Washington Real Estate Fundamentals Lesson 10: Principles of Real Estate Financing © 2011 Rockwell...

Washington Real Estate Fundamentals

Lesson 10:

Principles of Real Estate Financing

© 2011 Rockwell Publishing

Economics of Real Estate Finance

For a lender, a loan is an investment. Interest paid on loan is lender’s return.Riskier loan requires higher return

(higher interest rate).

Interest rate charged on a loan also depends on market forces and real estate cycles.


Economics of Real Estate FinanceReal estate cycles

Real estate cycles: Periodic shifts in level of activity in real estate market.

Real estate cycles obey law of supply and demand.


Real Estate CyclesLaw of supply and demand

Home prices go up when demand is high and supply is low.

Seller’s market.High prices stimulate home construction.

Home prices go down when supply is high and demand is low.

Buyer’s market.Low prices stimulate demand, and cycle

begins again.


Real Estate CyclesMortgage loan funds

Demand for homes tied to changes in supply of and demand for mortgage loan funds.

When supply of mortgage funds is large: interest rates lowdemand for home loans increases

When funds are scarce:interest rates high (tight money market)demand for home loans decreases


Real Estate CyclesMortgage loan funds

Supply of mortgage loan funds depends on: how much money investors have availablehow much they choose to invest in

mortgage loans

This is affected by:overall economymarket interest rateshow mortgage lending compares to other

investments


Economics of Real Estate FinanceInterest rates and federal policy

Federal government influences real estate financing and rest of economy through:

fiscal policymonetary policy


Interest Rates and Federal PolicyFiscal policy

Fiscal policy includes:spendingtaxationdebt management

Set by Congress and the President, through tax legislation and federal budget.


Interest Rates and Federal PolicyFiscal policy

Federal deficit: Shortfall created when U.S. government spends more than it collects in revenue. To cover deficit, Treasury borrows money by

selling interest-bearing securities to investors.Less money available for investment in

private sector. Increase in deficit tends to make interest

rates rise.


Interest Rates and Federal PolicyMonetary policy

Monetary policy: Federal government’s direct efforts to control money supply and interest rates.

Monetary policy determined by Federal Reserve (“the Fed”).

Major goals:economic growthstability in interest rates and markets


Interest Rates and Federal PolicyMonetary policy

Federal Reserve sets monetary policy using these tools:

key interest ratesreserve requirementsopen market operations


Monetary PolicyKey interest rates

Fed has control over two interest rates:federal funds ratediscount rate

These are rates charged when a bank borrows from another bank or from a Federal Reserve Bank.


Monetary PolicyKey interest rates

If Fed raises key rates, banks also raise interest rates they charge borrowers.

If Fed lowers key rates, banks also lower their interest rates.

Lower interest rates usually stimulate economy.


Monetary PolicyReserve requirements

Reserve requirements: Amount of money (percentage of deposits) banks must maintain on deposit, to meet requests for withdrawals.

If Fed raises reserve requirements:less money available for lendinginterest rates go up

If Fed lowers reserve requirements:more money available for lendinginterest rates go down


Monetary PolicyOpen market operations

Open market operations: When Fed buys and sells government securities (such as Treasury notes).

Fed’s primary method of managing money supply.


Monetary PolicyOpen market operations

Buying government securities from investors puts more money into circulation, so that:

money supply increasesinterest rates go down

Selling government securities to investors takes money out of circulation, so that:

money supply decreasesinterest rates go up


Interest Rates and Federal PolicyOther agencies that affect financing

Several other federal agencies also affect real estate financing, such as:

Federal Home Loan Bank SystemFederal Deposit Insurance Corp. (FDIC)Dept. of Housing and Urban

Development (HUD)Rural Housing ServiceFarm Credit System


SummaryEconomics of Real Estate Finance

• Real estate cycles• Supply and demand• Fiscal policy• Federal deficit• Monetary policy• Key interest rates• Reserve requirements• Open market operations


Real Estate Finance Markets

Two finance markets supply funds for real estate loans:

primary marketsecondary market


Real Estate Finance MarketsPrimary market

Primary market: Market in which mortgage lenders make loans to home buyers.

Historically, primary market was strictly local: local banks and savings & loans.

Now much more diverse, but local economic conditions still have impact on amount of funds lenders have available.



When local economy booming:less money savedlocal lenders can’t keep up with demand

for loans

When local economy slow:more money savedlocal lenders have ample funds but little

demand for loans



For lenders, it’s a problem to have either too much or too little money on deposit.

To address this problem, lenders look for opportunities beyond the local market.


Real Estate Finance MarketsSecondary market

Secondary market: Market in which private investors and government-sponsored agencies buy and sell mortgages secured by real estate nationwide.

Allows local lenders to sell loans, to obtain more funds to make more loans.

Moderates local real estate cycles because it’s a national market.


Secondary MarketBuying and selling loans

Mortgage loans can be bought and sold like other investments (such as stocks or bonds).

Value of loan depends on rate of return and risk of default.

Investors generally buy loans at a discount (for less than face value).But discounted loans can be foreclosed

for face value if borrower defaults.


Secondary MarketGovernment-sponsored agencies

Federal government established three secondary market agencies:

Fannie MaeFreddie MacGinnie Mae


Secondary Market AgenciesSecuritizing loans

Role of secondary market agencies:buying loans from primary market

lendersissuing securities using the loans as

collateralselling these mortgage-backed securities

to investorsguaranteeing investors a return even if

borrowers default


Secondary Market AgenciesUnderwriting standards

To reduce risk of default, agencies established their own underwriting standards.

Underwriting standards: Criteria used to evaluate loan applicant and property offered as security.

Primary market lenders that want to sell loans on secondary market generally must meet agencies’ standards.


Secondary Market AgenciesFannie Mae

Federal National Mortgage Association (FNMA)

Created as federal agency in 1938 to establish secondary market for FHA loans.

Reorganized as private corporation (government-sponsored enterprise, or GSE) in 1968.

Buys and securitizes conventional, FHA, and VA loans.


Secondary Market Agencies Freddie Mac

Federal Home Loan Mortgage Corporation Created in 1970 to provide secondary

market for savings and loans.Like Fannie Mae:

government-sponsored enterprisebuys and securitizes conventional,

FHA, and VA loans


Secondary Market Agencies Ginnie Mae

Government National Mortgage AssociationGovernment agency within HUD.Guarantees securities backed by FHA

and VA loans.


Secondary Market AgenciesRecent developments

Because of severe financial problems brought on by the recession, federal government placed both Fannie Mae and Freddie Mac in conservatorship in 2008.

Also created new regulator for them: Federal Housing Financing Agency (FHFA).


SummaryReal Estate Finance Markets

• Primary market• Secondary market• Secondary market agencies• Government-sponsored enterprises• Loan discounting• Mortgage-backed securities• Underwriting standards


Real Estate Finance Documents

Most real estate buyers are required to sign two finance documents:

promissory notesecurity instrument

(either a mortgage or a deed of trust)


Real Estate Finance DocumentsPromissory notes

Promissory note: Written promise to repay a debt (plus interest, in most cases).

Borrower = MakerLender = Payee


Promissory NotesBasic provisions

Promissory note states:amount borrowed (principal)interest rate (and whether fixed or variable)payment amountwhen and how payments are to be madematurity date (when loan to be paid in full)consequences of default

Does not include property description.


Promissory NotesTypes of notes

Promissory notes classified according to how principal and interest are repaid:

Straight noteInstallment note


Types of NotesStraight note

Straight note: Promissory note used for term loan, also called interest-only loan.

Payments during loan term cover only interest (no principal).

At end of term, borrower must pay back entire principal amount with one balloon payment.


Types of NotesInstallment note

Installment note: Promissory note used for amortized loan.

Part of each payment is interest and the rest is principal.

Each payment gradually reduces loan’s principal balance.

If note fully amortized, payments pay off all principal and interest by end of term.


Promissory NotesSimple interest

Interest paid on a real estate loan is almost always simple interest, as opposed to compound interest.

Interest is computed only on remaining principal balance.

Not computed on previously accrued interest as well as on principal.


Promissory NotesNegotiable instruments

Most promissory notes used in real estate transactions are negotiable instruments.

Negotiable instrument: Debt can be assigned to someone else by endorsement (like a check).

Endorsing note transfers right of payment to new party.


Real Estate Finance DocumentsSecurity instruments

Security instrument: Contract that makes borrower’s property collateral for loan.

Either a mortgage or a deed of trust.If borrower doesn’t repay loan,

lender can foreclose on property.

Foreclosure: Forced sale of debtor’s property so that creditor can collect debt from sale proceeds.


Security InstrumentsSecured creditor

Secured creditor: Creditor who has security interest in debtor’s property.

Promissory note can be enforced without security instrument.Creditor can sue to enforce note.

But secured creditor more certain of collecting debt than unsecured creditor.


Security InstrumentsHistorical background

Hypothecation: Borrower transferred title to lender as security, but retained possession of collateral property.

Lender held legal title (also called naked or bare title): title without possessory rights.

Borrower had equitable title: possessory rights without legal title.

Still works this way in some states.© 2011 Rockwell Publishing

Security InstrumentsHistorical background

In title theory states, lender holds legal title throughout loan term.

In lien theory states: Borrower retains full title while paying

loan off.Lender only has lien against property.

Most states, including Washington, are lien theory states.


Security InstrumentsTypes of security instruments

Two types of real estate security instruments:mortgagesdeeds of trust

Main difference: Foreclosure easier with deed of trust.

Deeds of trust much more widely used than mortgages in Washington and some other states.


Types of Security InstrumentsMortgage

Two parties to a mortgage:mortgagor (borrower) mortgagee (lender)

But note that “mortgage” and “mortgage loan” are commonly used to refer to any loan secured by real estate, regardless of type of security instrument actually used.


Types of Security InstrumentsDeed of trust

Three parties to a deed of trust:trustor or grantor (borrower)beneficiary (lender)trustee (neutral third party who handles

foreclosure if necessary)

Language in deed of trust based in title theory; says legal title conveyed to trustee pending repayment of debt.


Security InstrumentsRecording

Lender should record security instrument as soon as loan is made.

Recording:gives public notice of lender’s lien

against the propertyprotects lender from subsequent claims


SummaryReal Estate Finance Documents

• Promissory note• Straight note• Installment note• Security instrument• Foreclosure• Secured creditor• Mortgage• Deed of trust• Hypothecation• Title theory and lien theory


Finance Document Provisions

Mortgaging or granting clauseTaxes and insuranceAcceleration clauseAlienation clauseLate payment penalty provisionLock-in clausePrepayment provisionSubordination clauseDefeasance clause


Finance Document ProvisionsMortgaging or granting clause

Security instrument must include statement that property is pledged as security for loan.

Mortgaging clause in mortgage.Granting clause in deed of trust.

Must also include description adequate to identify the security property.


Finance Document ProvisionsTaxes and insurance

Security instrument provides that borrower must:

keep security property adequately insured against hazards such as fire

pay all property taxes and special assessments

Failure to comply is default on the mortgage, just like failing to make loan payments.


Finance Document Provisions Acceleration clause

Acceleration clause: Gives lender right to demand immediate payment of entire principal balance if borrower defaults.

Aka call provision (“calling the note”).Clause in both note and security

instrument.Triggered by any default on terms of

either document.


Finance Document Provisions Alienation clause

Alienation clause: Gives lender right to accelerate loan if borrower sells security property or transfers an interest.

Aka due-on-sale clause.

Doesn’t prohibit sale of property.

Does allow lender to force borrower to pay off loan if property sold without lender’s approval.


Alienation Clause Sale without loan payoff

If loan not paid off when property sold, buyer takes title subject to lender’s lien.

Buyer may assume mortgage or deed of trust.Buyer has primary liability to lender.Original borrower has secondary liability.

If buyer does not assume loan:buyer not personally liable for repayment lender can still foreclose in case of default


Alienation Clause Assumption with lender’s approval

If mortgage or deed of trust has alienation clause, lender has opportunity to screen buyer.

If buyer creditworthy, lender will:approve buyer’s assumption of loanrelease original borrower from liability

Lender charges buyer assumption fee and may raise interest rate.


Alienation Clause Assumption with lender’s approval

Buyer assuming loan should ask lender to provide certificate of reduction.

Certificate of reduction: States loan’s principal balance as of assumption date.Also called estoppel certificate.


Finance Document Provisions Late payment penalty provision

Late payment charges allowed only if clearly defined in finance documents and reasonable.

Federal law limits late fees for many residential loans.

IRS does not regard late payment penalties as interest, so not tax-deductible.


Finance Document Provisions Lock-in clause

Lock-in clause: Prohibits borrower from paying loan off early (prepaying loan).

Borrower locked in to loan payments for full term, or for specified number of years.

Helps ensure that lender will receive anticipated return on investment.


Finance Document Provisions Prepayment provision

Prepayment penalty: Charge borrower must pay lender if more than a specified amount of principal repaid before payment due.

Many loans have no prepayment penalty.This type is called an open mortgage.

Prepayment penalties are:more common with subprime loanslimited by federal and state law


Finance Document Provisions Subordination clause

Subordination clause: Gives this security instrument lower lien priority than another security instrument to be recorded later.

Common in loans for purchase of vacant land that borrower intends to develop.When construction loan obtained, that

later lender will demand first lien position.

Construction loans are high-risk.


Finance Document Provisions Defeasance clause

Defeasance clause: Provision in which lender agrees to cancel security instrument when debt has been paid off.

Lender must provide lien release document for recording:deed of reconveyancesatisfaction of mortgage


SummaryFinance Document Provisions

• Mortgaging or granting clause• Acceleration clause• Alienation clause• Assumption• Lock-in clause• Prepayment provision• Subordination clause• Defeasance clause• Deed of reconveyance• Satisfaction of mortgage


Foreclosure Procedures

Foreclosure: Forced sale of debtor’s property so that creditor can collect debt from sale proceeds.

Foreclosure is real estate lender’s remedy when borrower defaults. Default may be:

failure to repay loanfailure to insure property or pay taxesbreach of other loan agreement provision


Foreclosure Procedures

Two main forms of foreclosure:judicial foreclosurenonjudicial foreclosure

As a general rule:mortgages are foreclosed judiciallydeeds of trust are foreclosed

nonjudicially


Foreclosure ProceduresJudicial foreclosure

Main steps in judicial foreclosure:Mortgagee files lawsuit against

mortgagor called foreclosure action.Junior lienholders notified.Judge issues decree of foreclosure.Property sold at public auction called

sheriff’s sale.Highest bidder given certificate of sale.


Judicial ForeclosureEquitable redemption

Equitable redemption period: Period from filing of foreclosure action until sheriff’s sale.

During this period, borrower may stop foreclosure and redeem property by paying:

mortgage debt in full, including all principal and interest

costs incurred because of foreclosure


Judicial ForeclosureStatutory redemption

Statutory redemption period: Period after sheriff’s sale when borrower has final chance to redeem property. In Washington:

eight months if lender waives right to deficiency judgment

one year if lender does not

Sheriff’s deed: Deed given to holder of certificate of sale at end of statutory redemption period if property not redeemed.


Judicial ForeclosureSurplus or deficiency

After judicial foreclosure:Borrower entitled to any surplus left after

mortgage and other liens paid off.But if proceeds don’t even cover loan

amount, lender may be entitled to deficiency judgment for the difference.

Non-recourse mortgage: Mortgage that does not permit deficiency judgment.


Foreclosure ProceduresNonjudicial foreclosure

Power of sale clause: Provision in deed of trust authorizing trustee to sell property (without going to court) if borrower defaults.


Nonjudicial ForeclosureMain steps

Trustee sends borrower notice of default. Trustee issues notice of sale one month later.

Notice of sale recorded and sent to borrower, junior lienholders, and anyone who recorded request for notice.

Trustee conducts auction called trustee’s sale.

Successful bidder receives trustee’s deed.


Nonjudicial ForeclosureReinstatement and redemption

Borrower may reinstate loan and stop foreclosure:

by paying only past due amount plus costsuntil shortly before date of trustee’s sale

Or borrower may redeem property:by paying off entire debt plus costsat any time until trustee’s sale held

No post-sale redemption allowed.


Nonjudicial ForeclosureSurplus or deficiency

As with judicial foreclosure, borrower entitled to any surplus after deed of trust and other liens paid off.

However, deficiency judgment not permitted after nonjudicial foreclosure.

If proceeds don’t cover amount owed, lender can’t sue borrower for difference.


Alternatives to Foreclosure

Three alternatives to foreclosure for defaulting borrower:

loan workoutdeed in lieu of foreclosureshort sale


Alternatives to ForeclosureLoan workouts

Loan workout: Arrangement in which lender agrees to change payment schedule or other loan terms to help borrower avoid foreclosure.

Forbearance: Extra time to repay.

Loan modification might involve:changing variable interest rate to fixedlowering interest ratereducing principal amount owed


Alternatives to ForeclosureDeeds in lieu of foreclosure

Deed in lieu: Borrower who can’t arrange loan workout may avoid foreclosure by giving lender a deed in lieu of foreclosure.

Deed transfers title from borrower to lender.

Lender takes title subject to any liens other than its own.

Borrower should make sure lender can’t sue for deficiency.


Alternatives to ForeclosureShort sales

Short sale: When security property is sold for whatever it will bring on open market, but “short” of amount still owed on loan.

Lender generally agrees to accept proceeds from sale as payment in full.Borrower should make sure lender

can’t sue for deficiency.Difficult to arrange if multiple lenders.


SummaryForeclosure and Alternatives

• Judicial foreclosure• Nonjudicial foreclosure• Reinstatement• Redemption• Deficiency judgment• Loan workout• Deed in lieu • Short sale


Land Contracts

Land contract: Financing agreement in which real estate buyer agrees to pay seller purchase price in installments over time.

Alternative to note plus mortgage or deed of trust, in seller-financed transaction.

Also called real estate contract, real property sales contract, conditional sales contract, installment sales contract, or contract for deed.


Land ContractsVendor and vendee

Seller = Vendor

Buyer = Vendee

Vendee agrees to make regular payments of principal and interest to vendor over specified period.

Vendee takes immediate possession of property.


Land ContractsEquitable title and legal title

Although vendee takes possession immediately, holds only equitable title to property during contract term.

Vendor keeps legal title until contract price paid in full.

When contract paid off, vendor delivers deed to vendee, transferring fee simple estate.


Land ContractsRights and responsibilities

Vendee should record land contract to protect equitable interest.

Vendee responsible for paying property taxes and insuring property while paying off contract.

Vendor may encumber property, but not in a way that prevents delivery of clear title when contract paid off.


Land ContractsDefault

If vendee defaults on land contract, vendor may:

foreclose judiciallydeclare a forfeiture


Land ContractsForfeiture

Forfeiture allows vendor to terminate land contract and regain possession of property:

without having to go to courtwithout refunding vendee’s payments

In Washington, this option applies only if contract has forfeiture clause and is recorded.

Law also gives vendee with substantial equity some protection against forfeiture.


SummaryLand Contracts

• Land contract• Vendor• Vendee• Legal title• Equitable title• Forfeiture


Types of Mortgage Loans

Different types of mortgage loans are used in various circumstances or designed to serve particular functions.

In spite of term “mortgage loan,” deed of trust would almost always be used in Washington.


Types of Mortgage LoansFirst or second

First mortgage: Loan against a property that has higher lien priority than any other loans.

Loans against same property with lower priority are second mortgage, third mortgage, and so on.


Types of Mortgage LoansSenior or junior

First mortgage is senior to second mortgage.

Second mortgage is junior to first mortgage, but senior to third mortgage.

Lien priority determines order in which loans will be paid off in foreclosure.


Types of Mortgage LoansPurchase money

Purchase money mortgage: In general, any mortgage loan used to buy the property that will serve as security for the loan.

But also used more narrowly to refer to mortgage in seller-financed transaction.Seller extends credit to buyer and

“carries back” mortgage.Buyer pays seller in installments.


Types of Mortgage LoansSoft or hard money

Soft money mortgage: When seller gives buyer credit in exchange for mortgage.

Another term for purchase money mortgage in narrower sense.

Hard money mortgage: When lender gives borrower cash in exchange for mortgage.

May be purchase money mortgage in broader sense, unless borrower already owns security property.


Types of Mortgage LoansBudget

Budget mortgage: When borrower’s monthly payment includes prorated share of property taxes and insurance in addition to principal and interest.

Lender holds funds in reserve account, pays taxes and insurance when due.

Reserve account is aka impound account.


Types of Mortgage LoansPackage

Package mortgage: When single loan is used to purchase personal property along with real property.

Example: Buyer purchases commercial ovens, freezers, and other equipment along with restaurant property.


Types of Mortgage LoansConstruction

Construction loan: Temporary loan used to finance construction of improvements on land. Aka interim loan.

Take-out loan: Permanent financing of construction debt, replacing interim loan after construction completed.


Types of Mortgage LoansConstruction

Construction loans are risky: borrower could exhaust loan funds before construction finished.

To prevent that, construction lenders have various ways of disbursing funds, such as:Fixed disbursement plan: Borrower

receives obligatory advances at various stages in construction process.

Lender may also hold back 10% or more for mechanic’s lien claims.


Types of Mortgage LoansBlanket

Blanket mortgage: When several pieces of property secure a single loan.

Common in subdivision development.Partial release clause: Requires lender to

release some parcels from blanket lien once certain portion of loan repaid.


Types of Mortgage LoansParticipation

Participation mortgage: Lender entitled to portion of security property’s earnings, in addition to interest on principal.

Most common on large commercial projects.

Lender is insurance company or other large investor.


Types of Mortgage LoansShared appreciation

Shared appreciation mortgage: Lender entitled to portion of security property’s appreciation in value.

Part of increasing equity will belong to lender rather than borrower.

Equity: Difference between property’s market value and liens against it.


Types of Mortgage LoansWraparound

Wraparound mortgage: New loan to buyer that “wraps around” seller’s existing first loan.

Buyer makes payment on wraparound to seller.

Seller uses portion of buyer’s payment to make payment on underlying loan.

Underlying loan:can’t have alienation clauseshould be paid off before wraparound is


Types of Mortgage LoansOpen-end

Open-end mortgage: Allows borrower who has paid off part of loan to reborrow funds without arranging new loan.

Can reborrow up to the amount originally borrowed.

Loan usually has variable interest rate.Often used by builders and farmers.


Types of Mortgage LoansGraduated payment

Graduated payment mortgage (GPM): Borrower allowed to make smaller payments in early years of loan, then steps up to larger payments.

Good for borrowers who expect income to increase.


Types of Mortgage LoansSwing

Swing loan: Temporary loan to buyer who needs funds to close purchase of new property because old property hasn’t sold yet.

Secured by equity in old property.Paid off when sale of that property

closes.Aka gap loan or bridge loan.


Types of Mortgage LoansHome equity

Home equity loan: Loan secured by borrower’s equity in home she already owns.

Usually a second mortgage, junior to existing purchase money loan.

May be used for remodeling or other improvements, or for expenses unrelated to property.

HELOC: Home equity line of credit; works like credit card, but secured by equity in home.


Types of Mortgage LoansReverse

Reverse mortgage: Provides source of income for elderly person who owns home free and clear, by converting equity into cash.

Owner receives monthly payment from lender in return for mortgaging home.

Mortgage typically paid off when home sold after owner’s death.


Types of Mortgage LoansSubprime

Subprime loan: Loan made to borrower who doesn’t qualify for traditional (prime) mortgage loan.

Credit scores or income ratios don’t meet usual standards.

Or may be unable or unwilling to provide standard documentation.

Subprime lenders charge higher interest rates and fees to compensate for higher risk.


Types of Mortgage LoansRefinancing

Refinancing: New loan used to pay off existing loan secured by same property.

May be from same lender or new lender.Common reasons for refinancing:

to take advantage of lower interest ratesto make balloon payment on old loan

Cash-out refinancing: New loan is for more than amount needed to pay off old loan.


SummaryTypes of Mortgage Loans

• Purchase money mortgage• Budget mortgage• Package mortgage• Construction loan• Blanket mortgage• Participation mortgage• Wraparound mortgage• Open-end mortgage• Home equity loan• Reverse mortgage• Subprime loan• Refinancing


Washington Real Estate Fundamentals Lesson 10: Principles of Real Estate Financing © 2011 Rockwell...

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