RE 3381 Exam 2 Questions With Complete Solutions
What is the difference between a mortgage and a promissory
note?
In most cases, borrowers acquire financing for real estate
purchases using secured loans. Properting being purchased is
pledged as collateral. Mortgages (per lien theory) OR deeds of
trust (per title theory) AND promissory notes.
Mortgage- legal document that ties or "secures" a piece of real
estate to an obligation to repay money
Promissory note- document between lender and borrower where
the borrower promises to pay back the lender
How do lenders look at risk when considering the cash flow of a
property? The appreciation in value of the property?
Lower risk tolerance/expectations. Can't tolerate loan principal
volatility. Return drivers: current cash flow & value security.
How do equity investors look at risk when considering the cash
flow of a property? The appreciation in value of the property?
Equity investors have a higher risk tolerance/expectations. They
will tolerate more asset value volatility. Return drivers: current
cash flow & value appreciation.
What are the basic risks of real estate assets from a lender's
perspective and what are the tools that lenders use to account
for/charge for/price that risk?
,Basic risks from lender's perspective:
- Default risk
- Interest rate risk
- Liquidity risk
- Legislative risk
Tools lenders use to account for/charge for/price thar risk:
- Loan proceeds
- Level and type of interest rates
- Payment structure
- Fees and penalties
- Performance covenants
At a basic level, why do investors use debt to capitalize real
estate investments?
Decrease equity exposure (extend the limited resources in a
capital intensive asset class and limit risk exposure to any single
asset) and seek positive leverage
What is positive leverage? What is negative leverage? Be able to
understand this quantitatively as well as qualitatively.
Positive leverage- exists if an investor can borrow at a rate of
interest lower than the expected rate of return on total funds
invested in a property. As long as debt "costs" less than equity, it
takes less than its proportionate share of a property's cash flow.
Returns to equity are greater with than without debt
Negative leverage- your cash-on-cash return is less than if you
, were to have purchased the project with no debt (100% cash). In
other words, the financing is making your annual yield worse.
What is the difference between market risk and financial risk?
Without debt, an investor has market risk but not financial risk.
Downside risk is less current than cash flow return today
With debt, an investor has less equity at risk but more financial
risk associated with that investment. All of the downside risk of
reductions in NOI.
Market risk- the risk of losses in positions arising from
movements in market variables like prices and volatility
Financial risk- the possibility of losing money on an investment
or business venture
What are the key risks of commercial mortgages?
Interest rate risk
Default risk
Collateral risk
Credit risk
Lenders use loan terms and covenants to protect against risk
How is Loan to Value ("LTV") a measure of risk?
LTV = loan amount/property value
A higher debt load leads to higher debt service payments which
is directly associated with higher default risk
DSCR equation
annual NOI/annual debt service
What is the difference between a mortgage and a promissory
note?
In most cases, borrowers acquire financing for real estate
purchases using secured loans. Properting being purchased is
pledged as collateral. Mortgages (per lien theory) OR deeds of
trust (per title theory) AND promissory notes.
Mortgage- legal document that ties or "secures" a piece of real
estate to an obligation to repay money
Promissory note- document between lender and borrower where
the borrower promises to pay back the lender
How do lenders look at risk when considering the cash flow of a
property? The appreciation in value of the property?
Lower risk tolerance/expectations. Can't tolerate loan principal
volatility. Return drivers: current cash flow & value security.
How do equity investors look at risk when considering the cash
flow of a property? The appreciation in value of the property?
Equity investors have a higher risk tolerance/expectations. They
will tolerate more asset value volatility. Return drivers: current
cash flow & value appreciation.
What are the basic risks of real estate assets from a lender's
perspective and what are the tools that lenders use to account
for/charge for/price that risk?
,Basic risks from lender's perspective:
- Default risk
- Interest rate risk
- Liquidity risk
- Legislative risk
Tools lenders use to account for/charge for/price thar risk:
- Loan proceeds
- Level and type of interest rates
- Payment structure
- Fees and penalties
- Performance covenants
At a basic level, why do investors use debt to capitalize real
estate investments?
Decrease equity exposure (extend the limited resources in a
capital intensive asset class and limit risk exposure to any single
asset) and seek positive leverage
What is positive leverage? What is negative leverage? Be able to
understand this quantitatively as well as qualitatively.
Positive leverage- exists if an investor can borrow at a rate of
interest lower than the expected rate of return on total funds
invested in a property. As long as debt "costs" less than equity, it
takes less than its proportionate share of a property's cash flow.
Returns to equity are greater with than without debt
Negative leverage- your cash-on-cash return is less than if you
, were to have purchased the project with no debt (100% cash). In
other words, the financing is making your annual yield worse.
What is the difference between market risk and financial risk?
Without debt, an investor has market risk but not financial risk.
Downside risk is less current than cash flow return today
With debt, an investor has less equity at risk but more financial
risk associated with that investment. All of the downside risk of
reductions in NOI.
Market risk- the risk of losses in positions arising from
movements in market variables like prices and volatility
Financial risk- the possibility of losing money on an investment
or business venture
What are the key risks of commercial mortgages?
Interest rate risk
Default risk
Collateral risk
Credit risk
Lenders use loan terms and covenants to protect against risk
How is Loan to Value ("LTV") a measure of risk?
LTV = loan amount/property value
A higher debt load leads to higher debt service payments which
is directly associated with higher default risk
DSCR equation
annual NOI/annual debt service
