2010 Rockwell Publishing Lesson 9: Principles of Real Estate Financing Principles of California Real Estate 2010 Rockwell Publishing Economics of Real Estate Finance Real estate cycles In real estate, there may be periodic shifts in market activity levels. Buyers market: Few people buying homes, and homes take longer to sell. Sellers market: Many people buying, and homes sell quickly. 2010 Rockwell Publishing Economics of Real Estate Finance Real estate cycles Real estate cycles follow law of supply and demand: Housing prices go up when demand is high and supply low. Prices go down when supply is high and demand low. 2010 Rockwell Publishing Economics of Real Estate Finance Interest rates and federal policy Interest rates represent price of mortgage funds; fluctuate in response to supply and demand. When mortgage funds plentiful, interest rates are low. When funds are scarce, interest rates are highcalled a tight money market. 2010 Rockwell Publishing Interest Rates and Federal Policy Fiscal policy Fiscal policy: Activities federal government pursues through spending, taxation and management of national debt. For deficits, U.S. Treasury borrows money by selling interest-bearing securities to investors (T-Bills, T-Bonds). Government borrowing leaves less money for private sector, driving interest rates up. 2010 Rockwell Publishing Interest Rates and Federal Policy Monetary policy Monetary policy: Federal governments control of money supply and interest rates. Monetary policy determined by Federal Reserve (the Fed). Economy tied to money supply & demand. Low interest rates, economic activity increases. If funds scarce, slowdown will result. 2010 Rockwell Publishing Federal Reserve sets monetary policy using these adjustment tools: key interest rates reserve requirements open market operations Interest Rates and Federal Policy Monetary policy 2010 Rockwell Publishing Key interest rates: When the Fed raises or lowers interest rates member banks pay the Fed, banks adjust interest rates for their customers, too. Lower interest rates can stimulate economy. Interest Rates and Federal Policy Monetary policy 2010 Rockwell Publishing Interest Rates and Federal Policy Monetary policy Reserve requirements: Amount the Fed requires banks to keep on deposit to meet requests for withdrawals. If the Fed lowers reserve requirement, more money becomes available for loans and interest rates go down (and vice versa). 2010 Rockwell Publishing Interest Rates and Federal Policy Monetary policy Open market operations: The Feds buying and selling of government securities (such as Treasury notes). When Fed purchases government securities, more private money becomes available and interest rates go down (and vice versa). 2010 Rockwell Publishing Summary Economics of Real Estate Finance Real estate cycles Supply and demand Fiscal policy Monetary policy Key interest rates Reserve requirements Open market operations 2010 Rockwell Publishing Real Estate Finance Markets Mortgage loans bought and sold like other investments, such as stocks and bonds. Loan value depends on rate of return and risk of default. Seasoned loan (one with history of timely payments) is more valuable. 2010 Rockwell Publishing Real Estate Finance Markets Primary market Primary market: Market in which mortgage lenders make loans directly to borrowers. Although primary market has become more regional or even national, local conditions still have big impact on funding lenders have available for loans. 2010 Rockwell Publishing Real Estate Finance Markets Secondary market Secondary market: National market in which private investors and government agencies buy and sell mortgages. Lets local lenders sell loans to national investors; moderates local cycles. Secondary market transactions are between mortgagees (lenders/investors). 2010 Rockwell Publishing Real Estate Finance Markets Secondary market Secondary market investors generally buy loans at discount (less than face value). But discounted loans can be foreclosed for full face amount if borrower defaults. 2010 Rockwell Publishing Real Estate Finance Markets Secondary market agencies The federal government established secondary market agencies to help secondary market operate more smoothly: Fannie Mae Freddie Mac Ginnie Mae 2010 Rockwell Publishing Real Estate Finance Markets Secondary market agencies Agencies buy large numbers of home loans and then sell securities to investors using purchased loans as collateral. These are mortgage-backed securities. 2010 Rockwell Publishing Real Estate Finance Markets Secondary markets agencies Underwriting standards: To help lessen risk of loan defaults, federal agencies have established standard criteria for evaluating loan applicants. If primary market lenders want to sell loans in secondary market, they need to conform to these standards. 2010 Rockwell Publishing Real Estate Finance Markets Secondary market agencies Federal National Mortgage Association (FNMA) or Fannie Mae: Established to provide secondary market for FHA loans. (Now handles all loan types.) Government-sponsored enterprise (GSE). 2010 Rockwell Publishing Real Estate Finance Markets Secondary market agencies Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac: Established to provide secondary market for savings and loans, but now handles all loan types. Like Fannie Mae, a government- sponsored enterprise. 2010 Rockwell Publishing Real Estate Finance Markets Secondary market agencies Government National Mortgage Association (GNMA) or Ginnie Mae: Government agency within HUD. Buys and securitizes FHA and VA loans. 2010 Rockwell Publishing Real Estate Finance Markets Secondary market agencies In 2008, federal government placed Fannie Mae and Freddie Mac into conservatorship: essentially a government takeover of both agencies. Result of recent recession. New government regulator created for the two agencies: Federal Housing Finance Agency (FHFA). 2010 Rockwell Publishing Summary Real Estate Finance Markets Primary market Secondary market Loan discounting Underwriting standards Secondary market agencies GSEs 2010 Rockwell Publishing Real Estate Finance Documents Most real estate transactions include: promissory note security instrument (mortgage or deed of trust) 2010 Rockwell Publishing Real Estate Finance Documents Promissory notes Promissory note: Written promise to repay debt, plus specified amount of interest. Borrower = Maker Lender = Payee 2010 Rockwell Publishing Real Estate Finance Documents Promissory notes Basic provisions: loan balance (principal amount) interest rate (fixed or variable) payment amount and schedule names of borrower and lender 2010 Rockwell Publishing Real Estate Finance Documents Promissory notes State usury laws may prohibit interest rate in note from exceeding specified amount. In CA, however, most loans secured by real property are exempt from usury law. 2010 Rockwell Publishing Real Estate Finance Documents Promissory notes If each borrower is individually liable for entire loan amount, note will state that borrowers are jointly and severally liable for debt. 2010 Rockwell Publishing Real Estate Finance Documents Promissory notes Because note does not concern property, it need not include a legal description and is usually not recorded. 2010 Rockwell Publishing Types of Promissory Notes Straight note Straight note: Promissory note used for term loan or interest-only loan. Payments made during loan term cover interest only (no principal). At end of term, borrower must pay entire principal with balloon payment. 2010 Rockwell Publishing Types of Promissory Notes Installment note Installment note: Promissory note used for amortized loan, with part of each payment going to interest and principal. Each payment reduces principal balance, until loan paid off. Borrower pays less interest with installment note (vs. straight note). 2010 Rockwell Publishing Promissory Notes Simple interest Interest paid on real estate loan is always simple interest (not compound interest). Computed annually on (remaining) principal balance only. 2010 Rockwell Publishing Promissory Notes Negotiable instruments Most promissory notes used in real estate are negotiable instruments. Can be assigned to others by endorsement (signing over to another). If endorsed without recourse, endorsement is made without any assurances or warranty. 2010 Rockwell Publishing Holder in due course: Third party who purchases negotiable instrument in good faith, unaware of any problems. Entitled to payment even if there were problems with original transaction between payee and maker. Promissory Notes Holder in due course 2010 Rockwell Publishing Real Estate Finance Documents Security instruments Security instrument: Contract that makes borrowers property collateral for loan. If borrower doesnt repay loan, lender can foreclose. Forced sale of property. Lender collects debt from proceeds. 2010 Rockwell Publishing Security Instruments Create lien Security instrument secures loan by creating lien on property. Borrower gives property as collateral, but doesnt give up possession. 2010 Rockwell Publishing Security Instruments Securing personal property Buyer of property may keep possession of property while repaying loan by using a security agreement. In contrast, transferring personal property to lender pending repayment of loan is called a pledge (like pawnshop). 2010 Rockwell Publishing Security Instruments Recording Security instrument need not be recorded to be legal, but it should be, to give constructive notice of lenders interest. Real estate licensee who acts as mortgage loan broker is responsible for recording security instrument before funds disbursed (or within 10 days). 2010 Rockwell Publishing Security Instruments Classification as personal property While real estate notes, mortgages, and trust deeds are connected to real property, they are classified as personal property for owners. Promissory note may be pledged as security for another loan. 2010 Rockwell Publishing Security Instruments Offset statement If loan is sold or assigned, investor may request an offset statement from borrower to: confirm status of loan describe any claims that could affect investors interests Same statement from lender is called a beneficiarys statement. 2010 Rockwell Publishing Security Instruments Lenders permission Borrower must get lenders permission before making any changes that affect propertys value or lien priority. Lenders lien also includes any after- acquired title borrower gains in property (such as an easement). 2010 Rockwell Publishing Security Instruments Mortgages vs. deeds of trust Two types of security instruments: mortgages deeds of trust Main difference: foreclosure is easier with deed of trust. 2010 Rockwell Publishing Two parties to a mortgage: mortgagor (borrower) mortgagee (lender) Security Instruments Mortgages vs. deeds of trust 2010 Rockwell Publishing Three parties to a deed of trust: trustor or grantor (borrower) beneficiary (lender) trustee (neutral third party who handles foreclosure, if necessary) Security Instruments Mortgages vs. deeds of trust 2010 Rockwell Publishing In California (and other states), lenders usually prefer deeds of trust because foreclosure is easier and faster. Trustee holds deed in trust until loan has been repaid. Trustee has power of sale in event of default (can sell without going to court). Security Instruments Mortgages vs. deeds of trust 2010 Rockwell Publishing Summary Real Estate Finance Documents Promissory note Straight note Installment note Security instrument Mortgage Deed of trust 2010 Rockwell Publishing Finance Document Provisions Real estate documents contain numerous provisions: some mandatory, others optional. Certain provisions are unique to security instruments, others also appear in promissory notes. 2010 Rockwell Publishing Finance Document Provisions Property description Security instrument must adequately describe the real property serving as collateral. 2010 Rockwell Publishing Finance Document Provisions Mortgaging or granting clause Security instrument must state that property is pledged as security for loan. Mortgaging clause in a mortgage. Granting clause in a deed of trust. 2010 Rockwell Publishing Finance Document Provisions Acceleration clause Acceleration clause: Gives lender right to demand immediate payment of loan balance if borrower defaults; also known as calling the note. If borrower doesnt meet the demand, lender can foreclose. Can appear in promissory note and security instrument 2010 Rockwell Publishing Finance Document Provisions Alienation clause Alienation clause: Lets lender accelerate loan (demand immediate payment of loan balance) if borrower sells property or transfers it to someone else. Also called a due-on-sale clause. Lender may agree to assumption by creditworthy purchaser, but will likely charge a fee and raise the interest rate. 2010 Rockwell Publishing Finance Document Provisions Alienation clause Alienation clause does not prohibit sale of property, but borrower must be able to pay off loan if property sold without lender approval. 2010 Rockwell Publishing If loan isnt paid off when property sold or transferred, new purchaser can: assume sellers mortgage or deed of trust, or take title subject to mortgage or deed of trust. Finance Document Provisions Alienation clause 2010 Rockwell Publishing In assumption: new buyer assumes primary liability for repaying lender original borrower remains secondarily liable, unless released by lender Finance Document Provisions Assumption 2010 Rockwell Publishing If new buyer takes title subject to existing mortgage (instead of assuming it): original borrower remains primarily liable for repayment new buyer not personally liable for loan Lender can still foreclose if original borrower defaults. Finance Document Provisions Taking title subject to existing lien 2010 Rockwell Publishing Finance Document Provisions Late payment penalty Late payment charges allowed only if clearly defined in finance documents. In CA, payment isnt late until at least 10 days after due date, and penalties cant exceed (the greater of) 6% of principal and interest due or $5. Federal law: limit of 4%, grace period of 15 days 2010 Rockwell Publishing Finance Document Provisions Lock-in clause Lock-in clause: Prohibits borrower from paying loan off early. In CA, loans on residential property with four units or less cannot contain lock-in clauses. 2010 Rockwell Publishing Finance Document Provisions Prepayment penalty Prepayment penalty: Allows lender to charge borrower penalty if more than set amount of principal is paid back before due. With owner-occupied residences, prepayment penalty only allowed during first 5 years of loan term under state law, or first 3 years under federal law. If current interest rates high, lender more likely to waive prepayment penalties. 2010 Rockwell Publishing Finance Document Provisions Open mortgage Open mortgage: Loan without a prepayment penalty provision. 2010 Rockwell Publishing Finance Document Provisions Subordination clause Subordination clause: Makes it possible for security instrument recorded later to have higher lien priority (than earlier recorded instrument). 2010 Rockwell Publishing Finance Document Provisions Subordination clause Often found in security instrument for loan purchasing vacant land. Buyer plans to obtain construction loan. Later lender will want first lien position for construction loan (higher risk). 2010 Rockwell Publishing Finance Document Provisions Defeasance clause Defeasance clause: Lender agrees to cancel security instrument when debt is paid. If security instrument was deed of trust, lien removed through deed of reconveyance. When mortgage paid, certificate of discharge removes lien. 2010 Rockwell Publishing Finance Document Provisions Defeasance clause For deed of trust, beneficiary must submit request for reconveyance to trustee within 30 days after loan paid. Trustee has 21 days to execute deed of reconveyance. Need not be recorded, but should be to protect trustor. 2010 Rockwell Publishing Summary Finance Document Provisions Acceleration clause Alienation clause Late payment penalty Lock-in clause Prepayment penalty Subordination clause Defeasance clause 2010 Rockwell Publishing Foreclosure Foreclosure is lenders remedy when borrower defaults. Can be done judicially (in court) or nonjudicially. Actions constituting default include: failure to repay loan using property for illegal purpose failing to insure or maintain property 2010 Rockwell Publishing Judicial Foreclosure If borrower defaults, mortgagee files lawsuit (foreclosure action) in county where property located. Judge issues decree of foreclosure. Property sold at public auction (sheriffs sale). 2010 Rockwell Publishing While foreclosure action pending, borrower has right to reinstatement. Reinstatement period lasts until foreclosure decree is issued. To reinstate loan, borrower must pay: past due amount any foreclosure costs incurred Judicial Foreclosure Reinstatement 2010 Rockwell Publishing Even after sheriffs sale of property, borrower has statutory right of redemption. Borrower may redeem property by paying off: entire debt interest all foreclosure expenses Judicial Foreclosure Redemption 2010 Rockwell Publishing In California, redemption period lasts: three months if sale proceeds were enough to cover debt, or one year if sale proceeds were not enough to cover the debt No redemption period if lender waives deficiency judgment or not allowed to seek deficiency judgment. Judicial Foreclosure Redemption 2010 Rockwell Publishing During redemption period, borrower may retain possession of property but must pay rent. Successful purchaser at sheriffs sale receives sheriffs deed after redemption period, which transfers title and possession. Judicial Foreclosure Redemption 2010 Rockwell Publishing After all liens paid off, borrower receives any surplus from foreclosure sale. If proceeds dont cover loan amount, lender may be entitled to deficiency judgment; Not allowed with most residential loans. Judicial Foreclosure Surplus or deficiency 2010 Rockwell Publishing Nonjudicial Foreclosure Power of sale clause: Provision in deed of trust that authorizes trustee to sell property if borrower defaults (without going to court). Most mortgages have no equivalent provision. 2010 Rockwell Publishing Nonjudicial foreclosure must be conducted in accordance with statutory procedures. Trustee sends notice of default to borrower and other lienholders. Three months later, trustee posts and advertises notice of sale. Trustee holds auction (trustees sale) at least 3 months and 20 days after notice of default. Winning bidder receives trustees deed. Nonjudicial Foreclosure 2010 Rockwell Publishing Borrower may reinstate loan (and redeem property) by paying past due amount plus costs, up to 5 days before trustees sale. Reinstatement period lasts at least 3 months and 15 days. No post-sale redemption option (unlike judicial foreclosures). Nonjudicial Foreclosure Reinstatement and redemption 2010 Rockwell Publishing Deficiency judgments not permitted in nonjudicial foreclosures. Lenders may pursue judicial foreclosure to seek deficiency judgment. Notice to other lienholders important because junior lienholders claims terminated by trustees sale. Nonjudicial Foreclosure Deficiency judgments 2010 Rockwell Publishing Alternatives to Foreclosure If borrower cant reinstate loan, lender may accept deed in lieu of foreclosure. Transfers title from borrower to lender. Lender takes title subject to liens. Other alternatives to foreclosure include short sales and loan modification. 2010 Rockwell Publishing State law imposes special requirements on lenders that are foreclosing on residential loans made during boom years ( ), including longer notice periods. Generally, persons providing consultancy to homeowners facing foreclosure must have a written agreement with borrower. Various other rules apply. Alternatives to Foreclosure Recent law 2010 Rockwell Publishing Foreclosure vs. Bankruptcy Bankruptcy and foreclosure are separate legal procedures. If borrower facing foreclosure files for bankruptcy, foreclosure proceedings are temporarily put on hold. 2010 Rockwell Publishing Summary Foreclosure Judicial foreclosure Nonjudicial foreclosure Reinstatement Redemption Deficiency judgment Deed in lieu of foreclosure Bankruptcy 2010 Rockwell Publishing Types of Mortgage Loans Even though various loans secured by real property are often called mortgage loans, in California security instrument for these loans will usually be deed of trust (not mortgage). 2010 Rockwell Publishing Types of Mortgage Loans First mortgage First mortgage: Loan with first lien priority. Loans with lower priority are known as second mortgages, third mortgages, and so on. Generally, called junior mortgages. 2010 Rockwell Publishing Types of Mortgage Loans Purchase money mortgage Purchase money mortgage: Any mortgage loan used to buy property that serves as security for loan. May also refer to seller financing, where seller extends credit instead of requiring full payment at closing. (Also called soft money mortgage.) 2010 Rockwell Publishing Types of Mortgage Loans Hard money mortgage Hard money mortgage: When borrower gives lender mortgage and receives cash in exchange. 2010 Rockwell Publishing Types of Mortgage Loans Package mortgage Package mortgage: Mortgage used to finance real property and personal property. Example: office or farm equipment included in sale of real property. 2010 Rockwell Publishing Types of Mortgage Loans Construction mortgage Construction mortgage: Temporary (or interim) loan used to finance construction of land improvements. Loan funds are usually disbursed to borrower as construction proceeds using fixed disbursement plan. 2010 Rockwell Publishing Types of Mortgage Loans Construction mortgage When construction complete, interim loan replaced by permanent financing (called a take-out loan). Lenders promise to give a (future) take-out loan is called a standby loan commitment. 2010 Rockwell Publishing Types of Mortgage Loans Blanket mortgage Blanket mortgage: When several properties are used to secure one loan. Common in subdivision development. Partial release clause: Requires lender to release some of properties from blanket lien when specified portions have been paid off. 2010 Rockwell Publishing Types of Mortgage Loans Open-end mortgage Open-end mortgage: Mortgage that allows borrower who has paid back part of loan to re-borrow funds, up to a limit. Often used by builders and farmers. 2010 Rockwell Publishing Types of Mortgage Loans Subprime mortgage Subprime mortgage: Loan made to borrower who may not qualify for ordinary mortgage loan, often because of poor credit history, high debt-to-income ratio, or lack of documentation. Lender usually charges higher interest rates and fees to offset risk. 2010 Rockwell Publishing Types of Mortgage Loans Home equity loan Home equity loan: Borrower uses equity in residence to get mortgage loan. Money can be used for expenses unrelated to propertymedical bills, college tuition, etc. Home equity line of credit (HELOC): Revolving line of credit, much like credit card, but debt secured by borrowers home. 2010 Rockwell Publishing Types of Mortgage Loans Refinancing Refinancing: Borrower obtains new mortgage loan to replace existing one, using funds from refinance to pay off old loan. Often used when: interest rates are low date of balloon payment approaching 2010 Rockwell Publishing Land Contracts In seller-financed transaction, seller may use land contract to extend credit, rather than mortgage or deed of trust. Land contract serves as both promissory note and security instrument. Also called contract for deed or installment sales contract. 2010 Rockwell Publishing Summary Mortgage Loans and Land Contracts Purchase money mortgage Package mortgage Construction mortgage Blanket mortgage Open-end mortgage Home equity loan Refinancing Land contract