Sunday, November 23, 2014

It's Good To Be Back

Hello Blog Audience,

It's been a while, but I believe it is time to renew this blog and begin posting again. Having finished law school and gained a greater appreciation for the legal aspects of real estate and real estate securities, I have much to write about the wonderful world of real estate and real estate finance. I continue to augment my quantitative knowledge of both real estate and securities, but have found it necessary to also be intimately familiar with the law that makes all of this analysis possible.

I recently looked back at my previous posts and saw how the discipline of blogging about a topic forced me to confront the limits of my knowledge and seek answers. In that sense, this blog was, and continues to be, as much about my quest to better understand real estate finance as it is an expression of my knowledge of the asset class. Having stated that personal realization, I look forward to the more robust nature of the content of this blog. Post will be more frequent and necessarily more succinct in nature. I cannot promise daily posts, but I can promise to "get back on the bicycle yet again." Now for the legal disclaimers.

This blog is for the purposes of information only. I make no representations as to the correctness of the information posted on this blog and any posted information must be verified independently. Nothing on this blog is intended to give legal advice, suggest legal advice or be construed as engaging in the practice of law in any way. All discussions of legal matters should be verified by competent council, licensed to practice in the jurisdiction in question. Any of the opinions posted by anyone on this blog are those of the poster alone and are not necessarily shared by me. Such opinions include, but are not limited to, those from readers, fellow bloggers, guest bloggers and/or any miscellaneous commentary posted, with or without my knowledge.

That was a mouthful. Happy reading and feel free to leave a comment.

Tuesday, August 30, 2011

Lender’s Fees: How Should One Account For Them?

Lender’s fees are a fact of life in real estate acquisitions. I was recently reading a chapter in a real estate handbook that outlined the justifications of a number fees commonly associated with mortgage origination and it offered a number of options for reducing their amounts. The relative negotiability of each lender fee, however, depends greatly on the lender, the credit worthiness of the borrower, the size of the asset, the size of the down-payment and market conditions. Generally, the stronger the buyer, the larger the asset and the larger the down-payment, the more negotiable lender’s fees are. Below is a discussion of some of the most common lender fees and how to account for them.

Friday, August 5, 2011

Residential Mortgage Backed Securities: How They're Supposed To Work

Residential Mortgage Backed Securities (RMBS) are the fuel that powers our country's mortgage market. Their role in mortgage lending is not complicated, despite the fact that accurately pricing them requires in-depth knowledge of stochastic processes, matrix math, as well as a solid understanding of partial differential equations. I recently found a great article on-line by American University's Peter Chinloy that explains the how RMBS functions and the many of the assumptions that undergird them.
The long and short of it is that RMBS expands the lending capacity of financial institutions by allowing them to sell the home loans that they originate to purchasers on the secondary market to other institutions, exchanging the cash flow from the loans for cash for their balance sheets. The purchasers of these loans then package them and create investment vehicles or conduits. Investors are then offered an opportunity to participate in the cash flows that comes from the payment of these loans through the purchase of bonds issued on behalf of a conduit. These bonds are categorized as RMBS. They offer the investor exposure to the returns and activity of the housing market without the idiosyncrasies of property ownership or the capital  and labor requirements of lending. Moreover, a great deal of investment grade RMBS is guaranteed and can be insured. Add in the historically low home loan default rates with the lower capital reserve requirements of for insurance companies holding RMBS and it seems like a solid investment.
By now, the story of RMBS and its function has been told in many different places since the beginning of the economic downturn, so I harbor no delusion that what I have written thus far is not already widely understood. Chinloy's article, though written 16 years ago, offers a refreshing explanation of the purpose of each component of the mortgage lending system. It also illustrates the mathematical assumptions of lending behavior, important variables and basic RMBS pricing that can be easily used in Excel.
Chinloy describes the differences in private and agency RMBS that were once key to residential loan securitization. Originally, GNMA or agency RMBS was the outlet for borrowers that had less capital or lower credit scores than was required of conventional loans. Loans that fell under the purview of GNMA, known as FHA, VA or FmHA loans, were not only insured by FHA, VA or FmHA, but they also had default premiums priced into the mortgage payment. GNMA assumed  that the lower access to credit and/or capital typical of the borrowers of these loans would sever to lessen the frequency of prepayment through early payoff or refinance. Prepayment is generally undesirable to the bond holders of RMBS products, because it lowers the interest rate carry of each prepaid mortgage, reducing the amount of cash flow from that note and thus reducing the cash flow to the bond holder. The insurance premiums built into the loans covered prepayment due to default and the entire system was guaranteed with government credit. The added risk of the borrowers of an agency loan was therefore offset by the government's guarantee and the bond holder was generally assured that loan prepayment would be low.
Conventional mortgages, on the other hand required higher down-payments and were typically given by borrowers that had more access to capital (let's remember the borrowers give mortgages and banks give loans). Prepayment risk is generally higher via early payoffs or refinances, especially as interest rates tended downward. Fannie Mae and Freddie Mac, the largest purchasers of conventional mortgages, insured all mortgage collateral and the payments on their RMBS issues, in order to reduce this risk. The money from this insurance was both built into the price of the RMBS, but was also guaranteed by both organizations' access to a $2.5 billion credit line from the government. Principal Mortgage Insurance (PMI) was also employed in cases where the borrower's loan-to-value, LTV, exceeded 80%, making the loan more of a risk for default. PMI, however, only covered the difference between market value and mortgage value.
One of the most ironic aspects of the article is its discussion of private RMBS securitization, which it describes as a highly risky and generally below investment grade for a number of reasons. We know that this view of private securitization was largely ignored during the real estate bubble and that not only did private RMBS overtake the RMBS market, but also the resultant demand for mortgage notes led to the replacement of PMI. This practice traded insurance for increased exposure to risk from the same asset. Understanding the function of PMI, default rates and down payment requirements from the perspective of RMBS issuances, allows one to see why the once widespread practice of "piggyback loans" and "no money down" financing was a recipe for disaster. Not only did such lending practices dilute the relationship of the borrower to the property, making default much more likely, but they also eroded many of the insurance fail-safes of the private home mortgage lending system that insured the private RMBS payments to the investors in case of default. Additionally, piggyback loans, created two instances of default for a property instead of one, doubling the effect of default of each similarly financed property on the secondary market and on the related securities markets.
I could write a book about my reaction to Chinloy's article. I particularly like his analysis of mortgage payments and defaults as options, which lends borrowing behavior to derivative analysis. I also appreciate his in-depth explanation of forward and backward solving models for pricing RMBS. I am not sure which one I prefer, but I must say that I am somewhat partial to the type of analysis that the backward solving model employs. Though both types of models are useful tools, forward solving models are inherently more optimistic.  There is also a key point made on page 19 of the article regarding Fannie Mae's finding that properties with more than 10% negative equity have a high likelihood of default. Chinloy's mention of the lack of accounting for borrower liquidity in most RMBS pricing models is also noteworthy.
I do want to point out that some of the references in this article are dated. Due to mortgage acceleration clauses, new FHA, VA and FmHA mortgages are no longer assumable, therefore all of the sections about the assumablity of mortgages and selling the mortgage with the house are no longer relevant. It is also clear that Chinloy had no indication of the explosion of private and conventional loan and RMBS origination that would begin to take place just 3 or 4 years after the writing of his article and thus some of his predictions seem disconnected with what actually transpired in the real estate and securities markets. Chinloy, however, offers a cogent overview of the system of RMBS issuance that existed up until the late 1990's. It is clear that had this system been more clearly understood and followed by lenders, investment banks, investors and RMBS originators much of the calamity that recently befell our financial system could have either been predicted or avoided.

Tuesday, July 26, 2011

Capitalization Rates: Prespective on Their True Meaning

Cap rates are one of the most referenced metrics in all of commercial real estate. Unfortunately, they are also one of the most misunderstood metrics in our industry. I genuinely believe that this misunderstanding comes from the diversity of significant players in commercial real estate. Unlike the equities and debt markets, commercial real estate does not require the presence of a financial institution to mitigate the flow of information and to establish standard practices. Moreover, the equities markets are heavily regulated to insure honesty, transparency and equality of information. The debt markets, though not transparent, however, are generally restricted to institutional investors and high net worth individuals. Commercial real estate sales and acquisitions have no such regulations or restrictions and therefore do not require knowledge of the real estate metrics and their related mathematics to effectively transact. Many commercial property owners purchase properties based on simplified formulas, local knowledge of the property, purchasing rituals or merely "gut feelings." The presence of such transaction activity lends to frequent misuse of real estate metrics.

Despite the misunderstanding of real estate mathematics amongst a certain sector of the real estate market, savvy real estate purchasers, appraisers, institutional buyers and real estate analyst are typically comfortable with the metrics used to describe property performance. The Capitalization Rate or cap rate of a property is one such metric that can offer a wealth of information about the performance of a property and the market assumptions of the seller.

The cap rate expresses the annual rate of return of a property's net operating income given its market value or purchase price. Since debt service, income and expense escalations, and tax considerations, it is not the most reliable method of determining annual return. If properly calculated, however, the cap rate can be compared with a metric of opportunity costs, such as the Weighted Average Cost of Capital from the world of equities to determine the desirability of the property given alternative investments.

I recently found a paper written for the Journal of Real Estate Research that explains the components of cap rate. It explains that cap rates are significantly influenced by the debt and equities markets, but contain significant time lags, given the illiquidity of real estate. The paper asserts that there are 4 components to a cap rate: the risk free rate (here measured by 3 month treasuries, usually measured by the rate of 30 yr. treasuries); a component composed of the market cost of debt divided by the property value (let's call it the property's market LTV) and the spread of a BAA rated bond (lowest possible investment grade); a component comprised of the 1 minus the property's market LTV, the equity spread (as measured by the performance of the S&P 500) and a volatility coefficient beta for stocks (measured by the covariance between real estate equity returns and market returns, divided by the variance of market returns); finally, the negative of the growth rate.

Cap rates are also typically expressed as the discount rate less the property growth rate. Following this logic, one can collapse all of the above components of the cap rate, except for the growth rate negative, into the cap rate's given discount rate. Therefore, given a cap rate, one can look up the risk free rate, the market cost of debt, the BAA bond spread, the equity spread and the equity volatility beta and find the growth rate of the property assumed. All of the aforementioned components are regularly published.

Knowing the assumed growth rate of a property allows for a deeper understanding of how that property is priced and how it is expected to perform. It also explains the inverse relationship between cap rate and price, as a larger cap rate assumes more negative growth or appreciation, as it is called in real estate.

One caveat to both this discussion and the paper referenced is that I am not convinced that cap rates are significantly influenced by the changes in the equities market, although equities are an appropriate asset by which opportunity costs can be measured. The influence of both property REIT's and mortgage REIT's as well as the proximity of the stock market's historical returns (hovering around 8.5%) to historical cap rates (around 7.6%) all make the case that the equities market has some influence on cap rates. Given real estate's local nature and the idiosyncrasies of each property type, however, it is difficult to believe that the link between cap rates and equities can remain significant in the face of more influential determinants of the property's value. I prefer to think of the equities portion of the equation as open to be replaced by whatever alternative investment is feasible to the purchaser at the time the cap rate is figured, accompanied by its related volatility beta.

Friday, July 22, 2011

Commercial Notes and Properties

Commercial mortgage note valuations are distinguished from residential note valuations in that commercial notes, and by extension their related CMBS bonds and derivatives are based on the performance of the underwritten property, whereas residential notes and their related securities rely heavily on the financial behavior of the borrower. Many commercial mortgages are non-recourse to the borrower and often the borrower of a commercial mortgage is an entity, which can be dissolved and disappear upon insolvency or bankruptcy. It is also not unheard of to find commercial lenders and servicers managing properties obtained through foreclosure for a number of years to collect the cash flow from the property until it is sold. Bank-owned residential properties, however, are generally seen as liabilities to be sold at the highest price, as quickly as possible.

Given the non-recourse nature of most commercial financing and the strong consideration of the performance of the property, many commercial note valuation financial models are very similar to commercial asset acquisition models, with a number of lending considerations, such as debt yield, added. The closely related nature of commercial note and commercial property valuations has led me to title this post "Commercial Mortgage Notes and Properties." There are a number of elements that are essential components of both types of models. First, an asset description worksheet detailing the asset and its financing is key. This worksheet should be flexible enough to run a number of quick scenarios or "stress tests" and should have some basic information that it is being fed from other worksheets in the model.

The next essential component of a good commercial mortgage and property model is a rent role worksheet. This worksheet can be separate from combined with a lease expiration table. A clear presentation of such information will allow one to quickly evaluate the condition of the property's rent role in order to understand the flexibility of the asset and how it will perform over the life of the acquisition or note. The next component is a valuation table that should compare a number of different methods of valuing the worth of the property. Area cap rate, replacement costs, and appraised value are some of the many ways to find the value of an asset.  Another important component is an expense and profit escalation table. This table will allow one to project the possible value of the asset over the life of the deal. These projections will be essential to obtaining the asset's net present value (NPV) and for obtaining a rate for the internal rate of return (IRR). I also like to add a worksheet that attempts to predict how this asset as a note will behave if it were securitized with similar assets, worse assets or better assets. Access to the rating agencies' projected returns for each asset class can be very helpful in building and using such a worksheet.

Having discussed the relative de-emphasis of the credit worthiness of the borrower of a commercial mortgage, I must clarify that the borrower credit history is still important to commercial mortgage underwriting and note valuation. Unworthy borrowers lower the value of commercial note, as any foreclosure process, even a "springing-lock box" mortgage, deed of trust or bank foreclosure mortgage (the three least expensive mortgages to foreclose) can be costly in terms of lost cash flow and lost time. Management costs will also accrue after the foreclosure process is complete. No lender wishes to underwrite a deal that will lead to foreclosure, as it would be cheaper for the lender to simply purchase the property, therefore borrower risk must be evaluated and priced through an appropriate interest rate. Borrower credit-worthiness, therefore, should not be absent from your commercial mortgage note model.

Having posted this cursory overview of Commercial Mortgage Note and Asset modeling, I welcome your comments on this or any other post on this blog.

Friday, July 8, 2011

FICO Scores In Residential Lending

The FICO (Fair Isaac Company) score is the accepted method of evaluating the credit-worthiness of an individual consumer. Without discussing the origins and mechanics of FICO scores, which will go beyond the scope of this post, quantifying their meaning is essential to valuing residential mortgage notes. One of the accepted fallacies of residential lending is that the 3 companies that report FICO scores--Equifax, Experian and TransUnion, do so in a way that makes their scoring interchangeable. In support of this viewpoint, most lenders either accept the median score or average the FICO scores, despite the fact that each of these companies follows a different philosophy in issuing a FICO score and frequently works with different information than the other 2.

Placing aside the issues that arise from treating the scoring of these 3 companies as equal, below is a general set of guidelines that links FICO score ranges with the likelihood of default by a consumer possessing a FICO score in that range on a loan or line of credit:

800+ = 1%

750-799 = 2%
700-749 = 5%
650-699 = 15%
600-649 = 31%
550-599 = 51%
500-549 = 71%
0-499 = 87%

This scale is posted at and comes from a book called CreditBooster: Ultimate Guide to a Better Credit Score Credit, Debt, Credit Scores, Credit Reports, Free Credit Reports, written in 2007 by the In Charge Education Foundation.

Looking at the posted delinquency rates, one can clearly see why FICO scores are so strongly tied to interest rates, which are merely an expression of the compensation that owner will accept for the risk of lending.

In your work sheet, using a logic function, like the IF() function, you can convert the FICO scores reported in your model into likelihoods of default. These numbers can be used to explore the way that a note is pricing buyer risk, once you are aware of all other considered factors and hold them constant. One can also use these percentages as a method of discounting note cash flows for consumer risk.

If there are more in-depth FICO default scales or if you are aware of another way to use FICO default scores, please feel free to post a response to this post.

Wednesday, July 6, 2011

Residential Mortgage Financial Modeling Basics

Let's get started with some basics. There are a number of variables that must be accounted for in residential lending. I start with residential only because it is a little more involved than commercial mortgage modeling in that the borrower's potential lending behavior is of equal to greater importance than the value of the asset. Commercial lending, on the other hand, tends to be more asset based. Commercial mortgage financial models, therefore, tend to look more like cashflow projection models with mortgage-related concerns, such as float indices, added. Residential financial models, however, have a great deal of borrower-related variables tied into them. Ultimately, however, no matter what the underlying asset maybe, the central tenant of mortgage financial modeling is to predict the cashflows of the mortgage note in a multitude of scenarios. The more "flexible" your model, i.e. the more scenarios your model is able to predict accurately, the more valuable it is.

Now let's talk specifics. The following are a list of fields necessary for the "Description" or first page of your model:

Street Address: Allows one to evaluate local specifics of the property.

City: Has informational as well as legal ramifications for the note and asset.

State: Has informational as well as legal ramifications for the note and its underlying asset.

Zip: A good way to track lending trends, pool trends and also offers property level data.

County: Has informational as well as legal ramifications for the note and asset.

Property Type: In residential, the property types are Mobile Home, Houseboat (although both are technically financed with loans that are not mortgages, unless the land on the mobile home is also being covered in the loan), Single Family Home (SFR), 2 Family or Duplex (called a 2 flat in the Midwest), 3 Family, and 4 Family.

Year Built: Key in evaluating the property.

Year Renovated: Coupled with the year built, this value tells a story about the underlying property.

Lot Size: Self-explanatory

Price PSF: This can be used for both the square feet of the property or can be combined with a "Price per acre" field so that there is a calculation for the value of the improvements as well a value for the land itself. I prefer the later approach.

Taxes: Real Estate taxes are an unavoidable reality of real estate lending and investment. They must be accounted for in order to gain a true value of the note.

Amount of Tax Delinquency: Given that tax liens supersede even first position liens, keeping tax payments current is essential to maintaining a real estate investment. Delinquent taxes must be paid and interest penalties can hover around 25%, which is a safe number to estimate for such penalties. Actual delinquency penalty amounts, however, vary between municipalities.

Current Balance: Outstanding amounts speak to the value of the note.

Current Appraisal/BPO Amount: I believe both BPO's and appraisals should be used. Since real estate agents are more active in the sales market than appraisers, BPO's offer a better idea of a resell market value. Appraisals offer a manner in which to justify the value of an asset. This field should indicate whether the value used was derived from an appraisal or BPO. This can be done through color coating. or some other data validation method.

Date of Last Appraisal/BPO: Speaks to the currentness and therefore accuracy of the value of the property.

Underwritten Loan-to-Value (LTV): Reveals the underwriter's belief of value at the time and the amount skin the borrower had in the game.

Current LTV: We all know that the market can change in Real Estate. This value should compare the current balance of the note to the current value of the property, although I have some use it to compare the downpayment to the current value of the property. The second value yields much less useful information than the first.

Paid Through Date: The date of last payment speaks to the notes performance.

Pre-payment Penalty Amount: This value will tell you how much the note has been structured to offset prepayment loss. This amount is a statement of the risk of prepayment inherent in the note.

Type of Mortgage: There are many mortgage types like fixed, ARM, I/O, floating, hybrid, etc. Within these larger categories, there are many sub-categories.

Original Interest Rate: If the mortgage is fixed, this is the interest rate. If not this may or may not be the present interest rate of the note.

Current Interest Rate: Can vary from original

Interest Only Period: The length of time that mortgage payments are applied only to the amount of interest due on the mortgage and to principal.

Loan Term: This is important for Present Value (PV), Internal Rate of Return (IRR) and other cashflow considerations.

Amortization Term: This term is frequently not the same as the loan term. This term is crucial to interest calculations.

Margin Over Prime: Not typical of today's lending, but this field may still be useful.

Capped Rate: In some mortgage products, this term may be useful.

Note Floor Rate/Note Ceiling: These 2 separate fields can also be combined into a "Capped Rate" in some cases, but not all cases.

Default Margin Over Original Rate: This field should be a calculated field that expresses the risk premium of the note expressed by the note value given its underwritten rate.

Origination Date: Necessary to understand the ideology of the note.

Seasoning Period: Necessary to weed out the financing of flips, which cuts down on inertest gained on the notes. Notes without seasoning requirements should have their first few years of cashflows discounted by prepayment risk. This will, naturally, affect the notes PV.

Lien Position: Does anything other than 1st still exist? HELOC and 2nd bought at steep discounts may still yield some juice.

Borrower's FICO Scores: This is very important in residential lending. I tend to create 3 different columns for the 3 scores. Although the average FICO is a useful number, you'll find a borrower with 3 670 scores will behave differently than a borrower with 2 scores of 615 and an artificially high score of 780 or a borrower with 2 scores of 720 and an erroneous score of 580.

Borrower's Back End Ratio: Monthly debt, plus PITI, divided by monthly gross income. Doesn't included non-property insurance, cell phone, utilities and anything not reflected on your credit report. If above 36%, there may be a problem (see for more information on back end ratios, although its percentage guidelines should be updated).

Borrower's Front End Ratio: Monthly housing expenses divided by monthly income, If above 28% there may be a problem.

Required Reserve Capital: This is becoming more of a factor with the Congressional requirements of reserving against most private label MBS-related loans.

These are some of the fields that should be entered on the first page of your valuation model. Please feel free to post any others that I may have missed. Please stay tuned to our next topic: FICO scores.

Friday, July 1, 2011

Welcome to Real Estate Financial Modeling

I started this blog as place to share my experiences, as I attempt to synthesize a number of financial models that are able to account for the many levels of risk inherent in various types of real estate assets and securities. Specifically, I am looking to use MS Excel to set-up some worksheets that predict the value and performance of commercial real estate buildings in the different asset classes, commercial real estate mortgage note pools, residential real estate pools, commercial real estate investment grade notes, collateralized mortgage options on both commercial and residential mortgages, collateralized debt options composed of real estate mortgage notes and the synthetic products that cover such CDO's and CMO's.

The risk factors that I wish to account for include, but are not limited to: FICO scores, default rates on mortgages, default rates on mortgage notes, foreclosure, bankruptcy, asset levels of borrower, types of recourse financing, payment methods, prepayment penalties, etc.

Obviously, I will not attempt to model all of these factors at once. I will be working on different aspects of these models at a time. I will however, attempt to find a way to tie together all of these asset models in order create a clear picture of the real estate market as a whole.

In the spirit of full disclosure, I have to admit that I am presently least familiar with the valuation of real estate securities and valuations in the synthetics markets, however, I am presently working through a number of books and speaking to some of my friends in those markets, so that I may become more proficient.

Please feel free to post a comment, make a suggestion, help me with a problem that I have posted or give me your opinion. I will do my best to respond in a timely fashion and all responses will be given in a professional manner.