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FINA 4604

by: Heidi Seymour

FINA 4604 FINA 4604

Heidi Seymour

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Real Estate Financing - Exam 1, 2, 3 Study Guides
Real Estate Finance
Mr. Walker
Study Guide
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This 18 page Study Guide was uploaded by Heidi Seymour on Thursday February 25, 2016. The Study Guide belongs to FINA 4604 at East Carolina University taught by Mr. Walker in Spring 2016. Since its upload, it has received 66 views. For similar materials see Real Estate Finance in Business at East Carolina University.


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Date Created: 02/25/16
FINA 4604 Exam Review Definitions: Ch 1  What is the difference between real property and personal property? o Real property: the ownership rights associated with realty. Realty refers  to land and all things permanently attached. Stays with the house –  screwed in, built in the structure o Personal Property: the ownership rights associated with personality.  Personality are all things, tangible, intangible that are removable. Includes  things that are not realty. You can take with you. Ex: hanging on a hook  What is meant by estate? Why are estates important in real estate finance? o 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  economics benefits expected by lenders, investors, and other parties in  real estate transaction are affected by these legal factors.   How can a leased fee estate have value that could be transferred to another party? o The original fee owner can give up some property rights to the 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 is an abstract of title? o Abstract of title: a historical summary of the publicly recorded documents that affect title  Name the three general methods of title assurance and briefly describe each.  Which would you recommend to a friend purchasing a home? Why? o 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.  o Special Warranty Deed: makes the same warranties as general warranty  deed except that it limits their application to defects and encumbrances  which occurred only while the grantor held title to the property.  o Quitclaim Deed: offers the grantee the least protection in that it simply  conveys to the grantee whatever rights, interest, and title that the grantor  may have in the property. Give up right. No warranty.  o NC real estate: what you own, your wife’s owns too. o Would recommend the General Warranty Deed because it offers the most  comprehensive warranties about the quality of the title   Would it be legal for you to give a quitclaim deed for the Statue of Liberty to your  friend? o 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 Ch 2  Distinguish between a mortgage and a note: o Note: admits the debt and generally makes the borrower personally liable  for the obligation o Mortgage: Usually a separate document which pledges the designated  property as security/collateral for the debt.  What does it mean when a lender accelerates? What is meant by forbearance? o Lender Accelerates: Acceleration clause gives the lender the right or  option to demand the loan balance owed if default occurs. Balance is due.  o Forbearance: the lender allows the borrower time to cure a deficiency  without the lender giving up the right to foreclose at a future time.  Can borrowers pay off, part or all, of loans anytime that they desire? o 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 not.   What does non­recourse financing mean? o Non­recourse financing: 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 default.  What does assignment mean and why would a lender want to assign a mortgage loan? o Assignment gives the lender the right to sell or exchange a mortgage  loan to another party without the approval of the borrower.   What is meant by “purchase money” mortgage loan? When could a loan not be a purchase money mortgage? o Purchase money: funds from the loan will be used to purchase a  property. o It will not provide funds for other uses such as could be the case with  refinancing.   What does default mean?  o Default mean: the borrower has failed to (1) make schedule loan  payments or (2) violated on a provision in the note or mortgage.   When might a borrower want to have another party assume his liability under  mortgage loan? o 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.   What is a land contract? o Land Contract: An agreement between a buyer and seller to purchase  and sell real estate. 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.)  How can mechanics’ liens achieve priority over first mortgages that were  recorded prior to the mechanics’ lien? o Mechanics’ Liens: 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 its related back and  takes priority over all liens filed after the time when materials were first  delivered or work was first performed on real estate.   Name possible mortgageable interests in real estate and comment on their risk  as collateral to lenders. o Fee Simple estate: represents the most complete form of ownership of  real estate. The holder is free to divide, sell, lease, or borrow against them as he/she wishes. Little risk to lenders because the owner completely  owns all rights to the real estate o 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 severally limited.  o Remainder: exists when the grantor of a present estate with less  ownership rights than his/her own conveys to a third person the  reversionary interest he/she would otherwise have in the property upon  termination of the grantee’s estate o Reversion: exists when the holder of estate in land (the grantor) conveys  to another person (a grantee) a present estate in the property that has  less ownership rights than his/her own estate and retains for  himself/herself the right to take back, at some time in the future, the full  estate which he/she enjoyed before the conveyance. A reversionary  interest can be sold or mortgaged because it is an actual interest in the  property.   What is meant by mortgage foreclosure, and what alternatives are there? o Foreclosure involves the sale of property by the courts to satisfy the  unpaid debt.   Alternatives:  Restructuring the mortgage loan  Transfer of the mortgage to a new owner  Voluntary conveyance of the title to the mortgages  A “friendly” foreclosure  A prepackaged bankruptcy  Explain the difference between a buyer assuming the mortgage and taking title  “subject to” the mortgage. o If the purchaser acquires the property “subject to” the existing debt, he  does not acquire any personal for the debt o Mortgage is assumed the original borrower may be released from any  obligations to the lender   What dangers are encountered by mortgagees and unreleased mortgagors when the property is sold “subject to” a mortgage? o The mortgagor will be responsible if the person acquiring the property  subject to the mortgage defaults o 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  What is the difference between the equity of redemption and statutory  redemption? o The equity of redemption: 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. o Statutory redemption is the right to redeem after foreclosure  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?  o The mortgagee can use his/her 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? o 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 are the risks to the lender if a borrower declares bankruptcy? o The probability of default or bankruptcy by a borrower and the legal  alternatives available to each party affect the expected return to 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 debtors 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 does deficiency judgment mean? o Deficiency Judgment: If default occurs and the property is sold, if the  dollars from the sale is not enough to pay off the loan balance, the  borrower is liable for the difference.  What is deficiency judgment and how is its value to a lender affected by the  Bankruptcy Code? o Deficiency judgment: any deficit remaining after a 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 non­real 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.  Short Answer Study Guide    Earnest money: money paid to confirm a contract   Due diligence fee:  which is negotiable between the buyer and seller, comes on  top of the initial deposit that a buyer must put down when making an offer.  The fee is generally nonrefundable except in the event of a breach of contract by  the seller.    Seller’s agency  o Created when a property is listed with an agent. (1 agent) o The relationship between the real estate agent and the seller    Seller’s sub agency  o Created for all agents in the MLS (Multiple Listing Service) in which the  property is listed. o Subagent works with the buyer as a customer but owes fiduciary duties to  the listing broker and the seller o Ex: 600+ agents o Brings buyer o An agent of an agent; a person that an agent has delegated authority to,  so that the subagent can assist in carrying out the principal’s orders.    Buyer’s agency  o Created once a buyer employs an agent to work in their interest.   o Agent that was a seller’s subagent becomes buyer’s agent.   o A real estate agent/broker agrees and contracts to represent the buyer in  their purchase of a home/property o Do not have unless you hire someone  Duel: person works as both o licensee represents both the buyer and seller in the same transaction. Forms of Business Organization    Sole Proprietor o Business is taxed off personal income o Assumes all liability (unlimited) o Adds a line in the W2 o Taxation at personal level    Partnership o Taxed after losses are deduced from income o Each owner is personally liable for their share of business  o CAN NOT have personal assets attacked o Get portion o Taxation at personal level o Unlimited liability    Limited Liability Company(LLC) o Co­owned LLC’s do not pay taxes on business income; instead, the LLC  owners each pay taxes on their share of the profits on their personal  income tax returns o Owners in an LLC can not have a creditor come after their personal  assets; such that their car or house for failure to pay o Most popular o Passive Income o Separate entity o Only loss is in corporation    Corporation o Taxed at both the business and personal level (double­taxation) o Separate entity o Cant come after assets o Passive Income    Sub Chapter S­Corporation (S­Corp) o Have income “pass through” to their shareholders, however are able to  avoid double­taxation o Cant be publicly traded o Taxed at an individual level o Pay management  o Cant have 1 owner o Active income (Pay taxes) Passive Income VS Active Income  Passive income  o is money that you make without physica lly doing something, like a ROI ,  Get dividends o *How your income is taxed if you are a small time investor in real estate.   You don’t materially/physically participate in (14hrs or less/week) o You don’t pay payroll taxes or get social security  o Income by owning something, rather than income by working a job/career   Things you have because of things you just own  Active income o  is money that you actually have to work for, like money that’s receive  working for your company  o Definition: Income for which services have been performed. This includes  wages, tips, salaries, commissions and income from businesses in which  there is material participation. o Real estate when working 15+ hours/week, are continuously working for   EX: roof work o Pay payroll taxes on How are the 2 treated differently by the IRS? Per IRS:   “Generally, a passive activity is any rental activity OR any business in which the  taxpayer does not materially participate. Non­passive activities are businesses in which  the taxpayer works on a regular, continuous, and substantial basis. In addition, passive  income does not include salaries, portfolio, or investment income.” BREAKING DOWN 'Active Income' There are three main categories of income: active income, passive income and portfolio income. These categories of income are important because losses in passive income  generally cannot be offset against active or portfolio income.  Best Short Analysis: Passive income and earned income are subject to the same income tax rates. Tax  benefits of passive income are that it is possible to take a loss on passive activities, and no self­employment tax is owed. Disadvantages are that no credits attached to earned  income such as the Earned Income Credit can be obtained using passive income, and  no retirement benefits from Social Security or Medicare are earned.  Rental of real estate, unless you are a real estate professional, is passive income. The  other category of passive income is income from a business or trade in which you do  not materially participate. An example of this is a partnership in which you have invested money and receive income and deductions, but for which you provide no service.  Taxpayers often try to create passive income where there is none. This is because the  general rule is that passive losses can only be offset by passive income. However, if  your AGI is under $100,000, you can take up to $25,000 of passive losses against other income. This exception to the rule allows moderate income taxpayers to benefit from  income from rental real estate. Tax Credits VS Deductions  tax deduction  A  o A  qualifying expense which reduces your taxable income. A common  deduction on your federal income tax return (Form 1040) is for state  income taxes you pay. An example of how this works:  Say, when  considering all of your income and deductions except for state income  taxes, you have $35,000 of taxable income. Furthermore, let’s assume  you paid $1,000 in state income taxes for the year. By deducting the  $1,000 in state income taxes, your new taxable income is $34,000. o Reduce taxable income by itemizing payments. Things like business  expenses, health care, tuition, donations, and more eligible as a tax  deduction   Explain how a tax credit reduces your tax burden.  o A tax credit is a dollar­for­dollar reduction of the income tax you owe. For  example, if you owe $1,000 in federal taxes but are eligible for a $1,000  tax credit, your net liability drops to zero. Some credits, such as the  earned income credit, are refundable, which means that you still receive  the full amount of the credit even if the credit exceeds your entire tax bill.  Therefore, if you owe $400 in tax and claim a $1,000 earned income  credit, you will receive a $600 refund. o There is an array of tax credits available to all types of taxpayers covering  a wide range of expenses. As incentive for taxpayers to protect the  environment, the federal government offers a credit for the cost of  purchasing solar panels and wind turbines for use or for when you install  energy­efficient windows. To help families wanting to adopt a child, the  federal adoption credit can reduce your tax bill for the costs you incur that  are necessary to adopt a child. Other credits cover the expense of child  and dependent care and for taxpayers purchasing their first home. o Directly reduce your tax liability Itemized deduction VS Standard Deduction List possible Itemized Deductions  Mortgage Interest on your home  Charity Contributions  Medical expenses only itemized if expenses are 10% of income or greater (7.5%  once 65 years old) Mortgage pre qualifications:  o Going to the bank, and having the bank estimate how much of a mortgage they qualify for o Max payment = 28% of income  o All payments (income +loans) = can’t be more than 42% of income   Ex: 60k/year income = $5000/month payments  28% (of income) max payment on mortgage = $1400  All payments can’t be over = $2200 o Less of the two = $1400 = max payment you qualify  for o Car loan = $600  student loan = $400  o $1200 left / month for mortgage  o *If you qualify for a 4% (instead of 5%, if your credit is better) mortgage  with that same payment you can buy $28000 extra housing  o Credit: If you look at your paycheck  1/3 goes to taxes  1/3 goes to living (cell phone bill, gas, food, etc.)  1/3 housing  o Know how to calculate the mortgage preapproval process Fair Isaac Credit 3 Credit Bureaus (where your credit score comes from) 1. Equifax 2. Experion 3. Transunion o Use o Get a free credit report once a year per bureau (can get 3 a year spreading these out) o (FTC) Free credit report : to be able to find a way to look up your credit report  70% of your credit score is from the last 2 years (the old falls off) Separate credit report for Utilities o NC has a $300 down payment Factors that will affect your credit score o Pay on time (30%) o Types of credit (20-25%)  It’s better to have a bank credit card than a store credit card o Length of history (20%) o Usage (30-40%)  Is the easiest to manipulate Income Statement Sales Expenses - COGS <- “Keep” (repairs to maintain) – paint, carpet, appliances - Dep. <- “Put” – New student center, Greater than 10,000 (or 5% the value of the property) EBIT you have to count it as a capital improvement -Free Cash Flow (your bank account): take your EBIT and multiply it by (1-Taxes) and then add back deprecation then subtract the (cap expenses plus change in net operation capital). FCF: EBIT (1-T) + Depreciation – (Cap. Expenses + ∆NOWC) Sells Class 1. Frustration (opportunity in the solution) a. Nail in the head b. Don’t give me a problem unless you want me to try to fix it 2. Pricing a. Cost plus profit margins VS perceived value b. EX: health care 3. Overcoming Objectives a. Winning arguments 4. Influence the decision through context a. Dan Airely – Predictably Irrational b. Financial VS Social Context (We only treat situations as one or the other) i. Are decision makers working on Financial Value or Emotional Response? c. Power of the word “free” (Cost VS benefit analysis) d. When are people more likely to cheat? 5. Overcoming Objectives a. Feel, felt, found 6. Go create a fight you can win “Straw Man”. a. Look up YouTube video: The “Straw Man” Fallacy b. Are you wearing the white hat? Is there good and bad? I can rationalize anything I want to do. Are we deciding what we want to do and then justifying?  What I hope you gain from this: o Recognize the difference between information and influences  When are being sold VS informed  Recognize when decision is being framed  Social VS financial  Nothing is free; including lunch on your time  Great credit for your accomplishments  Always take the low hanging fruit. “Take all low hanging fruit!”  Remove victims from your life Theories  Decisions Theory  Parkinson’s Law Debt Equity Preferred Stock WACC = rdwd (1-T) + WeRe  The greater the difference between the weighted average and cost of capital the greater the return  Weighted average cost you use = The rate that you use and the softer present value Types of Loans  Might raise rates for 30 year loans  30 year fixed (backed by the gov’t) at a very low rate o 1-4-unit dwelling o 80% loan to value (LTV) without PMI  Up to 4 investment properties (any after - you are considered a professional) Traditional Mortgage Market o Use it to tap out a 30-year mark at a lower rate  Unlimited owner occupied o If you wait one year they will loan you 80% of the praised value (not purchase price)  100% financing  Property ladder  Interpret Bank Loans o After x there is a balloon Common Real Estate Formulas The real estate investment industry involves a lot of math, and understanding real estate finance includes knowing a lot of formulas and ratios. Sometimes its easy for even the best of us to forget or confuse many real estate formulas. Cap Rate The capitalization rate is used by many investors to quickly determine what a property is worth, or to measure the performance of a property they already own. The advantage of the cap rate is that it takes into account vacancy, credit losses, other income, and operating expenses. It also doesn’t require a multi-period projection of cash flows. This disadvantage of the cap rate is that 1) it only looks at the first year of operating data 2) it doesn’t take into account debt financing. Cash on Cash Return The cash on cash return measures the first year cash return of against the cash invested at the beginning of the year. The advantage of the cash on cash return is that it takes into account vacancy, credit losses, other income, operating expenses, AND debt financing (unlike the cap rate). It also is a simple formula that does not require projecting out cash flow over multiple years. The downside of using the cash on cash return is that it only takes into account one year of operating data. Gross Rent Multiplier The gross rent multiplier is that ratio of sales price over potential rental income (PRI). This is a simple measure that can give you an indication of value relative to market trends. The downside to this formula is that it only takes into account one year of data, and does not take into account operating expenses, debt financing, taxes, or risk. Loan to Value The loan to value ratio (LTV) is simply the ratio of the loan amount to the value of the property. This is a critical constraints banks face when financing a property, and ultimately the value side of the equation is typically restricted by a third party appraisal. Debt Service Coverage Ratio The debt service coverage ratio (DSCR) is expressed as net operating income (NOI) divided by total annual debt service. This is another critical constraint banks face when financing a property. Typically, both the loan to value ratio and the debt service coverage ratio will be determined by a banks loan policy. These are both important formulas to know because a loan amount will almost always be limited by the lesser of the two constraints. In other words, the maximum loan amount will be limited by either LTV or DSCR. Operating Expense Ratio The operating expense ratio is simply the total operating expenses divided by effective gross income (EGI). The ratio is a useful measure that shows you what percentage of income is consumed by operating expenses. Looking at operating expense ratio trends over time in a multi-year analysis can sometimes reveal important trends. Internal Rate of Return Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. IRR is also another term people use for interest or yield. Net Present Value Net Present Value (NPV) is an investment measure that tells an investor whether the investment is achieving a target yield at a given investment. NPV also quantifies the adjustment to the initial investment needed to achieve the target yield assuming everything else remains the same. Understanding IRR, NPV, and discounted cash flow analysis is critical for real estate investors, but its not immediately easy to grasp. Here’s another post that will give you a more intuitive understanding of IRR and NPV, and here’s one that will give you better grasp of discounted cash flow fundamentals. FINA 4604 Exam II Review 1. Understand how the mortgage pre-qualification process determines amount of mortgage a buyer is likely qualified to borrow. (Understand calculations in worksheet)  Getting prequalified is the initial step in the mortgage process. You provide your overall financial stance, including your debt, income and assets. The lender will give you an idea of what mortgage amount you qualify for. This quick procedure is usually at no cost involved in this, and can even be done over phone or internet. You lender can explore your mortgage options with you, and recommend which best suits you. Pre-qualification does not include your credit report, and is just an estimate for what you may get approved for. 2. Break down principle and interest components of an amortized loan.  Example: Determine the payment for a 15 years’ mortgage, of 200,000, and financed @ 3%st a. How much of the 1 payment is applied to interest? i. Monthly rate x principle balance 1. = -PV (.3/12,360, max mortgage payment)???? b. How much of the last payment is applied to interest? i. Payment of one month’s interest rate and the principle from the earlier month 1. (Principle * interest rate) + principle = last payment 2. Last payment / (1+interest rate) = principle 3. Payment – principle = interest paid 3. Create an Amortization schedule for the following property:  Residential rental value @144,000 with 20% of the value attributed to land. i. You can only depreciate the building not the land ii. Portion of purchase price attributed to the building (percent) 1. Residential property is deprecated using straight line depreciation and a useful like of 27.5 years a. Building value / 27.5 = first 27 years of depreciation b. Remaining book value + (1/2 the first 27 years) = Year 28 4. *Explain why projects become less valuable as financing terms become less desirable. Explain in context of options being eliminated as investors are categorized as businesses rather than homeowners whom also own a rental property.  Address: Changes in financing options available  Address: NPV changes as


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