FIN3600 Real Estate Finance & Investments

1. FIN3600Real Estate Finance & Investments Chapter 4 Fixed Interest Rate Mortgage Loans

2. Mortgage rates (p 77) • Most mortgage lenders are intermediaries or institutions and borrow from depositors or investors

3. Mortgage Lenders • The market rate of interest on mortgage loans is determined by: • The rates that borrowers are willing to pay • The rates that lenders are willing to accept as compensation • Fees that are additional to the interest payment

4. The supply and demand of capital that lenders are willing to devote to mortgages • The current rate of inflation and predictions about whether inflation is going up or down (economists determine this) • The demand for mortgage loans is founded in the demand for real estate so it is called a “derived demand”

5. Lenders also consider, • Profit in relation to the risk of other investments Therefore, lenders are always evaluating the risk in relation to competing investments such as stocks, bonds, small business loans, etc. Being aware of this, even when you are working in a large institution is important for your career. If you only talk to people in your own department, you will develop a very narrow perspective of the financial markets and not get promoted. In a similar light, you will not get noticed by the people who can promote you. If you are not identified early in your career and in turn promoted early in your career, it is likely that you will stay at the bottom of the company ladder for your entire career. YOU MUST PAY ATTENTION AND TALK TO YOUR COLLEAGUES ABOUT ALL OF THE ECONOMIC FACTORS.

6. Nominal interest rate (p 78-9) • The nominal interest rate must include a premium to compensate for the expected future changes in inflation rate • Nominal rate = real rate + inflation premium • Lenders establish their mortgage rates based on economists’ predictions of future inflation rates • If inflation is not what was predicted, the nominal rate will not have the same yield

7. The Real Rate of Interest The REAL Rate of Interest is the, that which you are left with after subtracting inflation from your profit. Example: 10% earned interest SUBTRACT 3% inflation rate = 7% Real (the amount that I benefit by after a period of time, considering all factors) The real rate of interest is the amount that must be offered to encourage potential investors to choose to put their capital with you, instead of somewhere else (from consumption to savings).

8. Inflation Expectation (review from last lesson) Lenders and investors must be sure that the interest rate charged will be enough to provide them the profit they require, taking into consideration the loss of purchasing power due to other factors • Inflation • Default • Property value decreases

9. Default RISK Premium (higher interest rates) can be charged to people that are considered a higher risk. Reasons. • Poor credit worthiness (low score) • Job loss (potential) • Property value could decrease and if the owner must sell, the risk exists that there will not be enough to repay the lender

10. Interest Rate Risk Factors that can come into play after the interest rate has been set, include, • The future supply of savings • Demand for housing at the regional or national level • Future levels of inflation

11. Unanticipated Inflation Example. Your company anticipates a 6% inflation rate for the next year. Your company charges 10% on their mortgage loans, thereby earning a profit, a real rate of return of 4%. If the unexpected happens and the inflation rate is 8% in the next one year, and you charged 10% for your mortgage loans, your real rate of return is only 2%. Unanticipated interest rate risk constitutes a major component of interest rate risk to all lenders.

12. Relationship between interest rate and length of the mortgage loan Economists evaluate the factors that influence the economy to predict whether interest rates will be going up or down. The farther into the future that they are looking, the less accurate will be their predictions. Example. Did you predict that Arab Spring uprisings would lead to dictators being deposed (2010/2011) and new democratically elected leaders, within one year, declaring themselves to have the same authority as the deposed dictators (EGYPT 11/2012) or HAMAS accessing guided missiles that can reach the interior of Israel from GAZA? ECONONOMISTS are not just human calculators. Economists take into consideration political events as they affect capital markets. To be a good economist means that you must have access to uncensored, accurate and up to date information. Give Example of Kurdistan.

13. Economics requires knowledge of the global economy and politics Kurdistan

14. Therefore, a five year mortgage loan will have a higher rate than a one year mortgage loan. If the future is very unpredictable, a floating rate may be a better temporary alternative.

15. Prepayment Risk Some loan agreements allow borrowers to increase the principal payments during the loan period. See: Mortgage Repayment Scenarios Class Exercisefor my example. Making a prepayment does the following: • Reduces outstanding principal • Reduces the interest payments Thereby • Reduces the cost to the borrower • Reduces the profit to the lender

16. When interest rates increase, borrowers are less likely to prepay their loans, if they can put their money to work elsewhere, earning a higher rate than they are paying on the mortgage. Example. If you have a five year termpaying 10% on a $100,000 mortgage, and you can invest your newly earned income an earn 11% profit, you will earn 1% more than you would have saved, had you made a prepayment on your mortgage.

17. Other Risks Liquidity Risk / Marketability Risk If the real estate market appears to be slowing, the risk that defaults will become more expensive, because they are more difficult to sell, or the resale value is less, and / or takes longer to sell, will result in lower profits for the lenders.

18. Other Risks (cont'd) Legislative Risks If the government changes the laws that govern property, or it is anticipated that changes may be in the future, the profit in your investment may be negatively or positively affected. Examples. • Taxes (personal or corporate) • Tax status (deductibility of interest – USA vs. Canada) • Rent controls (Ontario residential properties is 1-2% annually with special considerations when capital improvements are made) • Accessibility Standards (2012 – 2020 implementation dates requiring capital upgrades) These risks are much less likely in some environments (China vs. West).

19. Factors Summarized i = r+p+f i = rate of interest r = the amount that is competitive with real returns available on other investment opportunities in the economy p = premium to compensate for default and other risks f = premium to anticipate inflation and earn a real rate of interest Underestimating r, p or f of the equation will result in a financial loss to the lender. Remember that mortgages are usually fixed rates for long periods of time. Factors must be well thought out or you will lose your company money and your reputation will be sunk!

20. Accrued Interest and Loan Payments Scenario. You borrow $60,000 at 12% interest. 12% of $60,000 = $7,200 (to be paid every year IF your accrual is annual) HOWEVER, IF your accrual is monthly (12 months in the year), you will pay 1/12th of $7,200 when you own $60,000. In this case, the accrual rate is the interest rate divided by 12 (months). The Payment (PMT) is the amount that the lender and borrower agree to be paid every month. If the accrual and payment are equal, the loan balance will not change. This is called an Interest Only Loan or a Zero Amortizing Loan. If they were equal, the loan would remain at $60,000.

21. Maturity Dates and Amortization The Maturity Date is the date at the end of the lending period when the outstanding amount of the loan must either be repaid or a new loan negotiated. A Fully Amortizing Loan is one where the pay rate exceeds the accrual rate by enough to pay off the entire loan by the agreed upon maturity date.

22. A Partially Amortizing Loan is one where interest payments are honoured on schedule and some of the principal is paid off by the maturity date. A Negative Amortizing Loan is one where the interest paid is less than the accrual rate and the loan balance increases to a larger amount than when it was originally signed.

23. Question. Which scenario is the risk greatest to the lender? Answer. The risk is greatest in negative amortizing loans because if the property has to be sold, rather than refinanced, the value and marketability of the property becomes a factor in financial gain or loss.

24. Loan Closing Costs Additional fees that the lender charges are often called loan fees, or loan closing costs. Loan Origination Fees are a fee that the borrower pays to the lender, additional to the interest, to pay the expenses incurred, • processing and underwriting loan application • preparing loan documentation • Preparing amortization schedules • Obtaining credit reports, etc. These charges are due at closing time, rather than recovering them by increasing the interest rate over the period of the loan. WHY? Because the borrower may pay-off the loan early, reducing the interest income and the lender will not recover the costs. These are some of the jobs that bank employees do every day. You may have one of these jobs next year!

25. Loan Discount Fees These are additional finance charges. Do not be fooled! If your mortgage is $60,000 at 12% and the additional costs are $1,800, the lender may offer you the option of paying the additional costs by taking $58,200. If you agree, you will be paying interest for $60,000 but only applying $58,200 to the property. Your effective interest rate will no longer be 12%, but instead will be higher than 12%.

26. Reverse Annuity Mortgages This form of mortgage is becoming common. Imagine you are a senior citizen and you are running out of money to live, but your home is worth $500,000. • A lender may agree to loan you up to $250,000 at 10% for 10 years and secure your home as collateral. • Instead of take all the money right now, you take it in installments and pay interest. If you take the equal amounts over the agreed period, you will $250,000 after 10 years. • If your home has increased to $600,000, you can sell it, pay the $250,000 back to the lender and still have $350,000 OR you can stay in the house and continue to pay the interest that is owing.

27. In class Exercise – TuesdayDecember 4th You have had three weeks to review the excel spreadsheet describing the mortgage payment options for the single family country property (www.mrsilverteaches.com finance 3600). In-class Exercise: Value 5% of term grade. Based on your knowledge of borrowing, lending, personal financial planning, investing, mortgages and real estate financing, 1) explain the real estate scenario and 2) explain the alternatives and offer your opinion as to the what the owner should do. This is a closed book exercise. You must come prepared to write about it, having read about it as your homework assignment.