MGMT 170 Midterm

Name the four general real estate investment styles and describe each. Identify three investment strategies within these general categories and give examples of each. CH11

(4) styles: Core, Core Plus, Value Added, Opportunistic Core: Office Properties Trophy Properties Gateway Markets Core Plus: Properties to be re-tenanted Properties needing minor capital improvements Properties to be leveraged Value Added: Properties with excess land to be developed Properties need to have greater amenities (fitness center, restaurant) Properties needing major improvement (eg. parking lot expansion, improving elevators) Opportunistic: Raw land development Distressed assets Loans in default

Why should investors be concerned about market rents if they are purchasing a property subject to leases? CH11

Even if the investment is an existing building that has already been leased, the income can be affected when the existing leases expire and are renewed at the market rent at the time.

What is a buydown loan? What parties are usually involved in this kind of loan? CH6

A buydown loan is a loan that has lower payments than a loan that would be made at the current interest rate. The payments are usually lowered for the first few years of the loan term. The payments are "bought down" by giving the lender funds in advance that equal the present value of the amount by which the payments have been reduced.

What is the relationship between a discount rate and a capitalization rate? CH10

A capitalization rate is equal to the difference between the discount rate and the expected growth in income. In other words, changes in income over the economic life of the property are ignored when using a capitalization rate.

What is a deficiency judgment and how is its value to a lender affected by the Bankruptcy Code? CH2

A deficiency judgment is any deficit remaining after a judicial foreclosure and subsequent sale of a property. Unless the mortgagor owns other real estate, deficiency judgments are unsecured claims and take their place alongside other debts of the mortgagor. Unlike the mortgage from which such judgment springs, the latter gives the holder no right of preference against any of the non-real estate assets of the debtor. Therefore, a holder of a deficiency judgment has the same rights to a debtor's nonexempt assets and is affected by the Bankruptcy Code in the same manner as any holder of an unsecured loan.

Distinguish between a mortgage and a note. CH2

A note admits the debt and generally makes the borrower personally liable for the obligation. A mortgage is usually a separate document which pledges the designated property as security for the debt.

In general, what effect would a reduction in risk have on "going in" cap rates? What would this effect have if it occurred at the same time as an unexpected increase in demand? What would be the effect on property values? CH10

A reduction in risk lowers cap rates because expected returns are lower. If this occurred at a time when demand increases, property values would rise significantly because of increases in rents from greater demand and lower cap rates.

What is the sinking-fund factor? How and why is it used? CH3

A sinking-fund factor is the reciprocal of interest factors for compounding annuities. These factors are used to determine the amount of each payment in a series needed to accumulate a specified sum at a given time. To this end, the specified sum is multiplied by the sinking-fund factor.

When may a "terminal" cap rate be lower than a "going in" cap rate? When may it be higher? CH10

A terminal cap rate may be lower than the going in cap rate if between the present time and end of a holding period interest rates are expected to fall, risk is expected to decline, or demand is expected to increase (thereby producing higher rents and/or appreciation). A higher terminal cap rate would result if the opposite changes in the three situations stated above occurred.

What is meant by a unit of comparison? Why is it important? CH10

A unit of comparison is used in the sales comparison approach to valuation. To the extent that there are differences in size, scale, location, age, and quality of construction between the project being valued and recent sales of comparable properties, adjustments must be made to compensate for such differences. The appraiser must find an appropriate unit of comparison for a given property. Examples are price per square foot for an office building, price per cubic foot for warehouse space, price per bed for hospitals, or price per room for hotels.

Which of the following two ARMs is likely to be priced higher, that is, offered with a higher initial interest rate? ARM A has a margin of 3 percent and is tied to a two-year index with payments adjustable every two years; payments cannot increase by more than 10 percent from the preceding period; the term is 30 years and no assumption or points will be allowed. ARM B has a margin of 3 percent and is tied to a one-year index with payments to be adjusted each year; payments cannot increase by more than 10 percent from the preceding period; the term is 30 years and no assumption or points are allowed. CH5

ARM A is likely to be priced higher, because it has a longer-term index and adjustment period. Subsequently, the lender bears more risk and can expect a higher return.

Why might a wraparound lender provide a wraparound loan at a lower rate than a new first mortgage? CH6

Although the wraparound loan is technically a "second mortgage," the wraparound lender is only required to make payments on the existing mortgage if the borrower makes payments on the wraparound loan. Furthermore, the wraparound lender is typically taking over an existing mortgage that has a below market interest rate. Thus, the wraparound lender is benefiting from the spread between the rate being earned on the wraparound loan and that being paid on the existing loan. This allows the wraparound lender to earn a higher return on the incremental funds being advanced even if the rate on the wraparound loan is less than the rate on a new first mortgage.

Define amortization. CH4

Amortization is the process of loan principal repayment over the loan term. Types of amortization are fully, partially, zero or negative rates of amortization.

Why do adjustable rate mortgages (ARMs) seem to be a more suitable alternative for mortgage lending than PLAMs? CH5

An ARM provides for adjustments that are more timely for lenders than a PLAM because values for r, p, and f are revised at specific time intervals to reflect market expectations of future values for each component of i between adjustments dates.

What is an abstract of title? CH1

An abstract of title is a historical summary of the publicly recorded documents that affect title.

What is a land contract? CH2

An agreement between a buyer and a seller to purchase and sell land. However, passage of title is usually deferred until some future date or deferred until some event or condition occurs (e.g. payment of money, rent, etc.).

What is an annuity? How is it defined? What is the difference between an ordinary annuity and an annuity due? CH3

An annuity is a series of equal deposits or payments. An ordinary annuity assumes payments or receipts occur at the end of a period. An annuity due assumes deposits or payments are made at the beginning of the period.

Why might a borrower be willing to pay a higher price for a home with an assumable loan? Ch6

An assumable loan allows the borrower to save interest costs if the interest rate is lower than the current market interest rate. The investor may be willing to pay a higher price for the home if the additional price paid is less than the present value of the expected interest savings from the assumable loan.

What is a capitalization rate? What are the different ways of arriving at an overall rate to use for an appraisal? CH10

An overall rate or overall capitalization rate is the rate on the overall property (debt and equity). One way of arriving at an overall rate is to use the band of investment approach. This is based on taking into consideration the investment criteria of both the lender and the equity investor involved in a project. This is done by taking a weighted average of the equity dividend rate expected by the investor and the mortgage loan constant (expressed on an annual basis) required by the lender. Two different ways of arriving at an overall rate are the direct capitalization approach and the present value method.

What does assignment mean and why would a lender want to assign a mortgage loan? CH2

Assignment gives the lender the right to sell or exchange a mortgage loan to another party without the approval of the borrower.

What is the difference between base rent and effective rent? CH9

Base rent reflects rent that will be paid per rentable square foot of leased space. It does not include additional items such as tenant improvement costs, expense pass throughs and other costs that are included when calculating effective rents.

What are the major differences between the CAM and CPM loans? What are the advantages to borrowers and risks to lenders for each? What elements do each of the loans have in common? CH4

CPM - Constant Payment Mortgage - This payment pattern simply means that a level, or constant, monthly payment is calculated on an original loan amount at a fixed rate of interest for a given term, at which time the original loan amount or principal is completely repaid and the lender has earned a fixed rate of interest on the monthly loan balance. However, the amount of amortization varies each month. CAM - Constant Amortization Mortgage - Payments on constant amortization mortgages are determined first by computing a constant amount of each monthly payment to be applied to principal. Interest is then computed on the monthly loan balance and added to the monthly amount of amortization to determine the total monthly payment. When both loans are originated at the same rate of interest, the yield to the lender will be the same regardless of when the loans are repaid (i.e. early or at maturity).

How may supply and demand affect a property's projected NOI? CH11

Expected market rents and vacancy rates Expenses associated with operating the property Nature of any leases on the property

What are loan closing costs? How can they be categorized? Which of the categories influence borrowing costs and why? CH4

Closing costs are incurred in many types of real estate financing, including residential property, income property, construction, and land development loans. Categories include: statutory costs, third party charges, and additional finance charges. Closing costs that do affect the cost of borrowing are additional finance charges levied by the lender. These charges constitute additional income to the lender and as a result must be included as a part of the cost of borrowing. Lenders refer to these additional charges as loan fees.

What types of expenses would property owners pay when operating and maintaining common areas? Give examples for office, retail, and warehouse properties. CH9

Common area are for the benefit of all tenants. An example for office properties would be the lobby area. For retail properties a good example is enclosed malls where all the area not occupied by the store itself is common area to allow pedestrians to walk from store to store and use for special events. Warehouse properties might have a loading dock that is shared by all tenants. All of these property types might have parking as a common area. The tenants would often pay a pro-rata portion of the operating expenses related to these common areas such as property taxes, insurance, utilities and maintenance.

How are the interest factors in Exhibit 3-3 developed? How may financial calculators be used to calculate interest factors in Exhibit 3-3? CH3

Computed from the general formula for monthly compounding for various combinations of "i" and years. FV = PV x (1+i)n. Calculators can be used by entering $1 for PV, the desired values for n and i and solving for FV.

What does default mean? Does it occur only when borrowers fail to make scheduled loan payments? CH2

Default means that the borrower has failed to (1) make scheduled loan payments or (2) violated any other provision in the note or mortgage.

How must one discount a series of uneven receipts to find PV? CH3

Each periodic cash receipt or payment must be discounted individually then summed to obtain present value. That is: PV= CF1 ÷ (1 + i)1 + CF2 ÷ (1+ i)2 ....+ CFn ÷ (1 + i)n where CF is cash inflow and i equals the discount rate.

What is meant by an estate? Why are estates important in real estate finance? CH1

Estate is used to denote a possessory or potentially possessory interest in real estate. However, not all interests in real property are estates. Ownership can be quite different from possession and a variety of legal factors affect the ownership rights associated with real estate. The economic benefits expected by lenders, investors, and other parties in real estate transactions are affected by these legal factors.

mortgage loan is made to Mr. Jones for $30,000 at 10 percent interest for 20 years. If Mr. Jones has a choice between a CPM and a CAM, which one would result in his paying a greater amount of total interest over the life of the mortgage? Would one of these mortgages be likely to have a higher interest rate than the other? CH4

Explain your answer. A CPM loan reduces the principal balance more slowly. As a result, if Mr. Jones chooses a CPM, he will pay a greater amount of interest over the life of the loan. The initial monthly payments for a CPM are considerably less than those of a CAM. Because of lower initial payments with a CPM, this would reduce borrower default risk associated with a CPM loan. Additionally, lenders receive a greater portion of their return (interest earned) early with a CPM. By decreasing default risk, a CPM may have a lower rate of interest than a CAM.

Name possible mortgageable interests in real estate and comment on their risk as collateral to lenders. CH2

Fee simple estates, life estates, estates for years, remainders, reversions, leasehold interests, and options. Fee Simple estate - represents the most complete form of ownership of real estate. The holder is free to divide, sell, lease, or borrow against it as he/she wishes. Little risk to lenders because the owner completely owns all rights to the real estate. Life estate - is a freehold estate that lasts only as long as the life of the owner of the estate or the life of some other person. Because of the uncertainty surrounding the duration of the life estate, its marketability and value as collateral are severely limited. Remainder - exists when the grantor of a present estate conveys to a third person the interest that his/her heirs would otherwise have in the property upon the grantor's death. Reversion - exists when the holder of an estate (the grantor) conveys to another person (the grantee) a present estate in the property and retains for himself/herself or his/her heirs the right to get back, at some time in the future, the full estate which he/she enjoyed before the conveyance.

Under what conditions should financing be explicitly considered when estimating the value of a property? CH10

Financing should be explicitly considered when using the mortgage-equity capitalization method. With this method, the value of a property can be estimated by explicitly taking into consideration the requirements of the mortgage lender and equity investor, hence the term "mortgage-equity capitalization".

What are forward rates of interest? How are they determined? What do they have to do with indexes used to adjust ARM payments? CH5

Forward rates are based on future interest rate expectations that are implicit in the yield curve and reveal investor expectations of interest rates between any two maturity periods on the yield curve. For example, the yield for a security maturing one year from now is 8 percent, and the yield for a security that matures two years from now is 9 percent. Based on these two yields, we can compute a forward rate, or rate that an investor who invests in a one- year security can expect to reinvest funds for one additional year. This forward rate will be 10 percent because if investors have the opportunity to invest today in either the one- or the two-year security and are indifferent between the two choices, the investor buying a one-year security must be able to earn 10 percent on funds available for reinvestment at the end of year 1. This information is important and represents a reference point that may help lenders and borrowers when pricing ARMs and calculating expected yields at the time ARMs are made. Additionally, interest rate series, which may include forward rates of interest, comprise the indexes used to adjust ARMs. This is especially true if an index is long term in nature.

Name the three general methods of title assurance and briefly describe each. Which would you recommend to a friend purchasing a home? Why? CH1

General Warranty Deed - the grantor warrants that the title he/she conveys to the property is free and clear of all encumbrances, other than those that are specifically listed in the deed. Special Warranty Deed - makes the same warranties as a general warranty deed except that it limits their application to defects and encumbrances which occurred only while the grantor held title to the property. Quitclaim Deed - offers the grantee the least protection in that it simply conveys to the grantee whatever rights, interests, and title that the grantor may have in the property. No warranties are made about the nature of these rights and interests or of the quality of the grantor's title to the property. Would recommend the General Warranty Deed, because it offers the most comprehensive warranties about the quality of the title.

What does deficiency judgment mean? CH2

If a default occurs leading to a judicial foreclosure and the property is sold, and if the dollars from the sale are not enough to pay off the loan balance, the borrower is personally liable for the difference.

Assuming the borrower is in no danger of default, under what conditions might a lender be willing to accept a lesser amount from a borrower than the outstanding balance of a loan and still consider the loan paid in full? CH6

If interest rates have risen significantly, the market value of the loan will be less. Thus, the lender may be willing to accept less than the outstanding balance of the loan, especially if the lender still receives more than the market value of the loan. The lender can then make a new loan at the higher market interest rate.

Why do you think appraisers usually use three different approaches when estimating value? CH10

If perfect information was available, then theoretically the same value should result regardless of the methods chosen, be it cost, market, or income capitalization. Even with imperfect information, there should be some correspondence between the three approaches to value, which is the reason appraisal reports will typically contain estimates of value based on at least two approaches to determining value.

When might a borrower want to have another party assume his liability under a mortgage loan? CH2

If the loan was made with a favorable interest rate, the seller of the property may want to include this low rate loan as an additional incentive to sell the property.

Explain the difference between a buyer assuming the mortgage and taking title "subject to" the mortgage. CH2

If the purchaser acquires the property "subject to" the existing debt, he does not acquire any personal liability for the debt. When a mortgage is assumed the original borrower may be released from any obligations to the lender.

An expected inflation premium is said to be part of the interest rate, what does this mean? CH4

In general, the nominal interest rates for a specified period (say 10 years) is said to be a composite of three things; (a) real return-such as the growth rate in real GDP (underlying economic growth in the economy, (b) expected inflation , and (c) premium for risk. For example, if a lender quotes a 6% rate on a mortgage loan at a time when 10 year U.S. government bonds are yielding 3.6%, then the risk premium would be 2.4%. If at that same time growth in real GDP is 2.0% and is expected to continue at that rate for 10 years, then expected inflation can be estimated to be 1.6% (or 6%-2.4%-2.0% = 1.6%). Alternatively, if 10 year U.S. Government Bonds that are indexed for inflation (TIPs) are currently yielding 2.0% and 10 year Treasuries not indexed for inflation are yielding 3.6%, the difference, or 3.6%-2.0%, or 1.6% is an estimate of expected inflation.

What factors would result in a property increasing in value over a holding period? CH11

Inflation: This causes rents as well as the final sale price to be higher. Demand: Increased demand for space may increase value if the supply of space doesn't increase as well.

List each of the main terms likely to be negotiated in an ARM. What does pricing an ARM using these terms mean? CH5

Initial interest rate, index, adjustment interval, margin, composite rate, interest rate caps, negative amortization, floors, assumability, discount points, prepayment privilege. Anytime the process of risk bearing is analyzed, individual borrowers and lenders differ in the degree to which they are willing to assume risk. Consequently, the market for ARMs contains a large set of mortgage instruments that differ with respect to how risk is to be shared between borrowers and lenders. The terms listed above are features that might be used in pricing an ARM and establishing the bearing of risk.

What is the difference between interest rate risk and default risk? How do combinations of terms in ARMs affect the allocation of risk between borrowers and lenders? CH5

Interest rate risk is the risk that the interest rate will change at some time during the life of the loan. Default risk is the risk to the lender that the borrower will not carry out the full terms of the loan agreement. The fact that ARMs shift all or part of the interest rate risk to the borrower means that the risk of default will generally increase to the lender, thereby reducing some of the benefits gained from shifting interest rate risk to borrowers.

What is an tenant estoppel? Why is it used? Ch9

It is a legal document used in many circumstances. In real estate, it is used by prospective investors to determine factual information about existing tenants, such as the amount of any rent owed, improvements promised by the current owners, etc.

What is the significance of a debt coverage ratio? CH11

It is a ratio of the NOI to the mortgage payment that indicates the riskiness of a loan. It is the degree to which the NOI from the property is expected to exceed the mortgage payment. Lenders typically want a debt coverage ratio (DCR) to be at least 1.2.

What is meant by judicial foreclosure of a mortgage, and what alternatives are there to such action? CH2

Judicial foreclosure involves the sale of real property by the courts to satisfy the unpaid debt that is secured by the mortgage. Alternatives: 1. Restructuring the mortgage loan 2. Transfer of the mortgage to a new owner 3. Voluntary conveyance of the title to the mortgagee 4. A "friendly" foreclosure 5. A prepackaged bankruptcy

How does the use of leases shift the risk of rising operating expenses from the Lessor to the Lessee? CH9

Leases determine how much risk will be borne by the lessor versus the lessee. Future increases in market rent might be compensated for by including an inflationary adjustment, such as a CPI adjustment. In the case of a CPI adjustment, the risk is shifted to the lessee, because the change in rents is not known in advance. If the lessee is responsible for any unexpected increases in the level of inflation, the lessor is insured that the real value of the lease will be preserved. The lessor can shift additional risk to the lessee by including net lease or expense stop provisions in the lease. It is important to note, however, that we would expect the lessor to accept a lower base rent as the burden of risk from inflation and property expense costs are shifted to the lessee.

Why do lenders charge origination fees, especially loan discount fees? CH4

Lenders usually charge these costs to borrowers when the loan is made, or "closed", rather than charging higher interest rates. They do this because if the loan is repaid soon after closing, the additional interest earned by the lender as of the repayment date may not be enough to offset the fixed costs of loan origination.

What is meant by "loss to lease"? CH9

Many leases reflect market conditions and rents that existed when the lease was executed. Many financial statements estimate gross rental revenue based on (1) all rental space re-leased today at prevailing rents and compare that amount to (2) actual rental revenue based on leases that have been executed at various times in the past. The difference between (1) and (2) is "loss to lease", or the difference between current market rents and rents actually collected based on lease terms with each tenant.

How can mechanics' liens achieve priority over first mortgages that were recorded prior to the mechanics' lien? CH2

Mechanics' liens are permitted to be recorded after the fact. State laws generally give contractors, laborers, or suppliers of materials a certain period of time following the completion of work or delivery of materials during which to file their lien. When the lien is filed it relates back and takes priority over all liens filed after the time when materials were first delivered or work was first performed on real estate.

How do inflationary expectations influence interest rates on mortgage loans? CH5

Most savings institutions had been making constant payment mortgage loans with relatively long maturities, and the yields on those mortgages did not keep pace with the cost of deposits. These problems prompted savings institutions (lenders) to change the mortgage instruments to now make more mortgages with adjustable interest rate features that will allow adjustments in both interest rates and payments so that the yields on mortgage assets will change in relation to the cost of deposits.

What is negative amortization? CH4

Negative amortization means that the loan balance increases over time because payments are less than the interest due.

What are the motivations for investing in real estate income property? CH11

Net Income: Dollars left over after collecting rent and paying expenses but before considering taxes and financing costs. Property Sale: Expecting a price increase over a specified holding period increases investor return. Diversification: Reduces overall risk to hold many types of investments. Tax Benefits: Preferential tax benefits. Taxable income is often less than before-tax cash flow.

In the absence of loan fees, does repaying a loan early ever affect the actual or true interest cost to the borrower? CH4

No, the effective interest rate will equal the contract rate of interest.

Can borrowers pay off part or all of a loan anytime that they desire? CH2

No. In general, prepayment is a privilege not a right. In cases of residential/consumer loans made by federally related lenders, this option is usually provided to borrowers. In commercial real estate loans it is usually not.

Is a cap rate the same as an IRR? Which is generally greater? Why? CH10

No. The cap rate is the relationship between the current NOI and present value. The IRR is the return on all future cash flows from the operation and sale of the property. Usually the IRR is greater than the cap rate.

How does the price level adjusted mortgage (PLAM) address the problem of uncertainty in inflationary expectations? What are some of the practical limitations in implementing a PLAM program? CH5

One concept that has been discussed as a remedy to the imbalance problems for savings institutions is the price level adjusted mortgage (PLAM). To help reduce interest rate risk, or the uncertainty of inflation and its effect on interest rates, it has been suggested that lenders should originate mortgages at interest rates that reflect expectations of the real interest rate plus a risk premium for the likelihood of loss due to default on a given mortgage loan. Should prices of other goods, represented in the CPI increase faster than housing prices, indexing loan balances to the CPI could result in loan balances increasing faster than property values. If this occurred, borrowers would have an incentive to default. A second problem with PLAMs has to do with the relationship between mortgage payments and borrower incomes. Should inflation increase sharply, it is not likely that borrower incomes would increase at the same rate in the short run. During short periods, the payment burden may increase, and households may find it more difficult to make mortgage payments. A third problem with PLAMs is that the price level chosen for indexation is usually measured on a historical basis. In other words, the index is based on data collected in the previous period but published currently.

What is partial amortization? CH4

Partial amortization occurs when payments exceed the accrued interest due but not by enough to reduce the amount owed to zero at maturity.

What are pass through expenses, recoverable expenses and common area expenses? Give examples of each CH9

Pass throughs are expenses such as electricity, insurance, and property taxes that are billed directly to tenants on the basis of the rentable area that they occupy. Recoverables are expenses incurred by owners for specific expenses identified in a lease such as security, maintenance, utilities, etc. and are pro-rated and billed to tenants. Common areas include mall open areas, parking areas, lobbies, and hallways. Expenses related to these areas are referred to as common area expenses.

What are some of the potential problems with using a "going in" capitalization rate that is obtained from previous property sales transactions to value a property being offered for sale today? CH10

Problems occur if properties being used as "comparables" have different lease terms, maturities, and credit quality of tenants. Further, if properties are older, have depreciated, have different functional design, etc. than the subject, problems can occur. In these cases cap rates must be either adjusted to reflect these differences or not used at all.

What is meant by a "purchase money" mortgage loan? When could a loan not be a purchase money mortgage? CH2

Purchase money means funds from the loan will be used to purchase a property. It will not provide funds for other uses such as could be the case with a refinancing.

What is the difference between real property and personal property? CH1

Real property refers to the ownership rights associated with realty. Realty refers to land and all things permanently attached. Personal property refers to ownership rights associated with personalty. Personalty are all things, tangible and intangible, that are movable. This includes all things that are not realty.

What does it mean when a lender accelerates on a note? What is meant by forbearance? CH2

The acceleration clause gives the lender the right or option to demand the loan balance owed if a default occurs. Forbearance by the lender allows the borrower time to cure a deficiency without the lender giving up the right to foreclose at a future time.

What is the accrual rate and payment rate on a mortgage loan? CH4

The accrual rate is usually the nominal rate divided by the number of periods within a year that will be used to calculate interest. For example, if interest is to be accrued monthly, the nominal rate is divided by 12; if daily, the nominal rate is divided by 365. The payment rate, or "pay rate", is the % of the loan to be paid at time intervals specified in the loan agreement. This rate is used to calculate payments which are usually made monthly (but could be quarterly, semi-annual, etc.) If the pay rate exceeds the accrual rate, this indicates that some loan repayment (amortization) is occurring. When it is equal to the accrual rate, amortization is not occurring. If the accrual rate is lower than the interest rate there will be negative amortization.

What does non-recourse financing mean? CH2

The borrower is not personally liable on the note. The lender may look only to the property (security) to satisfy the loan in the event of a default.

What are the primary considerations that should be made when refinancing? CH6

The borrower must determine whether the present value of the savings in monthly payments is greater than the refinancing costs (points, origination fees, costs of (1) appraisal, (2) credit reports, (3) survey, (4) title insurance, (5) closing fees, etc.

What is the essential concept in understanding compound interest? CH 3

The concept of earning interest on interest is the essential idea that must be understood in the compounding process and is the cornerstone of all financial tables and concepts in the mathematics of finance.

How does discounting, as used in determining present value, relate to compounding, as used in determining future value? How would present value ever be used? CH3

The discounting process is a process that is the opposite of compounding. To find the present value of any investment is simply to compound in a "reverse" sense. This is done by taking the reciprocal of the interest factor for the compound value of $1 at the interest rate, multiplying it by the future value of the investment to find its present value. Present value is used to find how much should be paid for a particular investment with a certain future value at a given interest rate.

What is the equity dividend rate? CH11

The equity dividend rate relates the BTCF (or equity dividend) in the first year to the initial equity investment. It is not a measure of investment yield because it does not take into account future income from operations or resale of the property at the end of the holding period. It is based on a single year, usually the first year.

What is the difference between the equity of redemption and statutory redemption? CH2

The equity of redemption is the right of a mortgagor to redeem his/her property from default during the period from the time of default until foreclosure proceedings are begun. Statutory redemption is the right to redeem after foreclosure.

Under what conditions might a home with an assumable loan sell for more than comparable homes with no assumable loans available? CH6

The home with an assumable loan might be expected to sell for more than comparable homes with no assumable loans available when the contract interest rate on the assumable loan is significantly less than the current market rate on a loan with similar maturity and similar loan-to-value ratio. Note that if the dollar amount of the assumable loan is significantly less than that which could be obtained with a market rate loan, the benefit of the assumable loan is diminished because the borrower may need to make up the difference with a second mortgage.

Is the incremental cost of borrowing additional funds affected significantly by early repayment of the loan? CH6

The incremental cost of borrowing additional funds can be affected significantly by early repayment of the loan, especially if additional points were paid to obtain the additional funds. Thus, the borrower should consider how long he or she expects to have the loan when calculating the incremental cost of the additional funds.

What is meant by the incremental cost of borrowing additional funds? CH6

The incremental cost of borrowing funds is a measure of what it really costs to obtain additional funds by getting a loan with a higher loan-to-value ratio that has a higher interest rate. This measure is important because the contract interest rate on the loan with the higher loan-to-value ratio does not take into consideration the fact that this higher rate must be paid on the entire loan - not just the additional funds borrowed. Thus, the borrower should consider the incremental cost of the additional funds to know what it is really costing to borrow the additional funds.

If an ARM is priced with an initial interest rate of 8 percent and a margin of 2 percent (when the ARM index is also 8 percent at origination) and a fixed rate mortgage with constant payment is available at 11 percent, what does this imply about inflation and the forward rates in the yield curve at the time of origination? What is implied if a fixed rate mortgage were available at 10 percent? 12 percent? CH5

The initial interest rate and expected yield for all ARMs should be lower than that of a fixed rate mortgage on the day of origination. The extent which the initial rate and expected yield on an ARM will be lower than that on a fixed rate mortgage or another ARM, depends on the terms relative to payments, caps, etc. One would expect the difference between interest rates at the point if origination to reflect expectations of inflation and forward rates as well. As a fixed rate mortgage's interest rate increases from 11 percent to 10 percent and 12 percent, greater inflation and/or greater uncertainty with respect to inflation is implied.

What is an internal rate of return (IRR)? How is it used? How does it relate to the concept of compound interest? CH3

The internal rate of return integrates the concepts of compounding and present value. It represents a way of measuring a return on investment over the entire investment period, expressed as a compound rate of interest. It tells the investor what compound interest rate the return on an investment being considered is equivalent to.

What is meant by equity? CH11

The investor's initial equity in the project is equal to the purchase price less the amount borrowed. The amount of equity an investor has in a property may change over time if the property value and loan balance changes (e.g. if the property value increases and the loan balance is reduced through amortization, the investor's equity increases).

What special advantages does a mortgagee have in bidding at the foreclosure sale where the mortgagee is the foreclosing party? How much will the mortgagee normally bid at the sale? CH2

The mortgagee can use its claims as a medium of exchange in the purchase, except for costs, which must be paid in cash. Others must pay cash for their purchases or by obtaining a new loan. Lenders will normally bid the full amount of their claim only where it is less than or equal to the market value of the security, less foreclosure, resale, and holding costs.

Is a foreclosure sale sometimes desirable or even necessary when the mortgagor is willing to give a voluntary deed? CH2

The mortgagee may find it necessary to foreclose instead of taking a voluntary conveyance, because the title conveyed is subject to junior liens. Foreclosure provides the mortgagee with a lawful method of becoming free from the liens of junior claimants.

What dangers are encountered by mortgagees and unreleased mortgagors when property is sold "subject to" a mortgage? CH2

The mortgagor will be responsible if the person acquiring the property subject to the mortgage defaults. In turn, if the original mortgagor then defaults, the bank will have to foreclose on the property which may not be worth what is left to pay on the mortgage.

How can a leased fee estate have a value that could be transferred to another party? CH1

The original fee owner can give up some property rights to a lessee. The value of the leased fee estate will depend on the amount of lease payments expected during the term of the lease plus the value of the property when the lease terminates and the original owner receives the reversionary interest.

What factors must be considered when deciding whether to refinance a loan after interest rates have declined? CH6

The payment savings resulting from the lower interest rate must be weighed against the costs associated with refinancing such as points on the new loan or prepayment penalties on the loan being refinanced.

What are the risks to the lender if a borrower declares bankruptcy? CH2

The probability of default or bankruptcy by a borrower and the legal alternatives available to each party affect the expected return to a lender from the loan. Lenders may find that their security is tied up for years during the reorganization of the debtor's financial affairs and that they are unable to foreclose on their liens where such a foreclosure would interfere with the debtor's plan of reorganization. Lastly, lenders may not be able to accelerate balances or raise interest rates because borrowers have the right to cure default in bankruptcy and reinstate the mortgage.

What is the economic rationale for the cost approach? Under what conditions would the cost approach tend to give the best value estimate? CH10

The rationale for using the cost approach to valuing (appraising) properties is that any informed buyer of real estate would not pay more for a property than what it would cost to buy the land and build the structure. The cost approach is most reliable where the structure is relatively new and depreciation does not present serious complications.

Why do the monthly payments in the beginning months of a CPM loan contain a higher proportion of interest than principal repayment? CH4

The reason for such a high interest component in each monthly payment is that the lender earns an annual percentage return on the outstanding monthly loan balance. Because the loan is being repaid over a long period of time, the loan balance is reduced only very slightly at first and monthly interest charges are correspondingly high.

Why might the market value of a loan differ from its outstanding principal balance? CH6

The remaining principal balance of a loan depends on the original contract interest rate, whereas the market value of the loan depends on the current market interest rate.

What is the economic rationale for the sales comparison approach? What information is necessary to use this approach? What does it mean for a property to be comparable? Ch10

The sales comparison approach to valuation is based on data provided from recent sales of properties highly comparable to the property being appraised. For a property to be comparable, the sale must be an "arm's-length" transaction or a sale between unrelated individuals. Sales should represent normal market transactions with no unusual circumstances, such as foreclosure, sales involving public entities, and so on.

Discuss the differences between using (1) a terminal cap rate and (2) an appreciation rate in property value when estimating reversion values. CH10

The terminal cap rate approach to estimating a reversion value is based on the assumption that in the year of sale, investors will value the property based on the new "going in" cap rate at the time. Estimates of the terminal cap rate are made by adjusting the current or going in cap rate to reflect any depreciation that is likely to occur over the holding period. A risk premium may also be added because the cap rate is being applied to NOI several years in the future which is less certain than the current NOI that a going in cap rate would be applied to. Using a rate of appreciation to estimate the reversion value is based on the investor's expectation as to trends in property values. This could be a reflection of risk, expected cash flows, interest rates, and returns on other investments such as stocks and bonds.

What is meant by depreciation for the cost approach? CH10

There are three categories of depreciation for the cost approach. They are very difficult to determine and, in many cases, require the judgment of appraisers who specialize in such problems. The three categories are as follows: Physical deterioration. Functional or structural obsolescence due to the availability of more efficient layout designs and technological changes that reduce operating costs. External obsolescence that may result from changes outside of the property such as excessive traffic, noise, or pollution.

How do you think expense stops and CPI adjustments in leases affect the riskiness of the lease from the lessor's point of view? Ch11

There is less risk for the lessor with expense stops and CPI adjustments in leases. CPI Adjustments: The risk of unexpected inflation is shifted to the lessee. Expense Stops: The risk of increases in expenses is shifted to the lessee while allowing the lessor to retain the benefit of any decrease in expenses.

What are CAM charges? CH9

These are expenses related to common area maintenance of hallways, lobbies, etc. that are usually prorated and passed on to tenants.

In the previous chapter, significant problems regarding the ability of borrowers to meet mortgage payments and the evolution of fixed interest rate mortgages with various payment patterns were discussed. Why didn't this evolution address problems faced by lenders? What have lenders done in recent years to overcome these problems? CH5

These inadequacies stem from the fact that although payment patterns can be altered to suit borrowers as expectations change, the CPM, CAM, and GPM are all originated in fixed interest rates and all have predetermined payment patterns. Neither the interest rate nor the payment patterns will change, regardless of economic conditions. A variety of mortgages are now made with either adjustable interest rates or with variable payment provisions that change with economic conditions.

What is the effective borrowing cost (rate)? CH4

This differs from the contract rate because it includes financing fees (points, origination). It differs from the APR because the latter is calculated assuming that the loan is repaid at maturity. When calculating the effective cost, the expected repayment or payoff date must be used. The latter is usually sooner than the maturity date.

What is meant by the "nominal rate" on a mortgage loan? CH4

This rate is usually quoted as an annual rate, however the time intervals used to accrue interest is generally not quoted explicitly. Further, the rate generally does not specify the extent of any origination fees and/or discount points.

What does the time value of money mean? CH3

Time value simply means that if an investor is offered the choice between receiving $1 today or receiving $1 in the future, the proper choice will always be to receive the $1 today, because that $1 can be invested in some opportunity that will earn interest. Present value introduces the problem of knowing the future cash receipts for an investment and trying to determine how much should be paid for the investment at present. When determining how much should be paid today for an investment that is expected to produce income in the future, we must apply an adjustment called discounting to income received in the future to reflect the time value of money.

What is the connection between the Truth-in-Lending Act and the annual percentage rate (APR)? CH4

Truth-in-Lending Act: The lender must disclose to the borrower the annual percentage rate being charged on the loan. The APR reflects origination fees and discount points and treats them as additional income or yield to the lender regardless of what costs the fees are intended to cover. The APR is always calculated assuming that the loan is repaid at maturity.

What is meant by usable vs. rentable space? CH9

Usable space is the area actually occupied by the tenant. Rentable space is usable space plus a share of common area in a property which is included in the load factor.

If investors buy properties based on expected future benefits, what is the rationale for appraising a property without making any income or resale price projections? CH10

Using the direct capitalization approach, this technique is a very simple approach to the valuation of income producing property. The rationale is based on the idea that at any given point in time, the current NOI produced by a property is related to its current market value. A survey of other transactions including sales prices and NOI (NOI ÷ sales prices) indicates the cap rate that competitive investments have traded for. This survey provides cap rates that indicate what investors are currently paying relative to current income being produced. A parallel in equity securities markets would be earnings yield (or earnings per share ÷ price) or price earnings multiples (Price ÷ earnings per share).

When estimating the reversion value in the year of sale, why is the terminal cap rate applied to NOI for the year after the holding period? CH10

When we sell a property the price paid by the next investor is an assessment of income for his expected period of ownership. Therefore, for the next investor, or potential buyer, the NOI for his first year of ownership will be the year after we sell the property. This will be the first year of his investment.

What general rule can be developed concerning maximum values and compounding intervals within a year? What is an equivalent annual yield? CH3

Whenever the nominal annual interest rates offered on two investments are equal, the investment with the more frequent compounding interval within the year will always result in a higher effective annual yield. An equivalent annual yield is a single, annualized discount rate that captures the effects of compounding (and if applicable, interest rate changes).

Would it be legal for you to give a quitclaim deed for the Statue of Liberty to your friend? CH1

Yes, the quitclaim deed simply says that the grantor "quits" whatever claim he has in the property (which may well be none) in favor of the grantee.