State Tax Commission. Basic Income. MAAO Prerequisite Course. Published July 2014

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1 State Tax Commission Basic Income MAAO Prerequisite Course Published July 2014 All rights reserved. This material may not be published, broadcast, rewritten or redistributed in whole or part without the express written permission of the State Tax Commission 1

2 BASIC INCOME APPROACH The State Tax Commission gratefully acknowledges the assistance provided by the following reference sources: The Appraisal of Real Estate, 14th edition, published by the Appraisal Institute, 2013 Capitalization Theory and Techniques, 2nd edition, published by the Appraisal Institute and Charles B. Akerson, 2000 Property Assessment Valuation, 2nd edition, published by the International Association of Assessing Officers, 1996 All definitions in text from: The Dictionary of Real Estate Appraisal, 5th edition, published by the Appraisal Institute,

3 Table of Contents Chapter 1: Introduction to the Income Approach... 4 Chapter 2: Economic Principles Underlying the Income Approach Chapter 3: Real Estate Finance Basics Chapter 4: Types of Mortgages Chapter 5: Sources of Real Estate Capital Chapter 6: Compound Interest Tables Chapter 7: Leases: Types and Terminology Chapter 8: Potential Gross Income Chapter 9: Vacancy and Collection Loss Chapter 10: Miscellaneous Income & Effective Gross Income Chapter 11: Operating Expense Analysis Chapter 12: Net Operating Income, Debt Service and Equity Dividend Chapter 13: The Capitalization Process Chapter 14: Deriving Capitalization Rates Chapter 15: Residual Capitalization Techniques Chapter 16: Income Streams and Selection of Capitalization Methods Chapter 17: Putting it all Together

4 Chapter 1: Introduction to the Income Approach The income approach is based upon the premise that there is a definite relationship between the amount of income a property will earn and its value. When buying income producing properties, the expectation of monetary gain is the primary motivation of the typical purchaser. The income approach to value is the process that measures and estimates the extent to which these future benefits might reasonably be expected, and then translates these benefits into a lump sum value. income capitalization approach - A set of procedures through which an appraiser derives a value indication for an income-producing property by converting its anticipated benefits (cash flows and reversion) into property value. This conversion can be accomplished in two ways. One year s income expectancy can be capitalized at a market-derived capitalization rate or at a capitalization rate that reflects a specified income pattern, return on investment, and change in the value of the investment. Alternatively, the annual cash flows for the holding period and the reversion can be discounted at a specified yield rate. Procedurally, this process consists of estimating either the annual net or gross income the subject is capable of producing, deducting the amount of necessary annual expenses, selecting a capitalization technique and rate, and finally capitalizing the net income into value by the use of the appropriate technique. The process of converting the anticipated benefits (cash flows and reversion) into property value is termed capitalization. Direct capitalization is based on a single year s income expectancy that is converted into value in one step. In yield capitalization, the cash flows for the holding period and the reversion can be discounted separately at a specified yield rate or modeled to reflect the anticipated income pattern in order to derive an indication of market value. This course will focus on direct capitalization methods. direct capitalization - A method used to convert an estimate of a single year s income expectancy into an indication of value in one direct step, either by dividing the net income estimate by an appropriate capitalization rate or by multiplying the income estimate by an appropriate factor. Direct capitalization employs capitalization rates and multipliers extracted or developed from market data. Only a single year s income is used. Yield and value changes are implied but not identified. yield capitalization - A method used to convert future benefits into present value by 1) discounting each future benefit at an appropriate yield rate, or 2) developing an overall rate that explicitly reflects the investment s income pattern, holding period, value change, and yield rate. 4

5 As stated in the definition, the income approach is a valuation method in which the anticipated future benefits are discounted to a present value estimate through the capitalization process. We can dissect this definition into four distinct areas: Anticipated future benefits: An investor in income producing properties is trading a sum of present dollars (purchase price) for the right to receive a sum of future dollars during the ownership period. These future benefits may include annual cash flows from the operation of the property, appreciation in value over the holding period and potential income tax advantages. Discounting: The conversion of future benefits to a present value using a specified rate is called discounting. Because a dollar today is worth more than a dollar received in the future, these future dollars are discounted to the present. We will discuss these discounting concepts in more detail later in this course. Present worth: The current value in money of the right to collect future payments. The present worth is simply the discounted value of future payments. Capitalization: The process which converts an income stream into an indication of value. We will discuss capitalization theory in more detail later in this course. Income-producing properties are generally purchased for the income they will produce; the greater the earning power, the higher the value. The income approach is grounded in the premise that the income generated by a property has a direct correlation to the property's value. Direct Capitalization Methods The basic formula for calculating property value is sometimes called the IRV formula because it uses I = Income, R = Rate, and V = Value. The Income is the income that is generated by the property. The Rate is the capitalization rate. The Value represents the property value. 5

6 Capitalization Rate Method There are methods to determine I Income and R rates to arrive at V value. As you will see later in the course, the I Income can represent income to the property (NOI), income to the land (I L ), income to the building (I B ), and even income to the mortgage (I M ), and equity (I E ), positions. capitalization rate (R) - Any rate used to convert income into value The formula is displayed below: In the IRV formula, Income divided by Rate equals Value (I / R = V). If the unknown factor is covered, the relative position of the two remaining factors reveals the proper relationship. 6

7 Example 1-1 A property has a net operating income of $270,000 and the property overall capitalization rate is 10.20%. What is the indicated value? Income / Rate = Value or $270,000 /.1020 = $2,647,059. Income $270,000 Rate.1020 Value $2,647,059 Example 1-2 A property has a value of $1,000,000 and net operating income of $105,000. What is the overall capitalization rate? Income / Value = Rate or $105,000 / $1,000,000 = Income $105,000 Rate.1050 Value $1,000,000 7

8 Example 1-3 A property has a value of $475,000 and the overall rate is 9.50%. What is the net operating income? Rate x Value = Income or.095 x $475,000 = $45,125. Income $45,125 Rate.0950 Value $475,000 Multiplier Method A factor or multiplier may be used to convert income into value. multiplier -A figure that is multiplied by income to produce an estimate of value; called a gross income multiplier when gross income is used, a gross rent multiplier when gross rent is used, and a net income multiplier when net income is used; may be monthly or annual. When a factor is used instead of a rate to compute value, the following formula is used Value = Income x Factor or V = I x F. In the VIF formula, if the unknown factor is covered, the relative position of the two remaining factors reveals the proper relationship. 8

9 Example 1-4 A property has potential gross income of $570,000 and the potential gross income multiplier is What is the indicated value? I x F = V or $570,000 x 4.25 = $2,422,500. Value $2,422,500 Income $570,000 Factor 4.25 Example 1-5 A property has a value of $1,000,000 and an effective gross income of $200,000. What is the effective gross income multiplier? V / I = F or $1,000,000 / $200,000 =

10 Value $1,000,000 Income $200,000 Factor 5.00 Example 1-6 A property has a value of $480,000 and the net operating income multiplier is What is the net operating income? V / F = I or $480,000 / = $45,000. Value $480,000 Income $45,000 Factor As you can see, there are different types of income that may be used to determine value. In our examples we used potential gross income, effective gross income and net operating income. The factors applied therefore reflect potential gross income multipliers, effective gross income multipliers and net operating income multipliers. It is extremely important that the multipliers be applied in the same manner they are extracted. For example, PGI multipliers should be applied to PGI and not EGI. 10

11 Outline of Income Approach In the IRV formula, the I income typically reflects the net operating income of a property. The exhibit on the next page outlines the basic steps of income approach including the steps necessary to arrive at net operating income. Outline of the Income Approach Potential Gross Income (PGI) Less Vacancy and Collection Loss Plus Miscellaneous/ Other Income Equals Effective Gross Income (EGI) Less Operating Expenses Equals Net Operating Income (NOI) Less Annual Debt Service (ADS) Equals Cash Flow (CF) The proper income amount is then treated by the capitalization process for conversion into a value estimate. 11

12 Chapter 1 Quiz: Introduction to the Income Approach 1.) What is the term for a method used to convert an estimate of a single year s income expectancy into an indication of value in one direct step, either by dividing the net income estimate by an appropriate capitalization rate or by multiplying the income estimate by an appropriate factor? a.) capitalization rate b.) direct capitalization c.) yield capitalization d.) multiplier or factor 2.) What is the term for a figure that is multiplied by income to produce an estimate of value? a.) capitalization rate b.) direct capitalization c.) yield capitalization d.) multiplier or factor 3.) What is the term for any rate used to convert income into value? a.) capitalization rate b.) direct capitalization c.) yield capitalization d.) mortgage rate 4.) If a property has a net operating income of $150,000 and the appropriate capitalization rate is 10%, what is the value of the property? a.) $150,000 b.) $15,000 c.) $15,000,000 d.) $1,500,000 5.) If a property has potential gross annual income of $30,000 and a value of $180,000, what is the potential gross income multiplier? a.).1667 b.) 6.0 c.) $5,400,000,000 d.)

13 6.) Which of the following relationships is false? a.) I / R = V b.) I x R = V c.) V = I / R d.) R x V = I 7.) Which of the following relationships is true? a.) F x V = I b.) V x I = F c.) V / F = I d.) I x V = F 8.) If a property has a net operating income of $10,000 and a value of $160,000 what is the capitalization rate? a.) 6.25% b.) 16% c.) 625 d.) ) If a property has an effective gross income of $230,000 and an effective gross income multiplier of What is the value of the property? a.) $680,000 b.) $1,196,000 c.) $44,230 d.) $230, ) A 20 unit apartment community has annual net operating income of $36,750. The proper overall capitalization rate is 10.5%. What is the value per apartment unit? a.) $77,160 b.) $3,858 c.) $17,500 d.) $350,000 13

14 Chapter 2: Economic Principles Underlying the Income Approach The economic principles you learned in earlier courses are interrelated and interact within the marketplace. Several principles relate to the income approach with the principle of anticipation being most applicable. The principles of change and supply and demand also strongly relate to this approach. These principles plus several others will be highlighted as to their application within the framework of the income approach. Anticipation: Value is created by the expectation of benefits to be received in the future, i.e. the present worth of the right to receive future benefits. These benefits can be in the form of an income stream or amenities as anticipated by the market participants. anticipation - The perception that value is created by the expectation of benefits to be derived in the future. Anticipation is fundamental to the income approach. All income capitalization methods, techniques and procedures attempt to consider anticipated future benefits. Investors are anticipating the future income stream from property in their buying decisions. Examples include: Anticipated increases or decreases in future value, rents or expenses Expectations of future rates of return requirements and inflation Scheduled changes to contract rents Capitalizing income estimates into a value indication Relationship between contract rents and market rents Change: The law of cause and effect at work. Change is inevitable though, at times, it may be difficult to identify. The expectations of investors concerning changes in income, expense levels and property values must be considered by the appraiser. change - The result of the cause and effect relationship among the forces that influence real property value. The principle of change is related to the principle of anticipation and can affect the prediction of future benefits. Change is inevitable and may be gradual or rapid. 14

15 Examples include: Abrupt changes closing of plant or military base Price of construction materials with hurricane Oil and commodity price fluctuations Tax law revisions Changes to income (rents) and expenses (operating costs) Supply and Demand: The interaction of supply and demand (buyers and sellers; tenants and landlords) constitute the market. The related concept of competition is important for forecasting future benefits and rates of return. Both income and rates of return are determined in the market. supply and demand - In economic theory, the principle that states that the price of a commodity, good, or service varies directly, but not necessarily proportionately, with demand, and inversely, but not necessarily proportionately, with supply. In a real estate appraisal context, the principle of supply and demand states that the price of real property varies directly, but not necessarily proportionately, with demand and inversely, but not necessarily proportionately, with supply. Examples include: Increase in supply of property type (new development) Profitable hotel may face new competition Downtown retail properties compete with suburban mall Existing homes compete with new construction Balance: Value is created and sustained when the appropriate mix of land uses are developed. Value is enhanced by a reasonable balance of types and locations of income producing properties. When applied to an individual property, the principle states that the maximum market value is reached when the four agents of production (land, labor, capital and management) are in a state of equilibrium. Balance means the highest market value will be realized when the size and type of improvements are proportional to each other and as well as to the land. balance - The principle that real property value is created and sustained when contrasting, opposing or interacting elements are in a state of equilibrium. The principle of balance interrelates with other economic principles such as contribution, increasing or decreasing returns and conformity. 15

16 Examples include: Land to building ratios Amount and type of amenities with building Parking ratios Contribution: This principle states that a value of a component of property depends upon its contribution to the whole. A component does not necessarily add a dollar for dollar to its value to the entire property. contribution - The concept that the value of a particular component is measured in terms of the amount it adds to the value of the whole property or as the amount that its absence would detract from the value of the whole. With income producing properties, the value of a component can be measured by the amount it contributes to the net operating income. The principle of contribution is related to the principles of balance and increasing or decreasing returns. Examples include: Swimming pool could add, make no change, or be a detriment to value Addition of air conditioning and the impact on rent Contribution of existing use to site Interim use (temporary less than optimal use) Externalities: The principle of externalities states that factors external to a property can have positive or negative impact on its value. Because real estate is immobile, it is affected by external influences more strongly than other goods. externalities - The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value. 2. In appraisal, off-site conditions that affect a property s value. Exposure to street noise or proximity to a blighted property may exemplify negative externalities, whereas proximity to attractive and well-maintained properties or easy access to mass transit may exemplify positive externalities. Examples include: Uses and conditions of neighboring properties Foreign capital/currency exchange rates National fiscal policy and tax laws Local laws and ordinances Capitalization rates 16

17 Substitution: The value of a property in the market tends to be limited by the cost of acquiring an equally desirable substitute property with a similar income stream and level of risk and assuming no unreasonable delay. substitution - The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. This is the primary principle upon which the cost and sales comparison approaches are based. Examples include: Market rents Prices of competitive properties Selection of desirable substitutes Capitalization rates 17

18 Chapter 2 Quiz: Economic Principles Underlying the Income Approach 1.) The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value. a.) Anticipation b.) Change c.) Substitution d.) Externalities 2.) The perception that value is created by the expectation of benefits to be derived in the future. This is the underlying premise of the income approach. a.) Anticipation b.) Change c.) Substitution d.) Externalities 3.) The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. a.) Anticipation b.) Change c.) Substitution d.) Externalities 4.) The impact on value of an apartment property that contains a swimming pool in an area where properties with swimming pools command rents far in excess of the cost to construct pools. This concept reflects what economic principle. a.) Anticipation b.) Contribution c.) Substitution d.) Externalities 5.) Which principle indicates that the price of real property varies directly, but not necessarily proportionately, with demand and inversely, but not necessarily proportionately with supply? a.) Anticipation b.) Change c.) Substitution d.) Supply and Demand 18

19 6.) This principle is the result of the cause and effect relationship among the forces that influence real property value. a.) Anticipation b.) Change c.) Substitution d.) Contribution 7.) In a situation where landlords lower their rents to attract tenants from their competition reflects which economic principle? a.) Anticipation b.) Supply and Demand c.) Change d.) Externalities 8.) The appropriate amount of land to building ratios and parking ratios describe which principle? a.) Anticipation b.) Change c.) Balance d.) Externalities 9.) An investor s expectation of increases or decreases in future value, rents or expenses reflects which economic principle? a.) Anticipation b.) Contribution c.) Substitution d.) Externalities 10.) An increase in construction of new retail properties in a market reflects which economic principle? a.) Supply and Demand b.) Change c.) Substitution d.) Balance 19

20 Chapter 3: Real Estate Finance Basics Because of the dollar amounts of many real estate transactions, most purchasers of income producing real estate do not pay the entire purchase price with cash. Consequently, most real estate transactions are financed through a combination of cash and mortgage financing. A mortgage is a legal document which creates a security interest in the real estate for a sum of money loaned to a borrower. As a condition of this loan, the borrower conveys an interest in the real estate to guarantee satisfaction of the mortgage terms. The terms and conditions of a mortgage vary widely and can be as individual as the parties who negotiate the document. The financial strength of the borrower, general economic conditions and desires of the lender and borrower are all ingredients which come together in determining the terms of the mortgage. Mortgage Terminology We will begin with some definitions of common mortgage related terms. mortgage - A pledge of a described property interest as collateral or security for the repayment of a loan under certain terms and conditions. Remember, a mortgage is a legal document which creates a security interest in the real estate but it is not the loan document. mortgagee - A party who advances funds for a mortgage loan and in whose favor the property is mortgaged; the lender mortgagor - One who gives a mortgage as security for a loan; the borrower. interest rate - The rate of return, or yield, on debt capital. This is the annual rate for use of the borrowed money. It is the rate paid for the right to use capital. amortization - The process of retiring a debt or recovering a capital investment, typically through scheduled, systematic repayment of the principal; a program of periodic contributions to a sinking fund or debt retirement fund. See also negative amortization. 20

21 amortization schedule - A schedule of debt repayment specifying the timing and amount of payments; a program of retiring debt through the scheduled, systematic repayment of principal. On the next page is a sample amortization schedule for a $100,000 loan with a 6% interest rate and a 10 year mortgage repayment term. As you can see in the schedule, the annual payment (end of year in this example) is $13,587. This first payment can be further divided into the amount needed to pay the 6% interest on the outstanding balance (.06 x $100,000 or $6,000) with the remainder of the payment $7,587 ($13,587 -$6,000 = $7,587) used to reduce the outstanding loan balance. The outstanding balance at the end of the first year is $92,413 ($100,000 - $7,857 = $92,413). A review of each year on the schedule shows that while the amount of the payments remain constant, the amount of interest and principle repayment change. For example in the second year, the 6% interest is applied to the outstanding balance of $92,413 resulting in annual interest of $5,545. The resulting amount applied to principle reduction is $8,042 ($13,587 -$5,545 = $8,042). At the end of the tenth year the final payment covers the annual interest on the remaining balance of $769 and the remaining principal amount of $12,818 to fully extinguish the loan. AMORTIZATION SCHEDULE Fully Amortizing 6.0% Period Amount Payment Interest Principal Balance 1 $100,000 $13,587 $6,000 $7,587 $92,413 2 $92,413 $13,587 $5,545 $8,042 $84,371 3 $84,371 $13,587 $5,062 $8,525 $75,847 4 $75,847 $13,587 $4,551 $9,036 $66,811 5 $66,811 $13,587 $4,009 $9,578 $57,233 6 $57,233 $13,587 $3,434 $10,153 $47,080 7 $47,080 $13,587 $2,825 $10,762 $36,318 8 $36,318 $13,587 $2,179 $11,408 $24,910 9 $24,910 $13,587 $1,495 $12,092 $12, $12,818 $13,587 $769 $12,818 $0 partially amortizing mortgage loan - A loan that is not fully amortized at maturity; the outstanding principal must be repaid in one lump sum; often created by writing a loan for one maturity and calculating debt service payments based on a longer amortization period. See also balloon mortgage. 21

22 The following is a sample partially amortizing amortization schedule for a $100,000 loan with a 6% interest rate and a 10 year mortgage repayment term. While similar to our first example, in this instance the annual payment is only $10,000 and not the $13,587 that would be needed to bring the loan balance to zero at the end of ten years. This first payment can be further divided into the amount needed to pay the 6% interest on the outstanding balance (.06 x $100,000 or $6,000) with the remainder of the payment $4,000 ($10,000 -$6,000 = $4,000) used to reduce the outstanding loan balance. The outstanding balance at the end of the first year is $96,000 ($100,000 - $4,000 = $96,000). A review of each year on the schedule shows that while the amount of the payments remain constant the amount of interest and principle repayment change. At the end of the tenth year the final payment covers the annual interest on the balance of $3,242 and $6,758 toward the outstanding principal. The loan is not paid in full. At the end of ten years there is an outstanding balance of $47,277 still owed by the mortgagor/borrower. AMORTIZATION SCHEDULE Partially Amortizing 6.0% Period Amount Payment Interest Principal Balance 1 $100,000 $10,000 $6,000 $4,000 $96,000 2 $96,000 $10,000 $5,760 $4,240 $91,760 3 $91,760 $10,000 $5,506 $4,494 $87,266 4 $87,266 $10,000 $5,236 $4,764 $82,502 5 $82,502 $10,000 $4,950 $5,050 $77,452 6 $77,452 $10,000 $4,647 $5,353 $72,099 7 $72,099 $10,000 $4,326 $5,674 $66,425 8 $66,425 $10,000 $3,985 $6,015 $60,410 9 $60,410 $10,000 $3,625 $6,375 $54, $54,035 $10,000 $3,242 $6,758 $47,277 balloon payment - The outstanding balance due at the maturity of a balloon mortgage. A balloon payment is a lump sum principal amount or a portion that remains of a mortgage loan at the end of the term or at some specified date. In the example above, the balloon payment amount is $47,

23 loan term or mortgage term - The amount of time, specified in the loan documents, between the loan closing and the date the loan is to be paid off. The loan term (or mortgage term) may differ from the amortization period. For example, a loan may be amortized over 25 years but be due in 5 years. principal - A capital sum invested; a payment that represents partial or full repayment of the capital loaned or invested, as distinguished from the payment of interest; the unrecovered capital remaining in a loan or investment. loan-to-value ratio - The ratio between a mortgage loan and the value of the property pledged as security, usually expressed as a percentage; also called loan ratio. For example a property sells for $1,000,000. The purchaser pays a $300,000 down payment and finances the remaining $700,000 with a mortgage loan. In this example the loan to value ratio is 70% ($700,000 loan / $1,000,000 value) mortgage constant - The periodic mortgage payment expressed as a proportion of the original loan amount; also called the loan constant. It may be easier to view the Mortgage Constant as the ratio of total annual debt service (principal and interest payments) to the principal amount of the mortgage loan. In our fully amortizing loan example, the mortgage constant is % ($13,587 payment / $100,000 loan amount = or %). A dynamic feature of the mortgage constant is that every loan with a 6% interest rate, annual payments and a10 year amortization will have the same exact mortgage constant of To ensure that you understand this concept, fill in the blanks in the following table for loans with a 6% interest rate, annual payments and a10 year amortization. Loan Amount Annual Payment Mortgage Constant $100,000 $13, $500 $67.94 $250, $679, The frequency or the interval over which mortgage payments are scheduled for payment can be monthly, quarterly, semiannual, or annually and the frequency of payment impacts the mortgage constant. 23

24 For example, we know that a loan with a 6% interest rate, annual payments and 10 year amortization has a mortgage constant of However, a loan with a 6% interest rate, monthly payments and 10 year amortization has a mortgage constant of As a check, the monthly payments to amortize a $100,000 loan are $1, Multiplying the monthly payment by the 12 months in a year results in an annual payment of $13,322. Dividing the annual debt service payments of $13,322 by the loan amount of $100,000 results in a mortgage constant of The slightly lower mortgage constant is logical because each monthly payment is paying down some of the principal thus reducing the amount subject interest. Other things being equal, the more frequent the payments, the lower that mortgage constant. debt coverage ratio (DCR) - The ratio of net operating income to annual debt service (DCR = NOI/IM), which measures the relative ability of a property to meet its debt service out of net operating income; also called debt service coverage ratio (DSCR). A larger DCR indicates a greater ability for a property to withstand a downturn in revenue, providing an improved safety margin for a lender. The purpose of the Debt Coverage Ratio or the ratio of net operating income to annual debt service is to give the lender a cushion to ensure the property can generate enough net operating income to be able to support its debt service (mortgage payments). For this reason, debt coverage ratios will always be greater than 1.0. For example, in our fully amortizing loan example the mortgage payment (debt service) for our $100,000 loan with a 6% interest rate, annual payments, and 10 year repayment term was $13,587. As the lender, we would want to ensure that this property generates at least $13,587 in net operating income (NOI) to repay the debt (loan). If our property generated NOI of $19,022 what would be the indicated debt coverage ratio. Net Operating Income (NOI) $19,022 = 1.40 Mortgage Debt Service (DS) $13,587 In this example the property generates NOI 1.40 times that needed to support the mortgage payments. Later in this course we will learn a method that uses this debt coverage ratio concept to derive an overall capitalization rate. 24

25 Chapter 3 Quiz: Real Estate Finance Basics 1.) The ratio of net operating income to annual debt service, which measures the relative ability of a property to meet its debt service out of net operating income is called? a.) b.) c.) d.) Loan to value ratio Debt coverage ratio Amortization schedule Balloon payment 2.) A party who advances funds for a mortgage loan and in whose favor the property is mortgaged; the lender is called? a.) b.) c.) d.) Mortgage Mortgagee Interest Rate Mortgagor 3.) What is the mortgage constant for a $200,000 loan with annual payments of $17,000? a.) b.) 8.5% c.) 11.76% d.) ) A loan that is not fully amortized at maturity with outstanding principal that must be repaid in one lump sum is called? a.) b.) c.) d.) Loan to value ratio Partially amortizing mortgage loan Fully amortization mortgage loan Balloon Payment 5.) The periodic mortgage payment expressed as a proportion of the original loan amount; also the annual debt service divided by loan amount. a.) b.) c.) d.) Mortgage constant Amortization schedule Debt coverage ratio Balloon Payment 25

26 6.) One who gives a mortgage as security for a loan; the borrower. a.) b.) c.) d.) Mortgage Mortgagee Interest Rate Mortgagor 7.) Which loan would have the highest mortgage constant? a.) b.) c.) d.) Partially amortizing loan Interest only loan Fully amortizing loan Partially amortizing loan with balloon payment 8.) A property with a loan of $2,900,000 generates net operating income of $340,000. The annual mortgage payments for this property are $272,000. What is the debt coverage ratio? a.) 9.38% b.) 80% c.) 11.72% d.) ) The outstanding balance due at the maturity of a partially amortizing loan is called? a.) b.) c.) d.) Loan residual ratio Debt coverage ratio Amortization schedule Balloon payment 10.) A property just sold for $2,000,000. The purchaser supplied a down payment of $600,000 and financed the remainder with a mortgage loan. What is the loan to value ratio for this transaction? a.) 30% b.) 70% c.) 20% d.) 80% 26

27 Chapter 4: Types of Mortgages Mortgage loans supply most of the capital involved in real estate investments. Traditional mortgages loans are made for long terms of years and carry fixed interest rates. A level payment mortgage requiring the same dollar amount payment each period for the entire loan term is the most popular. Some of the more common types of mortgages include: fixed-rate mortgage (FRM) - A conventional mortgage with an interest rate that does not vary over the life of the loan. In a fixed rate mortgage each payment includes a portion of the principal balance and interest on the unpaid balance. Payments are periodic (generally monthly) and equal. interest-only mortgage - A non amortizing loan in which the lender receives interest only during the term of the loan and recovers the principal in a lump sum at the time of maturity. In an interest only mortgage the payment is just that, the amount of interest that accrued on the unpaid balance between payment periods. adjustable-rate mortgage (ARM) or variable-rate mortgage (VRM) - A debt secured by real estate with an interest rate that may move up or down following a specified schedule or in accordance with the movements of a standard or index to which the interest rate is tied. These are mortgages where the interest rate may fluctuate. Changes in the rate are triggered by movements in some independent standard or index. Common indices to which the interest rates are tied include federal banking cost of funds, the one-year Treasury interest rates, the prime rate, or LIBOR. graduated-payment mortgage (GPM) - A debt secured by real estate in which mortgage payments are matched to projected increases in the borrower s income. The periodic payments start out low and gradually increase. A graduated-payment mortgage provides for lower debt service payments during the early years of the mortgage with regular periodic increases over the life of the loan. equity participation mortgage - A mortgage in which the lender receives a share of the income and sometimes a share of the reversion from a property on which the lender has made a loan; also called participation mortgage. 27

28 Equity participation mortgages provides for the lender to receive a portion of the net operating income and perhaps part of the proceeds from the sale of the property. Lenders may opt for this type of arrangement either as a hedge against inflation or as a means of increasing their total yield on the loan. wraparound mortgage - A mortgage that is subordinate to, but inclusive of, any existing mortgage or mortgages on a property. Usually a third-party lender refinances the property, assuming the existing mortgage and its debt service and wrapping around a new, junior mortgage. The wraparound lender gives the borrower the difference between the outstanding balance of the existing mortgage or mortgages and the face amount of the new mortgage To execute a wraparound mortgage the original loan must be assumable. A wraparound lender gives the borrower the difference between the outstanding balance on the existing mortgage and the face amount of the new mortgage. Wraparound mortgages became widespread in periods of high mortgage rates and appreciating property values, but they have generally fallen into disuse with declining mortgage rates. reverse mortgage - A type of mortgage whereby senior homeowners systematically borrow against the equity in their home, receiving regular (usually monthly) payments from the lender. Borrowed funds and accrued interest come due when the last surviving borrower dies or permanently vacates the premises. Also called a reverse-annuity mortgage or home equity conversion mortgage. Seller Financing purchase-money mortgage (PMM) - A mortgage that is given by a purchaser to a seller in lieu of cash as partial payment for the purchase of real property; if the purchaser defaults on a payment, the seller may foreclose. A PMM is an alternative to an institutional loan. Title to the property is provided at closing. The lender/seller may also attach additional collateral to the loan beyond the property being sold. land contract - A contract in which a purchaser of real estate agrees to pay a portion of the purchase price when the contract is signed and additional sums, at intervals and in amounts specified in the contract, until the total purchase price is paid and the seller delivers the deed; used primarily to protect the seller s interest in the unpaid balance because reversion to clear title can be accomplished more quickly than it could be under a mortgage; also called contract for deed or installment (sale) contract. 28

29 A seller finances the sale of a property by permitting the buyer to pay for it over a period of time, but the title is delivered only after all payments are made. In the event of default, the buyer normally forfeits all payments made and the seller may also elect to hold the buyer to the contract. 29

30 Chapter 4 Quiz: Types of Mortgages 1.) A mortgage that provides for lower debt service payments during the early years of the mortgage with regular periodic increases over the life of the loan is called? a.) b.) c.) d.) Purchase money mortgage Fixed rate mortgage Land contract Graduated payment mortgage 2.) A mortgage in which the lender receives a share of the income and sometimes a share of the reversion from a property on which the lender has made a loan is called? a.) b.) c.) d.) Reverse mortgage Fixed rate mortgage Wraparound mortgage Equity participation mortgage 3.) A seller finances the sale of a property by permitting the buyer to pay for it over ten years. After all payments are made the seller gives the buyer title to the property. What type of financing does this transaction represent? a.) b.) c.) d.) Purchase money mortgage Fixed rate mortgage Land contract Graduated mortgage 4.) A type of mortgage where each level payment includes a portion of the principal balance and interest on the unpaid balance is called? a.) b.) c.) d.) Interest only mortgage Fixed rate mortgage Land contract Graduated mortgage 5.) A type of mortgage whereby senior homeowners systematically borrow against the equity in their home, receiving regular (usually monthly) payments from the lender. Borrowed funds and accrued interest come due when the last surviving borrower dies or permanently vacates the premises is called? a.) b.) c.) d.) Reverse mortgage Fixed rate mortgage Land contract Graduated mortgage 30

31 6.) A non-amortizing loan in which the lender receives payments of interest on the outstanding balance and then recovers the principal in a lump sum at the time of maturity is called? a.) b.) c.) d.) Purchase money mortgage Fixed rate mortgage Interest only mortgage Graduated mortgage 7.) What type of loan could have an interest rate that is based on being 3% above the LIBOR rate and reset every year? a.) b.) c.) d.) Fixed rate mortgage Interest only mortgage Adjustable rate mortgage Partially amortizing mortgage with balloon payment 8.) A loan is originated for $1,000,000. The terms of the loan call for annual interest only payments at a 4% interest rate for a loan term of ten years. What are the annual interest payments and what is the amount due at the end of the loan term? a.) b.) c.) d.) $4,000 payments and $1,000,000 due at end of term $40,000 payments and $600,000 due at end of term $400,000 payments and $600,000 due at end of term $40,000 payments and $1,000,000 due at end of term 9.) A mortgage that is given by a purchaser to a seller in lieu of cash as partial payment for the purchase of real property is called? a.) b.) c.) d.) Fixed rate mortgage Purchase money mortgage Adjustable rate mortgage Partially amortizing mortgage with balloon payment 10.) A mortgage that is subordinate to, but inclusive of, any existing mortgage or mortgages on a property. Usually a third-party lender refinances the property, assuming the existing mortgage and its debt service and wrapping around a new, junior mortgage. The lender gives the borrower the difference between the outstanding balance of the existing mortgage or mortgages and the face amount of the new mortgage is called? a.) b.) c.) d.) Fixed rate mortgage Interest only mortgage Adjustable rate mortgage Wraparound mortgage 31

32 Chapter 5: Sources of Real Estate Capital Real estate requires capital for both equity and debt positions. The financial goals and motivations of both positions are quite different. The equity position is willing to assume a level of risk. The debt position is generally conservative, passive and less willing to assume risk. The difference between equity and debt investors is shown through their market actions. An equity investor is more willing to assume risk. Equity investors realize their earnings are subordinate to a project's operating expenses and debt service requirements. As we will see later in the course, equity investors earnings are termed dividends. These equity dividends, however, are just part of the total return anticipated by the investor. Investors may also expect the value of their original investment to appreciate, remain stable or decline during their holding period. The debt investor participates in bonds or mortgages, usually pursuing conservative investments in search of certain and predictable income and the repayment of their principal. This type of investor expects a priority claim on investment earnings and often looks for security in the form of a lien on the assets involved. Equity - An ownership claim on property. Property value minus total debt equals total equity value, which has a residual claim to property income subordinate to operating expenses and the claims of creditors. Therefore, equity investors assume greater risk than creditors (e.g., mortgagees). Equity investment is compensated with dividends (periodic cash flow) and uncertain but possible appreciation in the value of the investment. Equity sources of capital include: Partnerships A partnership is a common vehicle for pooling real estate equity funds where two or more persons jointly own a business and share in its profits and losses. Partnership - An association of two or more persons who carry on as co-owners of a business for profit A general partnership is an ownership arrangement in which all partners share in investment gains and losses and each is fully responsible for all liabilities. A partner has complete liability for the acts of the other partners and is responsible for the debts incurred. 32

33 A limited partnership is an ownership arrangement consisting of general and limited partners. General partners manage the business and assume full liability for partnership debt, while limited partners are passive and liable only to the extent of their own capital contributions. Syndications A syndication is a private or public partnership that pools funds for the acquisition and development of real estate projects. Private syndications are limited to small groups of investors and are relatively free from government regulation. Public syndications involve large groups of investors and generally operate in more than one state, so they are subject to Security Exchange Commission (SEC) registration regulations. Real Estate Investment Trusts (REITS) Real estate investment trusts (REIT's) pool investment funds of small investors to acquire real estate investment positions that could not be handled by these investors individually by buying shares of REIT stock. REITs tend to purchase properties in superior locations in superior markets or certain property types. Joint Ventures A joint venture is a combination of two or more entities that join to undertake a specific project. Although a joint venture often takes the form of a general or limited partnership, it differs from a partnership in that it is intended to be temporary and project-specific. Pension Funds Private and government-operated pension funds are a huge and rapidly growing source of investment capital. Usually the pension contributions are placed with a trustee who invests the money prudently. The real property holdings of a pension fund may be in the form of equity or debt investments. Life Insurance Funds Life insurance companies invest heavily in real estate as both mortgage lending (debt) and property ownership (equity). Life insurance companies usually acquire real estate positions that are long-term in nature. International Equity Funds Foreign investors supply needed equity capital to realty ventures in this country. This international investment capital comes from a variety of sources, such as foreign individuals, countries, financial institutions, and pension funds. 33

34 Sources of debt capital include commercial banks, savings and loan associations, life insurance companies, mutual savings banks, junior mortgage companies and secondary mortgage market. Debt - One of two characteristic types of capital, the other being equity. The debt investor expects a priority claim on investment earnings and looks for security in the form of a lien on the assets involved and usually the promise to repay. Debt investors may participate in bonds or mortgages and receive fixed or variable interest on the investment with repayment of the principal upon maturity. Sources of debt capital Commercial Banks Commercial Banks offer a variety of financial services to businesses and individuals. In keeping with their role as short-term lenders, commercial banks have traditionally supplied construction and development loans for commercial and industrial properties. Savings and Loan Associations Savings and loan associations (S&Ls) are financial intermediaries. They receive savings deposits, lend them at interest, and distribute dividends to depositors after paying operating expenses and establishing appropriate reserves. The failure of many S&Ls in the 1980 s has had a profound effect on real estate market and lending and appraiser regulation. Life Insurance Companies The mortgage investments of life insurance companies cover the full range of realty types such as residential, apartments, offices, shopping malls, hotels, and industrial properties. Because many companies have great financial resources, they have been important in financing larger high dollar properties such as hotels, office buildings and shopping malls. Mutual Savings Banks Mutual savings banks are owned by their members and have broader investment powers than savings and loan associations and while they concentrate on mortgages, they also invest in other types of equity investments. 34

35 Junior/Second Mortgage Originators Junior mortgages or second mortgages are used to raise additional mortgage funds. These second mortgages are used for creating additional leverage and facilitating sales of properties with first mortgages that cannot be refinanced. Junior mortgages involve greater risk than senior liens do and therefore command higher interest rates. Banks, savings and loan associations, and life insurance companies are usually precluded from making large junior mortgage loans. Other private lenders and financing companies are not supervised to the same extent and provide this secondary financing. Secondary Mortgage Market In the secondary mortgage market, mortgagees sell packages of their mortgages at prices consistent with current rates. Selling these mortgages frees up their capital permitting them to lend when they might otherwise lack funds. Securities are investment instruments that convey stock or bonds by dividing a pool of property mortgages into partnerships, corporations or trust entities. By pooling a large numbers of mortgages the risk inherent to an individual property can be mitigated. The secondary mortgage market also contains CMO s and CMBS. collateralized mortgage obligations (CMOs) - Securities issued and sold in capital markets on debt collateralized by pools of Ginnie Mae, Fannie Mae, Freddie Mac, and conventional institutional mortgages. Collateralized mortgage obligations are an important source of liquidity for the mortgage industry. commercial mortgage-backed securities (CMBS) - A bond or other investment instrument backed by loans secured with commercial rather than residential property. 35

36 Chapter 5 Quiz: Sources of Real Estate Capital 1) A loan from a commercial bank falls within this category of real estate capital? a.) b.) c.) d.) debt capital equity capital secondary market both debt capital and equity capital 2) A market where mortgagees sell packages of their mortgages thus freeing up capital so they may continue to lend when they might otherwise lack funds is called? a.) b.) c.) d.) general partnership market equity capital market secondary market commercial loan market 3) Life insurance companies deal within this category of real estate capital? a.) b.) c.) d.) debt capital equity capital secondary market both debt capital and equity capital 4) A general partnership is a form of this type of real estate capital? a.) b.) c.) d.) debt capital equity capital secondary market both debt capital and equity capital 5) This type of investor s claim to property income is subordinate to operating expenses and the claims of creditors and therefore assumes greater risk? a.) b.) c.) d.) debt investor equity investor secondary market both debt capital and equity capital 36

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