Chapter Six

1. Chapter Six Real estate lending

2. Learning objectives • Explain what real estate loans are • Explain how real estate loans are evaluated • Explain, with the help of specimen real estate loan applications, how the principles of lending are applied in practice • Enumerate the precautions to be taken in assessing these types of loan applications • Outline the trends in real estate credit • Explain the pricing aspect of real estate loans

3. Introduction • Real estate lending can be defined as loans that are made for: • The purchase of a home, or • To fund improvements to a private residential block • Also known as residential mortgages • Generally for longer terms, i.e. 10– 30 years

4. Evaluating real estate loan applications • Some basic terms need to be understood in real estate lending: • Property: Anything that is owned or controlled, e.g. land, furniture, clothing, etc. • Real Estate: Earth, land and man-made hereditaments (items that can be inherited)

5. Interest in Real Estate: • Freehold: Fee Simple Interest, Joint Tenancy and Tenancy in Common • Leasehold: Lessor and Lessee contract • Encumbrances and Liens: • Encumbrance: Party, other than owner, has interest in the property, e.g. utilities • Liens: Party, other than owner, has financial interest in the property, e.g. debt security

6. Promissory Note and Mortgage: • All real estate borrowers sign a promissory note specifying repayment details • Mortgage creates an enforceable lien over the property backed by a promissory note

7. Title Deeds: • On the sale of real estate, title is transferred on a written deed • Titles can be in the form of be common law, Torrens, Company, Strata and Community • Public Records: Any interest held in real estate is on public record to inform interested parties that the lend is owned and by whom

8. Valuation of property • Loan features: • Loan-to-Value (LVR) not to exceed 80% without mortgage insurance • Valuation only conducted by approved valuers • Three traditional approaches • Market Value Approach • Cost Approach • Income Capitalisation Approach

9. Market Value Approach • Very popular method based on recent sale values of comparable properties • Potential problems • May have limited comparability • House’s condition may vary considerably • Quality of foundations may differ greatly • Sale reflects historical trends and may be inaccurate for current market conditions • Are any special features apparent, e.g. on sacred site or other sentimental value?

10. Cost (Summation) Approach • Step 1 – Value of land alone is assessed using recent property sales • Step 2 – Adds value of all improvements • Step 3 – Subtracts allowance for depreciation, wear-and-tear, etc. • Step 4 – Adjustments for any other matters, e.g. desirability of location • May be disputes over costs used

11. Capitalisation Approach • Uses ratio of rental income from comparable properties and adjusted for any specific differences/characteristics • Relies on net income (gross income minus expenses) to determine yield • Also known as ‘years purchase method’ or ‘net income multiplier method’

12. Step-by-step evaluation of home loans • Five steps involved: • Step 1 – Applicant completes prescribed form including privacy waiver. • Step 2 – Determine loan eligibility and serviceability, arrange valuation and determine interest rate, fees, caps, etc. • Step 3 – If loan approved, send loan offer document to borrower. If loan declined, use bank’s standard letter due to possible legal implications.

13. Step 4 – If applicant proceeds, gather all legal and title details from applicant’s solicitor and other institution if refinancing involved. Applicant must sign mortgage documents in presence of authorised bank officer. • Step 5 – Arrange settlement of loan transaction with applicant’s solicitor. Debit stamp duty and other fees/charges/taxes from nominated mortgage account.

14. Financial appraisal of real estate loans • Can applicant comfortably service loan repayments on their income? • Three factors in loan instalments • Amount of loan • Period of loan • Applicable interest rate (sometimes with sensitivity analysis)

15. Example of a real estate loan application • Sourced from www.commbank.com.au • Details requested by lender include: • Purpose of loan, i.e. owner-occupied or investment • Property details, i.e. address, price, access for valuation, contractor/builder, etc. • Type of loan requested, repayment options, whether mortgage insurance required and proposed insurance

16. Applicant’s personal details including name, address and financial position • Legal elements including purchaser’s solicitor/conveyancing firm, and validity of property's title. Important to note that this document does not constitute an offer to lend • Applicant’s gross monthly income, LVR, mortgage insurance (if any) • Lender’s decision about loan completed

17. Precautions in granting real estate loans • The following are some precautions that the lender should consider: • Accurate factual information such as valuation, dimensions of land, title, etc. • Information about recent local sales • Vendor has proper title to transfer • For new housing, permissions granted from council, water authorities, electricity, telephone and determining suitability of site for construction

18. Verifying that applicant has not withheld information such as health or employment (although may be difficult to obtain) • Despite lender’s best efforts, default may be possible from problems with health, injury, employment, family disputes, etc. • Ensuring loan officer has complied with the many complex lending procedures • Ensuring loan officers are aware of all lending policy changes

19. Trends in real estate credit • High borrowings from low interest rate environment • Mortgage originators have seized significant market share • Considerable pressure has been placed on interest rate margins • Greater emphasis on fee income

20. Pricing and structuring of real estate loans – loan pricing • Loan Pricing • Loan pricing refers to the: • Interest rates • Fees • Other terms imposed by the lender • Greatly affected by the sources and costs of funds and any capital charges required • Lender borrows from surplus units (those with savings to lend) to deficit units (those seeking to borrow funds)

21. Traditional loan pricing method

22. Calculation of interest on loans • Fixed: Generally set for 1–5 years though increases lender’s risk • Floating: Generally altered at bank’s discretion in line with Official Interest Rates

23. Bank fees • Bank’s shown great fee-generating creativity including fees for: • Loan establishment, service, loan switching, progressive loan drawing, lodgement, settlement, statement,early repayment, etc.

24. Determinants of interest rates on home mortgages • Rates largely determined by supply/demand forces in property market and in funding sources • Monthly Repayment (MRP) calculations

25. Pricing and Structuring of Real Estate Loans • Loan structuring • Refers to repayment patterns and any other term agreed upon • Includes loan security and any covenants • Usually has the following documents • A promissory note • Mortgage deed • Letter of guarantee • Property’s sale deed • Assignment of other collateral (if required) • Loan agreement with terms and conditions

26. Pricing and Structuring of Real Estate Loans • Terms and conditions • Repayments: Amount and frequency • Interest Rates: Fixed, variable or variant • Security/Insurance: Details of assets to be mortgaged and any insurance details • Default Clause: Actions available in the event of default • Pre-Payment Clause: Pre-payment procedures and costs • Fees: Schedule of fees and payment timing • Stamp Duty and Government Charges