© 2012 rockwell publishing financing residential real estate lesson 1: finance and investment

© 2012 Rockwell Publishing

Financing Residential Real Estate

Lesson 1:

Finance and Investment


Introduction

This lesson will cover:mortgage financinginvestments and returnstypes of investmentsinvestment risksmarket interest rates


Borrowing for Home Purchase

Buyer’s ability to afford a home depends on:housing pricesincome leveltax considerationsmortgage financing availablemany other factors



Typical loan transaction: Lender loans buyer portion of purchase

price. Buyer makes down payment. Buyer executes security instrument

(mortgage or deed of trust), creating lien. Lien released when loan paid off.



Buyers pay back loan with monthly payments over specified period.

Loan term: period of loan repayment. Principal: amount borrowed. Interest: cost of borrowing money.



Lender sees loan as an investment.Interest paid by buyer is lender’s profit

from investment.


Investments and Returns

National economy is driven in part by investment capital: money used to fund business enterprises, ventures, projects.


Investments and Returns

Investor’s return takes various forms:Return on investment: profit over and

above the amount originally invested.Return of investment: getting full amount

originally invested back (also called recapture).


Types of Investments

Two general categories of investments:ownership investmentsdebt investments



Ownership investment: asset (or property interest in an asset) purchased by investor:

generates income, and/orappreciates in value over time.

Return in the form of appreciation ordinarily not realized by investor until asset is sold.

Ownership investments


Ownership Investments

Real estate is example of ownership investment. It may:

produce income (rent), and/orappreciate in value.

Real estate


Ownership Investments

Corporate stock another example of ownership investment.

Shares = ownership interest in corporation.

Stockholder’s return may take form of:dividends, and/orappreciation of stock value.

Corporate stock



Debt investment: investor provides money to individual or company that will repay money along with interest.

Examples: loans, bonds, savings accounts.

Debt investments


Debt Investments

Loan that earns interest for lender is debt investment.

Includes residential mortgage loans.Bank makes debt investment by loaning

money to home buyers.Home buyers make ownership

investment by investing money to purchase asset.

Loans


Debt Investments

Bond: certificate of indebtedness issued by governmental body or business entity.

Coupon rate: interest rate paid on bond.Principal: face amount of bond.

Bonds


Debt Investments

Funds deposited into savings accounts are used by bank to make loans to other borrowers.

Depositor loans money to bank and receives interest in return.

Bank makes another debt investment (loan to another customer).

Savings accounts


Debt Investments

Certificates of deposit (CDs): similar to savings accounts.

Depositor agrees to keep funds on deposit for certain time period in return for interest payments.

Bank can charge penalty for early withdrawal of funds.

Certificates of deposit



Securities: investment instruments that grant holder interest or right to payment, but no managerial control.

May be ownership or debt investments.Liquid assets = quickly converted to

cash.Traded in established financial markets.Examples: stocks, bonds.

Securities


Securities

Mutual fund: company that buys and sells stocks, bonds on behalf of investors.

Investors purchase shares in company.Company uses capital to invest in

securities.Fund managers choose which securities

to buy and sell.

Mutual funds


Securities

Issuance and trading of securities regulated by federal Securities and Exchange Commission (SEC).

Requires companies to disclose financial information to public.

Enforces insider trading rules.

Regulation of securities


Securities

Securities trading affects mortgage lending in two ways:

Mortgage lending competes with other investments for funds.

Mortgages can be pooled together and “securitized” for sale to investors as mortgage-backed securities.

Securities and the mortgage industry


Key Investment Characteristics

Investors look at three potential investment advantages:

safetyliquidityyield



Investment is safe if there’s little risk that investor will actually lose money.

Investor can count on return of investment, if not return on investment.

Safety



A liquid investment can be converted into cash (liquidated) quickly.

Illiquid investments “lock up” investor funds, making them unavailable for other purposes.

Liquidity



Investment’s yield is its rate of return.Low yield = safe and liquid investments.High yield = high risk/illiquid investments.

Yield isn’t necessarily fixed when investment is made.

Yield



Investor diversifies portfolio by putting money into variety of different investments.

Portfolio: a mix of investments and cash reserves.

Diversification


Investment Risk

From lender’s point of view, risks involved in mortgage lending include:

risk of defaultrisk of lossinterest rate riskprepayment risk

Lending risks


Lending Risks

Degree of risk for loan depends on likelihood of borrower default.

Underwriting process screens loan applicants for risk.

Lender may charge borrower more to compensate for extra risk.

Risk of default


Lending Risks

Lenders take steps to limit risk of financial loss in event of default/foreclosure or damage to collateral property.

Steps include:appraising propertyrequiring borrower to maintain hazard

insurancerequiring mortgage insurance for some

loans

Risk of loss


Lending Risks

If market rates rise after loan is made at a certain interest rate, lender can’t reinvest money at higher rate.

Risk increases with length of loan term.Lenders deal with risk by:

using adjustable-rate mortgagesselling loans on secondary market

Interest rate risk


Lending Risks

Prepayment: borrower repays all or part of principal before it’s due.

Decline in interest rates = borrowers refinance and prepay existing loans.

Prepayment = lender’s yield is less.

Lenders compensate for reduced yield by charging prepayment penalty.

Prepayment risk


Investment Risk

Investors who underestimate risk of particular investment may get lower yield than expected or even lose money.

Poor investment decisions may result from:inaccurate informationdeceptionbad judgment

Misjudging risk


Market Interest Rates

Market interest rates: typical rates lenders are currently charging borrowers for loans.

Can be influenced by:size of loanwhether rate fixed or adjustableloan termborrower’s credit score


Market Interest Rates

Mortgage rates have considerable impact on real estate activity.

High rates cause slowdowns in real estate activity.

Low rates spur market.

Mortgage rates also respond to changes in supply and demand.


DiscussionChapter 1: Finance & Investment

• Break into small groups

• Read discussion questions

• Choose your group’s question

• Discuss

• Present groups conclusions to class

© 2012 rockwell publishing financing residential real estate lesson 1: finance and investment

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