FIN3600 Real Estate Finance & Investments

FIN3600Real Estate Finance & Investments Chapter 3 Mortgage Calculations

In class exercise. Read the first paragraph on page 42 of your text and summarize, in your own words, the meaning. Financing the purchase of real estate usually involves borrowing on a long or short term basis. Because large amounts are usually borrowed in relation to the prices paid for real estate, financing costs are usually significant in amount and weigh heavily in the decision to buy property. Individuals involved in real estate finance must understand how these costs are computed and how various provisions in loan agreements affect financing costs and mortgage payments. Familiarity with the mathematics of compound interest is essential in understanding mortgage payment calculations, how loan provisions affect financing costs, and how borrowing decisions affect investment returns. This chapter provides an introduction to the mathematics of finance, sometimes referred to as the time value of money or TVM. It forms a basis for concepts discussed in financing single family properties and income producing properties and in funding construction and development projects.

My summary, to be shared with students after they have written and handed in their summary • When buying property, large amounts of the purchase are usually borrowed, meaning that the cost to finance, or the amount to be paid back, is directly dependent upon the amount borrowed, the interest rate and the length of time taken to repay the loan. • Borrowers should understand how to calculate the Time Value of Money to ensure that the repayment calculation is correct AND to calculate their savings if they increase their payments. • Borrowers must be very familiar with details of the repayment agreement (mortgage) so that they can reduce their borrowing costs as their own financial situation improves. • A person who has skill in calculating future interest payments and knowledge of contract provisions, can save a lot of money for themselves or their customers. Saved money equals new investment leverage.

www.mrsilverteaches.com Download the excel spreadsheet titled: Chapter 3 Mortgage Scenarios Exercise Class Exercise. By the end of chapter 3, if you understand the meaning and value of these calculations, you will have one additional skill to assist you in making wise real estate decisions of your own.

Mortgage: Comparison Over Time

Time value of money review • Page 46 – paragraph 2: “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.” • Also, know that the compounding rate will match the frequency of payments. • The next slides illustrate the chart on page 46

Time value of money review (p 46)

Read the first paragraph on the top of page 78. I will be asking you several questions about the content after you read it.

Take up homework (reading pages 77-81)In class Exercise Concept 1: (Page 78) Lenders consider returns and the associated risk of loss on alternative investments in relation to returns available on mortgages. The mortgage market is part of a larger capital market, where lenders and investors evaluate returns available on mortgages and all competing forms of investment, such as bonds, stocks, and other alternatives and the relative risks associated with each.

Question. Why would an institutional lender allocate more of their capital into funds for mortgages? Answer. If a lender believes that the market will return larger profits when lending their money for mortgages, after the risk associated with default they will choose to allocate more of their capital to mortgage loans.

Question. Why would an institutional lender allocate less of their capital into funds for mortgages? Answer. If a lender believes that the market will return smaller profits when lending their money for mortgages, they will choose to allocate more of their capital to other opportunities. Other opportunities may include, bonds, business loans and other proven investments. Reasons to not choose mortgages may include a depressed economy and the risk of default is higher (job loss, higher unemployment).

Question. If you were a decision maker at a large institutional lender, when would you make your capital available to people borrowing for mortgages. Answer. I would begin lending money for mortgage loans when it appeared that a housing boom was on the horizon. Reason. People are buying houses, demand is greater than supply and prices are going up. If people default, the resale value will remain strong and our losses will be minimized.

Question. Imagine that you are a senior decision maker for an institutional lender. Where might you gather your information to help you make the best decision as to how to allocate the capital? Answer. You would have regular meetings, individually and in a group, with the heads of each business unit (lending, investments, service products, acquisitions, etc). These experts would tell you about the future trends and anticipated profits in the different sectors of the economy. Based on their expertise and your ability to evaluate and check the reliability of their information, you will make the decision as to where your capital is invested, to return the greatest profits for the people that own stock in your company.

Real Rate of Interest Definition. The minimum rate of interest that must be earned by savers to induce them to divert the use of resources (funds) from present consumption to future consumption. What does this mean? Financial institutions must be able to convince ordinary people like you and me, that we can earn an attractive profit if we save our money. The banks must have such a good offer that we choose to save our money with them instead of spending it today.

How does the financial institution determine the amount to pay to people that lend money to them? See slide 15. In summary. The decision makers consult their experts and answer the following questions (this is overly simplified). • How much profit can we earn on the investments we make? • How much do we need to pay our stock holders to keep them happy? • How much profit do we need from this investment to contribute to our operating expenses? • How much do we have to pay to borrow money that we then invest? They will then add up #2, #3 and #4 and subtract it from #1.

Concept #2 Interest Rates and Inflation Expectations Question. How does inflation affect investment returns? Answer. Lenders and investors must be convinced that interest rates on the money they lend, will be high enough to compensate for any expected loss in purchasing power during the period that the investment or loan is outstanding, otherwise an inadequate real return will be earned.

Nominal interest rate vs. Real interest rate Nominal interest rate (example). $10,000 invested for one year at 10%. The principal and interest is paid in full at the end of the one year. You get $11,000 after one year. If inflation was 6% during that same period of time, your $11,000 will buy the equivalent of $10,377 of the what it could buy for $10,000 one year earlier. $11,000 / 1.06 = $10,377.

If you did not invest your $10,000 but kept it in a cookie jar at home for one year, it would have lost 6% purchasing power and buy the equivalent of $9,434 one year later. In the preceding example, the nominal rate of interest was 10%, but inflation reduced your purchasing power by 6% of the $11,000 to $10,377. Question. Was it worth taking the risk and making the investment? Why? Yes. In this example, if you did not invest your money, your $10,000 would be almost worthless in 20 years. If you invest it, and it grows faster than inflation, you will be doing a good job of preparing for your retirement.

Conclusion to this example. If you are the lender and you believe that your investments must outpace (stay ahead) inflation by approximately 4%, you will need to earn 10% on your investment.

NEXT CLASSDiscuss Mortgage ScenarioPull up excel spreadsheet

In class exercise Using the paper that has been handed out to you, and in the time remaining in class, write a summary explaining the difference between nominal and real interest rates. Return the exercise to Mr. Silver before leaving class.

FIN3600 Real Estate Finance & Investments