net income minus preferred stock dividends divided by number of common shares outstanding. FFO is calculated by adding back depreciation and amortization and other non-cash deductions to earnings minus any capital gains from property sales. Although subject to different methods of calculation, AFFO is usually calculated by subtracting from FFO (i) normalized recurring expenditures that are capitalized by the REIT and then amortized, and (ii) straight-lining of rents. The resulting AFFO calculation is sometimes referred to as the cash available for distribution (CAD) or funds available for distribution (FAD). Dividends per share is what the REIT actually distributes to shareholders and is calculated as dividends paid divided by number of common shares outstanding.

Question 19-8 There are several ways that mortgages can be sold in the secondary market. Choose two and compare and contrast their length of distribution channel, relative ease of transaction, and efficiency as it relates to maximizing funds flow from sale.

Essentially, mortgages are originated by lenders and are pooled by them or sold to FNMA or FHLMC. If pooled by the originator, the originator will work with a securities underwriter to issue the securities. These securities are then sold through security dealers to individuals and institutional investors. In the early 1980s both FNMA and FHLMC instituted swap programs in which originators pool mortgages, then swap them for pass-through securities simultaneously issued by Fannie Mae or Freddie Mac. Depending on market interest rates, the originator may then choose to sell part or all of the mortgage securities at a premium or a discount. These securities could be sold directly by the originator to institutional investors, to security dealers, or through the trading department operated by FHLMC. By swapping securities for mortgages, the originator has more flexibility when deciding whether to own securities or how and when such securities will be sold to raise cash.

Question 17-1 How might land development activities be specialized? Why is this activity different from project development discussed in the preceding chapter?

Firms can specialize in acquiring raw land in suburban fringe areas and developing sites for single family detached units or for multiple uses, such as combinations of single family units, multifamily apartments, and cluster housing. Land developers and builders or project developers may, or may not, be the same entities. Land developers may or may not have the expertise to undertake building construction and/or project development.

Question 20-12 Name the major types of credit enhancement used for commercial-backed mortgage securities

Forms of credit enhancement include issuer or third-party guarantees, surety bonds and letters of credit, advance payment agreements, loan substitutions and repurchase agreements, lease assignments, over collateralization, and cross-collateralization and cross default. Credit also can be enhanced with commercial mortgage-backed securities through the CMO structure. In this case, the lower priority classes incur any losses from default before the higher classes.

Question 18-14 How are general partners usually compensated in a syndication? What major concerns should investors consider when making an investment with a syndication

General partners can receive a number of different fees for structuring the partnership, acquiring property on behalf of the partnership, managing the partnership, etc. They may also receive a disproportionate allocation of cash flow from operations and/or sale of the properties. The investor should be concerned about the general partner's ability to manage the partnership including acquisition and/or development of the properties, property management, etc. The investor should also be concerned about whether the general partner is likely to act in the best interest of the limited partner.

Question 18-10 What are the different ways that the general partner is compensated?

General partners can receive a number of different fees for structuring the partnership, acquiring property on behalf of the partnership, managing the partnership, etc. They may also receive an allocation of cash flow from operations and/or sale of properties.

Question 16-8 What are "gross ups" in determining tenant reimbursements for operating expenses? Why are they used?

Gross ups are used by developers to increase reimbursable operating expenses to be paid by tenants based on reimbursable expenses that would be expected when the property is fully occupied. This way, as actual expenses are incurred by the developer as the property leases up, the developer is receiving funds from tenants "in advance" and will have adequate cash flow today to cover expenses prior to full occupancy.

Question 15-14 Why should corporations have their real estate appraised on a regular basis?

Having the real estate appraised helps the corporation determine whether property is being used at its highest and best use. The results of the appraisals might also be reported to shareholders in a special report or note to the financial statements to reduce the problem of "hidden value".

Question 16-11 What are holdbacks in construction lending? Why is the practice of "holdbacks" used?

Holdbacks are used by construction lenders to be sure that a developer has met all of his or her obligations before all of the funds from the construction loan are given to the developer.

Question 16-10 It is sometimes said that land represents "residual" value. This statement reflects the fact that improvement costs do not vary materially from one location to another whereas rents vary considerably. Hence, land values reflect changes in rents (both up and down) from location to location. Do you agree or disagree?

If improvement costs do not vary significantly between different locations, then the difference in rents may be often attributable to differences in the productivity or suitability of the land for that development and hence the land value becomes the residual value. (Author's note: In recent years there has been more of an awareness that once a development is complete, some of the income may reflect a return on the "business" aspects of the development, e.g. a successful hotel that is a part of a national franchise or a nursing home. Thus, the appraiser must be careful not to attribute this business value to the land.)

Question 19-2 What were the three principal activities of FNMA under its 1954 charter? What is its principal function now?

In 1954, Congress rechartered FNMA, assigning it three separate and distinct activities: (1) enhancement of secondary market operations in federally insured and guaranteed mortgages, (2) management of direct loans previously made and, where necessary, liquidation of properties and mortgages acquired by default, and (3) management of special assistance programs, including support for subsidized mortgage loan programs. Eventually, the investment by life insurance companies in common stocks and bonds grew at the expense of mortgages. Mortgage companies and other originators became concerned because their traditional source of funds from secondary mortgage sales diminished. Industry related associations advocated that FNMA's secondary market operations be expanded to include its principal function today: namely, holding mortgages.

Question 19-10 What is a mortgage swap certificate?

In a mortgage swap, an originator pools mortgages, then swaps them for pass-through mortgage securities issued simultaneously by Fannie Mae or Freddie Mac. Mortgage swap certificates are the securities guaranteed by FNMA and FHLMC.

Question 21-1 What are the general requirements regarding income, investments, and dividends with which a REIT must comply to maintain its qualification to be taxed as a REIT?

In general, at least 75 percent of gross income must be from rents, interest on obligations secured by mortgages, gains from the sale of certain assets, or income attributable to investments in other REITs. At least 75 percent of the value of a REIT's assets must consist of real estate assets, cash, and government securities. A REIT must distribute at least 90 percent of its taxable income to shareholders as a dividend. December 18, 2015 enactment of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) featured significant changes to various real estate investment trust (REIT) rules so that not more than 20% of the assets of a REIT (by value) can consist of securities of one or more TRS for 2018 and later tax years

Question 14-12 What are the benefits and costs of renovation?

In general, renovation can have many benefits, including increasing rents, lowering vacancy, lowering operating expenses and increasing the future property value.

Question 14-4 What causes the marginal rate of return to change over time? How can the marginal rate of return be used to decide when to sell a property?

Increasing rents and increases in the value of the property tend to increase the MRR. Equity buildup from price appreciation and loan repayment, however, tends to lower the MRR. Also, because the depreciation deduction is fixed but rents are rising, the relative amount of tax benefits from depreciation decreases each year. The property should be sold when the marginal rate of return falls below the rate at which funds can be reinvested.

Question 20-15 Why would anyone want to purchase an (F) or (IF) derivative type of investment?

Investors may have different expectations about the change in interest rates. Purchasers of a floater may expect rates to rise and purchasers of an inverse floater may expect rates to fall. An inverse floater also can be used by lenders to hedge a portfolio of adjustable rate mortgage loans that they hold.

Question 17-5 What are the unique risks of land development projects from the developer's and lender's point of view?

Land development can be quite risky for both the developer and the lender, especially when compared to existing projects. During the development period, a developer must be concerned about changing market conditions that subsequently affects the price and rate at which parcels are sold. The cost to develop the site can also be greater than anticipated. Ultimately, the same factors affect the lender's risks because proceeds from the sale of parcels are used to repay the loan. Lenders get paid as lots are sold. As a result, the rate at which lots sell affects the lender's, as well as, the developer's, rate of return. A higher release price might reduce this risk to the lender. However, if the release price is too high, the developer may not have sufficient funds to successfully develop the project.

Question 20-1 What is a mortgage pay-through bond (MPTB)? How does it resemble a mortgage-backed bond (MBB)? How does it differ?

MPTBs are issued against mortgage pools and, like MPTs, cash flows from the pool are passed through to security holders. However, unlike an MPT, this security is a bond and not an undivided equity ownership interest in a mortgage pool. Like the MBB, the MPTB is a debt obligation of the issuer, who retains ownership of the mortgage pool.

Question 15-11 Why has real estate often been a key factor in corporate restructuring?

Many corporations do not understand the value of their real estate holdings, especially based on its highest and best use which could be for a different use than being used by the corporation. Thus, real estate often presents an opportunity for management (or takeover investors) to restructure the way the real estate is used. Excess real estate may be sold as a source of corporate financing.

Question 19-6 What is a mortgage-related security? What are the similarities and differences between mortgage securities and corporate bonds?

Many originators are no longer willing to take the interest rate risk associated with originating loans with funds obtained from deposits and have found a way, through securitization, to raise funds and shift interest rate risk to various classes of investors. Large mortgage originators place mortgages in pools and sell securities of various types, using the mortgages in these pools as collateral. With the aid of investment bankers, large originators can issue securities in small denominations that are purchased by numerous investors. Like corporate bonds, mortgage securities are: underwritten by investment banks, rated by independent bond rating agencies, sold through an underwriting syndicate, and issued with fixed-coupon rates and specific maturities. However, unlike corporate bonds, mortgage securities are "overcollateralized."

Question 15-13 What factors might cause the highest and best use of real estate to change during the course of a typical lease term?

Market conditions can change such that the property and/or the underlying land owned by the corporation is more valuable to someone who wants to use it for a different purpose - e.g. there could be an increase in the demand for office space in an area surrounding a property currently being used for warehouse space.

Question 15-3 Why might the cost of a mortgage loan be greater than the cost of using unsecured corporate debt to finance corporate real estate?

Mortgage loans are typically on a non-recourse basis for real estate income property. This means that the risk of default must be built into the mortgage interest rate. A corporation with a high credit rating may find that it can borrow money at a cheaper rate based on the creditworthiness of the corporation. That is, the corporation may be less risky than a specific property that the company wants to finance.

Question 20-2 Are the overcollateralization requirements the same for mortgage pay-through bonds as for the mortgage-backed bonds?

Most pay-through issues are based on residential pools and, like MBBs, will generally be overcollateralized with (1) more mortgages in the pool than the sum of the securities issued against it or (2) additional collateral in the form of U.S. government bonds or other agency obligations.

Question 15-5 What would cause the rate of return for an investor that purchases real estate and leases it to the corporation to differ from the rate of return earned by the corporation on the incremental investment in owning versus leasing the same property?

One reason these returns might differ is that the corporation may be taxed quite differently than the investor - e.g. they may have very different marginal tax rates. The cost of financing to the investor may also be quite different that that for the corporation.

Question 17-2 What is an option contract? How is it used in land acquisition? What should developers be concerned with when using such options? What contingencies may be included in a land option?

Option contracts are used to reserve a parcel of land so that it will not be sold to someone else, while the developer does preliminary analysis of the site. The developer should be concerned about the price of the option and the length of time until a decision is made. Contingencies might include passing an environmental inspection, being able to get the land rezoned, or receiving any necessary permits for development.

Question 21-5 Explain how an investor in an equity REIT may receive a current dividend, part of which may be tax-deferred.

Part of the dividend paid by a REIT may represent "return of capital." This can occur when the dividends per share exceeds earnings per share.

Question 18-13 Differentiate between public and private syndications? What is an accredited investor? Why is the distinction used?

Private partnerships are exempt from registration requirements of Regulation D of the Securities Act of 1933 which can substantially reduce the costs of setting up a partnership. An accredited investor is one that meets certain criteria that, in general, apply to investors who can afford to invest in the partnership and who should understand the risks associated with the investment. If the securities are sold only to accredited investors, it is not necessary to provide investors with the information otherwise required to obtain an exemption under Regulation D.

Question 15-7 Why is the value of corporate real estate often considered "hidden" from shareholders?

Real estate is shown on the corporation's books at its historical cost less book depreciation. Thus, if the properties owned by the corporation have increased in value rather than decreased, this is not reflected on the company's balance sheet.

Question 15-6 Why might the decision to own rather than lease real estate have an unfavorable effect on the corporation's financial statements?

Real estate may have a lower current return than the typical investment that the corporation makes. Thus, owning the real estate lowers the company's return on assets. If the real estate is highly levered, it can also make the corporation look more risky.

Question 14-8 Why would refinancing be an alternative to sale of the property?

Refinancing would increase financial leverage. Refinancing at a higher loan-to-current-value ratio may provide the investor with additional funds to invest. This, to some extent, is an alternative to a sale of the property. No taxes have to be paid on funds received by additional borrowing, whereas taxes would have to be paid if the property is sold.

Question 14-13 Do you think renovation is more or less risky than a new investment?

Renovation can be more risky because of the uncertainty as to the cost of the renovation. It is often easier to estimate the costs of new construction relative to the costs of renovating an older building that may have hidden structural and environmental problems.

Question 16-7 What do we mean by overage in a retail lease agreement? How might it be calculated?

Retail leases often specify a minimum rent that must be paid by tenants, as well as a percentage rent provision whereby the tenant pays rent based on a percentage of sales revenue once sales revenue exceeds a specified minimum amount. The amount by which the total rent exceeds the minimum rent is referred to as overage rent.

Question 15-12 Why might refinancing be considered an alternative to a sale-leaseback?

Sale and leaseback of real estate is essentially a way to obtain financing. Thus, refinancing the real estate without selling it may accomplish the same objective of raising funds.

Question 16-9 What is sensitivity analysis? How might it be used in real estate development?

Sensitivity analysis is a way of determining how sensitive the expected results of projects are to changes in the underlying assumptions. This is an excellent way of evaluating the riskiness of a real estate development project.

Question 16-1 What are the sources of risk associated with project development?

Sources of risk associated with project development include market risks and project risks. Market risks are the result of unexpected changes in general market conditions affecting the supply and demand for space. Project risks are the result of choosing a specific location to develop a property and the design of the project.

Question 14-9 How can tax law changes create incentives for investors to sell their properties to other investors?

Tax law changes affect the relative benefits of existing versus new investors in the same property. If the tax law becomes less favorable, as it did in 1986, this tends to favor existing investors. If the tax law becomes more favorable, as it did in 1981 when ACRS was passed and depreciable lives were shortened considerably, then new investors tend to be favored. Tax law changes tend to affect the turnover or sale of real estate. It is important to understand these concepts since tax laws are always subject to change and these changes affect the relative risk and return opportunities for new and existing investors.

Question 14-10 How important are taxes in the decision to sell a property?

Taxes are important for a number of reasons. If a property is sold, capital gains tax must usually be paid. This increases the opportunity cost of selling versus keeping the property. Also, tax laws may have changed since the property was purchased. This means that the depreciation deductions available to a new investor might be better or worse than that which the current owner is using. This affects the return that a new investor can get relative to that which the current owner can get by keeping the property.

Question 18-7 What causes the after-tax IRR (ATIRRe) for the general partner to differ from that of the limited partner?

The ATIRRe for the general partner can differ from that of the limited partner due to differences in the way cash flow and taxable income is allocated to each partner as well as differences in their marginal tax rates.

Question 19-4 When did GNMA come into existence? What was its original function? What is its main function now?

The Government National Mortgage Association was created by the Housing and Urban Development Act of 1968. Originally, it was organized to perform three principal functions: (1) management and liquidation of mortgages previously acquired by FNMA; the liquidation of the portfolio acquired from FNMA at the time of its partition comes through regular principal repayments and sales; (2) special assistance lending in support of certain federal subsidized housing programs; GNMA, also known as "Ginnie Mae," is authorized to purchase mortgages, which are originated under various housing programs designed by FHA, to provide housing in areas where it cannot be provided by conventional market lending; and (3) provision of a guarantee for FHA-VA mortgage pools, which would provide a guarantee for mortgage-backed securities. By providing the buyer with a guarantee of timely payment of interest and principal, GNMA was, in essence, guaranteeing monthly payments of interest and principal from amortization. This guarantee enabled originators of FHA and VA mortgages to pool or package mortgages and to issue securities, called pass-through securities, which were collateralized by the mortgages, and were based on the notion of investors buying an undivided security interest in a pool of mortgages with interest and principal passed through to investors as received from borrowers.

Question 18-4 Why is the Internal Revenue Service concerned with how partnership agreements in real estate are structured?

The IRS does not want the allocation of taxable income (or losses) to differ from the allocation of cash flow in an extreme manner such that there is no "substantial economic effect" of the allocations.

Question 18-2 What is the advantage of the limited partnership ownership form for real estate syndications?

The advantage of a limited partnership is that any tax losses can be allocated to the partners to reduce their personal taxable income.

Question 20-3 Name two different ways that MPTBs can be overcollateralized.

The are overcollateralized in two ways: (1) more mortgages in the pool than the sum of the securities issued against it or (2) additional collateral in the form of U.S. government bonds or other agency obligations.

Question 18-8 What is the significance of capital accounts? What causes the balance in a capital account to change each year?

The capital accounts are used to keep track of allocations to each partner of cash flow and taxable income. They increase when the partner is allocated income and decrease if the partner is allocated losses. They also increase when the partner makes a cash contribution to the partnership and decrease when cash is distributed to the partner.

Question 15-2 What factors would tend to make leasing more desirable than owning?

The cost of leasing may be less than the cost of owning the space, especially if the company can not use the tax benefits associated with owning. The company may also be concerned about the effect that owning real estate may have on its income and balance sheets. It may also prefer the flexibility associated with leasing, especially if the company only plans to use the space for a short period of time.

Question 18-11 How do you think the federal income tax policy affects the desirability of investing in real estate partnerships?

The depreciable life for real estate income property has varied considerably over time as federal tax policy has shifted in its desire to encourage investments in real estate. This impacts the ability of investors to invest in properties that can generate losses for tax purposes. One of the benefits of a partnership compared to a corporate structure is the ability to use these tax losses to offset other sources of income to the investor.

Question 17-3 What are some of the physical considerations that a developer should be concerned with when purchasing land? How should such considerations be taken into account when determining the price that should be paid?

The developer should be concerned about the physical characteristics of the land and how this affects the number of parcels that can be developed, as well as, the cost of developing them. Examples of important physical characteristics include the land's size, topography, soil condition, amenities, and accessibility.

Question 14-1 What factors should an investor consider when trying to decide whether to dispose of a property that he has owned for several years?

The factors are based on an incremental, or marginal, return criteria that should be utilized by investors when faced with such decision making. The investor should evaluate the expected future performance of the property and then compare the IRR for holding versus sale of the property. The investor must consider whether the net funds obtained from the sale of the property (after tax and expenses) can be reinvested at a greater rate of return (ATIRR) than the return that would be earned if the property is not sold. Tax laws in effect at the time of purchase/sale of a property. Tax law changes affect the relative benefits of existing versus new investors in the same property.

Question 20-6 Name the four major classes of mortgage-related securities. As an issuer, explain the reasons for choosing one type over another.

The four major classes of mortgage-backed securities are mortgage-backed bonds (MBBs), mortgage pass-through securities (MPTs), mortgage pay-through bonds (MPTBs) and collateralized mortgage obligations (CMOs). The issuer may choose one type over another due to differences in the amount of risk that might be incurred. For example, the issuer retains the prepayment risk on MBBs, whereas the investors incur this risk with MPTs. Also, the issuer may find that there is more of a market for one type of mortgage securities versus another at any given time.

Question 18-9 How does the risk associated with investment in a partnership differ for the general partner versus a limited partner?

The general partner is personally liable for the debts of the partnership whereas the limited partner has "limited liability" like a shareholder in a corporation.

Question 16-6 What is the major concern construction lenders express about the income approach to estimating value? Why do they prefer to use the cost approach when possible? In the latter case, if the developer has owned the land for five years prior to development would the cost approach be more effective? Why or why not?

The income approach usually provides a good indication of the expected value of an income-producing property once construction is complete and it has been leased-up. The projected value should exceed construction costs, if this is not the case, the project is not feasible and the loan should not be made. Assuming that the project is feasible, using the cost approach would provide a more conservative estimate of value, especially if the land has appreciated in value from its original cost to the developer.

Question 18-12 What concerns should an investor in a real estate syndication have regarding general partners?

The investor should be concerned about the general partner's ability to manage the partnership including acquisition and/or development of properties, property management, etc. The investor should also be concerned about whether the general partner is likely to act in the best interest of the limited partner.

Question 20-11 What is the primary distinction between mortgage-related securities backed by residential mortgages and those backed by commercial mortgages?

The key risk with residential mortgage-related securities is prepayment. Default risk is eliminated when the securities are backed by a federal agency. Commercial mortgages on the other hand are not backed by any federal agencies and therefore default risk must be incurred by investors. Prepayment risk is generally not as significant with commercial mortgage backed securities because these loans typically have significant prepayment penalties and "lock-out" provisions.

Question 15-8 How does the analysis of a sale-leaseback differ from the analysis of owning versus leasing?

The main difference is that if the property is already owned, capital gains tax must be paid if the property is sold.

Question 19-7 Name the principal types of mortgage-related securities. What are the difference between them?

The major types of mortgage-backed securities currently in use are: mortgage-backed bonds (MBBs), mortgage pass-through securities (MPTs), mortgage pay-through bonds (MPTBs), collateralized mortgage obligations (CMOs). The major difference between them is whether they are more like bonds where the issuer owns the mortgage pool and pays interest to investors, versus principal and interest flowing directly to the investors.

Question 14-3 What is the marginal rate of return? How is it calculated?

The marginal rate of return is the return gained by holding the property for one additional year. The marginal rate of return considers what the investor could get in the future by keeping the property versus what he could get today by selling the property.

Question 19-12 In general, would a falling rate of market interest cause the price of an MPT security to increase or decrease? Would the increase or decrease be greater if the security was issued at a discount? Would an increase in prepayment be likely or unlikely? Describe with an example.

The market value of an MPT security will increase as the market interest rate fells. An increase or decrease will affect MPTs in the same manner whether they are issued at a discount, a premium or par. As interest rates decrease below the rates of individual mortgages in a pool, borrowers will begin to refinance their loans assuming they are able to secure lower rates. Conversely, as interest rates rise above those of individual mortgages in a pool, borrowers will be less apt to prepay as their ability to secure rates below that of the market diminishes.

Question 20-9 What is the purpose of the accrual tranche? Could a CMO exist without a Z class? What would be the difference between the CMO with and without the accrual class?

The purpose of the accrual tranche is to provide additional cash flow to shorten the maturity of the higher priority tranches. That is, the interest not going to the Z tranche is used as additional principal for the A tranche until it is completely repaid, then the B tranche until it is repaid, etc.

Question 15-4 Why might the riskiness of cash flow from the residual value of the real estate differ from the riskiness of cash flow from the corporation's core business? What would cause these cash flows to be correlated?

The residual value of the real estate depends on factors affecting the supply and demand for space where the property is located. This might be quite different from factors that affect the supply and demand for the products and/or services offered by the corporation.

Question 19-1 What is the secondary mortgage market? List three reasons why it is important.

The secondary mortgage market is the "after" market in which mortgages are sold and resold. The secondary mortgage market is important for the following reasons: (1) it enables mortgage lending companies to sell existing mortgages and thereby replenish funds with funds from which new loans can be originated, (2) it facilitates the geographic flow of funds, and (3) it increases the investing options available to individuals and institutions.

Question 18-3 How can the general partner-syndicator structure the partnership to offer incentives to limited partners?

The syndicator can offer the limited partner a greater proportion of the tax losses and a greater proportion of the cash flow that is available for distribution.

Question 18-6 What are special allocations?

The term "special allocation" refers to allocations of income (losses) in different proportions to the partners. For example, the limited partners may be allocated all of the tax losses but only half of the cash flow.

Question 21-2 What are the two principal types of REITs?

The two principal types of REITs are mortgage and equity.

Question 15-15 What factors would tend to affect the value of a lease?

The value of a lease to the corporate lessor will increase if market rental rates rise above the contract rate in the lease. This means that the corporation is benefiting from the below market rental rate.

Question 15-1 What are the main reasons that corporations may choose to own real estate?

There are a number of reasons a corporation may decide to own (rather than lease) real estate. It may find that owning is less expensive than leasing when considering the cost of leasing and the tax benefits of owning. The corporation may also want to have more control over the real estate than is possible with leasing. It may also feel that owning real estate provides diversification of its asset base.

Question 14-15 In general, what kinds of tax incentives are available for rehabilitation of real estate income property?

There are several tax incentives for rehabilitation. For example, investment tax credits are available for certain rehabilitation expenditures. A property placed in service before 1936 may be eligible for a 10% credit and a building that is a certified historic structure may be eligible for a 20% tax credit. There are also credits available for renovation of low income housing.

Question 14-5 Why might the after-tax internal rate of return on equity (ATIRRe) differ for a new investor versus an existing investor who keeps the property?

This could be due to tax law changes that affect the relative benefits of existing versus new investors in the same property. If the tax law becomes less favorable, as it did in 1986, this tends to favor existing investors. If the tax law becomes more favorable, as it did in 1981 when ACRS was passed and depreciable lives were shortened considerably, then new investors tend to be favored. Tax law changes tend to affect the turnover or sale of real estate. It is important to understand these concepts since tax laws are always subject to change and these changes affect the relative risk and return opportunities for new and existing investors.

Question 14-6 What factors should be considered when deciding whether to renovate a property?

To determine whether a property should be renovated, consider the incremental benefit associated with renovating the property versus not renovating the property

Question 19-3 Name two ways that FNMA currently finances its secondary mortgage operations.

To provide a financial base to operate FNMA, the Charter Act also authorized issuance of nonvoting preferred and common stock for the financing of secondary market operations. Additional funding came from FNMA's issuance of notes and debt instruments.

Question 19-9 What is the function of the optional delivery commitment?

Under the optional delivery, originators pay Fannie Mae a fee for the "right but not the obligation" to sell (deliver) their mortgages to Fannie Mae. Hence, if interest rates increase, originators can sell mortgages to Fannie Mae, but if interest rates fall, they can retain the option to sell mortgages to another party for a better price (or even to renegotiate a price with Fannie Mae).

Question 21-6 What are some important lease provisions which investors should be aware of when analyzing the financial statements of REITs?

When analyzing the financial statements of REITs, investors should consider the effect of lease provisions such as provisions for tenant improvements and free rents, leasing commissions and lease guarantees. The accounting treatment of these provisions can affect the reported FFO for one REIT versus another REIT.

Question 14-7 Why is refinancing often done in conjunction with renovation?

When properties are renovated, the investor often uses that opportunity to refinance the entire property. Thus, the investor may be able to borrow funds in addition to what is needed for the renovation, especially if the investor plans to obtain a new loan on the entire property rather than obtain a second mortgage to cover the renovation costs. The total amount of funds that the investor will be able to borrow is usually based on a percentage of the estimated value of the property after renovation is completed.

Question 14-14 What is meant by the "incremental cost of refinancing?"

When the interest rate is higher on the larger loan amount, the incremental cost of the additional funds borrowed is even higher than the rate on the larger loan. This is due to the fact that the higher rate has to be paid on all the funds borrowed, not just the additional funds. For refinancing to be a profitable strategy, the effective cost of the debt must be less than the unlevered return on the project being refinanced.

Question 18-1 What is the difference between an IRR preference and an IRR lookback?

With an IRR preference the investor receives all additional cash flow from sale (after each party has received capital equal to their initial investment) until they have received a specified IRR. With an IRR lookback the cash flow after each party has received capital equal to their initial investment is split in a predetermined proportion. An IRR preference will always give the investor a return that is equal to or better than what the return would be with an IRR lookback.

Question 14-11 Are tax considerations important in renovation decisions?

Yes. First, the improvements may result in an increased depreciable basis and more tax deductions. Second, there may be tax credits available for renovating the property.

Question 21-3 List and characterize equity REITs based on their property types.

• Industrial/Office: REITs that specialize in owning industrial, office and/or a mix of industrial and office properties. These REITs can be further divided based on the property location in which they invest, such as CBD versus suburban. • Retail: REITs that specialize in owning retail properties. These REITs can be further segregated into retail subcategories, such as neighborhood centers, regional malls, outlet centers, and/or free-standing retail properties. • Residential: REITs that specialize in owning residential properties. These REITs can be further segregated into residential subcategories, such as multi-family apartments, manufactured home communities, student housing and/or military housing. • Lodging/Resorts: REITs that specialize in owning lodging/resorts properties, including hotels, resorts and/or motels. • Health Care: REITs that specialize in owning health care related facilities, including hospitals, senior housing, medical office and/or related health care facilities that are leased back to private health care providers who operate such facilities. • Self-Storage: REITs that specialize in owning self-storage facilities. • Timber: REITs that specialize in owning timberland. • Infrastructure: REITs that specialize in owning various types of infrastructure, including railroads, electric and gas transmission and distribution, cell towers and other forms of infrastructure. • Diversified or Specialty: REITs that own a variety of different product types or property types that are not otherwise classified, such as golf courses, prisons, data centers, etc.