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The Real Estate Think Tank: Episode 5: Foreclosures and Shorts Sales
Please join us for the third episode of The Real Estate Think Tank Podcast
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The Real Estate Think Tank: Episode 5: Foreclosures and Shorts Sales
ARMs: A Definition
Adjustable rate mortgages are mortgages with monthly
payments that track a chosen index. These payments can adjust monthly,
yearly or after a couple of years, with the most frequent adjustment period
being annually. Although it is possible for an ARM to adjust after the first
month or year, in which case it is a traditional ARM, most ARMs are hybrids. Hybrid ARMs have an initial period during which the rate is fixed, after which
the mortgage converts into an adjustable mortgage with fluctuating payments.
Hybrid ARMs are popular, because they come with an initial “teaser rate”
during the fixed period that is typically lower than the prevailing rate for
fixed mortgages. This lower rate allows the borrower a period of adjustment that could
result in either refinance, liquidation or increased preparation for the impending larger payments. There are also Interest-Only (I/O) ARMs, which have an
initial period during which only the interest of the mortgage is paid before
the adjustment period begins, and Payment Option or Option ARMs, which allow
the borrower to pick a fixed payment during the initial period of the mortgage,
before the adjustment period begins. Both of these products, however, fell out
of favor after the mortgage crisis of 2009 due to concerns around retail consumer suitability.
Below is a list from www.thetruthaboutmortgage.com of
the most popular hybrid ARM products:
As is apparent, there is a variety in the length of both the fixed
rates and the adjustment periods offered amongst hybrid mortgages.
ARM Indices
All ARMs, be they hybrid or traditional, are tied to an index that regulates payment fluctuations during their adjustment periods. Below
is a list of the most popular list of indices to which most ARMs are attached,
along with an explanation of their functions:
T-Bill: The yield resulting from the weekly auctions
of one-year Treasury-Bills held by the US Treasury.
Prime: The rate set by the Federal Reserve that most
commercial banks charge their creditworthy customers for lending products.
Constant Maturity Treasury (CMT): The derived yield of a mix of Treasury securities, with various maturities, including T-bills, T-notes, T-bonds and off the run securities, adjusted to a one-year term.
Monthly Treasury Average (MTA): The average of the last 12 values of
the CMT, adjusted for lag effect.
The 11th District Cost Of Funds Index (COFI): The rate
savings institutions pay depositors for checking and savings accounts in the 11th
Federal Home Loan Bank District. This district includes banks in Arizona,
California and Nevada.
London Interbank Offered Rate (LIBOR): The
interest rate charged among London-based banks for borrowing transactions
between them. This rate is set by a panel of global banks and is based on their global currency trading estimates.
Secured Overnight Financing Rate (SOFR): The volume-weighted
median of transactions taking place in the overnight U.S. Treasury repo market.
ARM Metrics
When evaluating the performance of any ARM, a number of factors
must be taken into consideration. Below is a short list of terms and
definitions that are helpful to evaluating ARM yields:
Index Value: The mortgage rate, based on the market index.
Initial Coupon/Teaser Rate: The first rate paid by the borrower
until the first adjustment period.
Gross Margin: The amount above the index value paid by the
borrower during the adjustable term of the mortgage.
Net Margin: The spread paid to the investor after
deducting the servicing and guarantee fees or credit enhancements.
Servicing Fees: The rate charged by servicer to service the
loan.
Guarantee Fees: The rate charged by MBS servicer to ensure
that payments from the mortgage will be supplemented in case of default.
Credit Enhancements: Collateral posted to offset any
credit risk from the mortgage.
Reset Frequency: The amount of time between reset periods.
Periodic Rate Collar: The maximum allowable adjustment to
the rate paid by the borrower during any one adjustment period.
Gross Life Cap: The maximum allowable rate paid by the
borrower during the life of the loan.
Gross Life Floor: The minimum allowable rate paid by
the borrower during the life of the loan.
To find the rate of an ARM during its adjustment period, one need only take the initial coupon and add the index value and gross margin, limiting this value by the lesser of the periodic rate collar and gross life cap. If the rate later decreases at some point, the negative index value is added to the gross margin and limited by the greater of the gross life floor or periodic rate collar.
The gross life cap and floor are also helpful in calculating a best and worst case scenario for performance during the life of the loan. Running a maturity value calculation that results from the sum of the fixed period calculation, graduated payment escalations from the teaser rate to the gross life cap, bounded in each period by the rate collar and the adjustment period, assuming that the rate will remain at the gross life cap for the duration of the loan will yield a max value. Performing a similar calculation, graduating the payments down by the rate collar until the loan reaches its teaser rate and then assuming that the loan stays at the teaser rate for the duration of the loan, will yield a worse case scenario. Either one of these calculations can be weighted by the historical performance of the index to which the ARM is tied for a risked-weighted calculation.
Finally prepayments can be assumed to have a 100 PSA, in the absence of any other prepayment data. The PSA or Public Securities Association’s Standard Benchmark is a method calculating prepayments based on a derived prepayment curve. A more in-depth discussion of the PSA can be found here.
That is my take on Adjustable Rate Mortgages. Please feel free to
leave your thoughts below.
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1. Choose Your Market Wisely
The most effective way to navigate any real estate investment
is by carefully choosing the market in which to invest. Location, location,
location once again proves to be a sage cliché. Being aware of legal risks
and rewards is just as important to the analysis of any property as its income numbers
and property condition. The location of a property will not only determine
the set of laws that an investor must navigate, but it will also determine the
prevailing legal sentiment around the property. This sentiment will effect the laws passed in a given market and have a bearing on
how local courts will view real estate disputes like waste, nuisance,
foreclosures, evictions, etc. Understanding the local view of these issues will
allow investors to accurately estimate the legal costs and make an informed investment decision as a result.
2. Know The Laws That Affect The Property
Understanding the applicable laws influencing property can
be the difference between a profitable investment and a poor acquisition. Legal
frameworks like rent control, affordable housing zoning and industrial tax
credits will all effect the viability of an investment. This is especially true
with real estate development, as many jurisdictions have detailed, idiosyncratic
new development requirements that protect the rights of both the developer
and the community. These requirements may affect zoning, construction ordinances, restrictions on selling and transfer
of the property and even property taxes. An intimate knowledge of these regulations is essential, even if the purchased property is not newly constructed,
as an acquisition that is economic in some jurisdictions can be rendered
uneconomic by the prevailing local new development requirements. Please also keep in mind that recently renovated buildings
can be considered “newly developed” in some jurisdictions and subject to new
development laws.
In addition to new development regulations, investors must be aware of other laws that could affect properties. Building ordinances, for example, affect all properties, not just those that are undergoing construction and renovation. These ordinances are also present at every level of legislation from the federal American Disabilities Act and FHA guidelines all the way down to the village building code. Properties that are not compliant with the requirements of the local building code are subject to fines and violations, both of which eat into investment profits. Much of the same can be said for zoning ordinances. In most jurisdictions, there is a mechanism to apply for a variance or appeal for both zoning laws and the building codes. Variances to zoning are more frequent than building code appeals, as building codes are driven by use and public safety concerns, whereas zoning is primarily driven by municipal planning and use. Understanding local building codes and zoning laws is essential to real estate profitability. To do avoid doing so is to raise the risk of an investment by exposing it to additional risk that can be easily mitigated. Attorneys, expeditors and knowledgeable contractors are effective allies in mitigating this area of legal exposure.
3. Understand The City/Town/Village Plan
Every municipality publishes a plan of development for its
area. Much has been stated and written about the importance of the local plan. This
document outlines the areas that the local government wishes to develop and the
incentives that it will provide to stimulate such development. Often times unviable
projects become realities, because they are either moved to or fortuitously located
in a development zone. Understanding the presence of incentives is essential to
obtaining an accurate estimation of value for a property. The local municipal
planning document will assist with such a determination.
4. Hire Great Professionals
This point is mentioned in numerous articles on this blog and above,
so it won’t be expanded in much detail here. If legal analysis and/or real
estate planning is not a strength, it is important to hire professionals to
ensure that the necessary information is readily available.
5. Remember That It’s Not Personal
Laws reflect the dominant ideology of an area. Every area
has its own context, demographic and history, which leads to a prevailing
sentiment of how real estate should be managed by default. In other words, real
estate laws are a collection of the most popular ideas of how real estate should
be run in an area. Most people aren’t anti-investment, nor are they against
wealth per-se. Most voters, however, will vote to protect their
interests and this takes different forms in different locales. In most
instances, with notable exceptions, real estate laws are not enacted for
personal reasons and, in the absence of extreme lobby power, there isn’t much
any one investor can do to change the laws. The most viable course of action for
most investors is to be aware of the legal scheme that affects a property, earnestly
consider if the local laws work for the investor’s criteria and find viable
ways to navigate the relevant laws.
So, this is my take on how to navigate legal structures affecting
a property. This a high-level view of this topic. This post definitely could
have been substantially longer, but I am happy to discuss your comments below.
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The Real Estate Think Tank: Episode 3: Should I Buy A House Now?
Please join us for the second episode of the The Real Estate Think Tank Podcast.
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Please join us for the first episode of the The Real Estate Think Tank Podcast.
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The Real Estate Think Tank Podcast: Episode 1: Welcome to TRET