Real Estate Finance Exam 1

Finance

Study of processes, institutions, markets, and instruments that transfer money & credit among individuals, businesses, and governments.

Real Estate Finance

Institutions, markets, and instruments transferring funds for acquiring/developing real property.

Time Value of Money (TVM)

A dollar today is worth more than a dollar in the future.

Interest Rates

Price of borrowing money; influences financing decisions.

Cash Flows vs. Profits

Finance emphasizes actual cash flows, not accounting profits.

Risk

Actual outcomes may differ from expected outcomes.

Real Property

Rights, powers, and privileges associated with real estate.

Real Estate

Physical land and immovable improvements.

Savings–Investment Cycle

Savings from surplus units flow to deficit units for investment.

Financial Intermediaries

Institutions channeling funds between savers & borrowers (banks, thrifts, insurance companies, pension funds, investment companies).

Direct Financing

Funds flow directly between parties without intermediaries.

Primary Mortgage Market

Where loans originate (banks, mortgage lenders).

Secondary Mortgage Market

Where existing mortgages are traded (Fannie Mae, Freddie Mac, Ginnie Mae, FHLB).

Money Market

Market for short-term securities (≤ 1 year).

Capital Market

Market for long-term securities (> 1 year); real estate relies here.

General Level of Interest Rates

Market bond prices move inversely with required yields; interest rates reflect market conditions and asset risk.

Fisher Equation

i=r+p where i = nominal interest rate, r = real interest rate, p = expected inflation.

Default Risk

Risk that borrower won’t repay.

Callability Risk

Risk that borrower repays early (lender loses interest income).

Maturity Risk

Longer maturities → greater price sensitivity to interest rate changes.

Marketability Risk

Risk asset cannot be easily sold/traded.

Inflation Risk

Loss of purchasing power due to rising prices.

Interest Rate Risk

Risk fixed-income assets lose value when interest rates rise.

Yield Curve

Graph showing relationship between maturity and yield at a point in time.

Liquidity Premium Theory

Long-term rates higher because investors demand premium for illiquidity.

Market Segmentation Theory

Different investors prefer different maturities; yields differ by market segment.

Expectations Theory

Long-term rates are an average of expected future short-term rates.

Asset Valuation

Value of asset = PV of expected future cash flows.

Prepayment (Call) Option

Borrower can repay early.

Default (Put) Option

Borrower can walk away; lender forecloses.

Explicit Purchase Option

Right to purchase property at a set price/time.

Financial Intermediaries

Institutions standing between savers and borrowers, managing liquidity and risk.

Interest Rate Risk

RE assets’ values are sensitive to rate changes.

Efficient Market Theory

• Weak Form – Prices reflect past info.

• Semi-Strong Form – Prices reflect all public info.

• Strong Form – Prices reflect all public & private info.
  Real estate markets are weak form efficient (illiquid, few large players, high transaction costs).

Weak Form

Prices reflect past info.

Semi-Strong Form

Prices reflect all public info.

Strong Form

Prices reflect all public & private info.

Agency Theory

Conflicts between principals (owners) and agents (managers). Costs include monitoring, bonding, and structuring.

Equitable Right of Redemption

Borrower’s right to reclaim property after default by repaying debt.

Maturity Mismatch

Banks fund long-term mortgages with short-term deposits → risk.

Disintermediation

Withdrawal of funds from banks/S&Ls when deposit rates are lower than market alternatives.

Assumable Loan

Mortgage that allows a new buyer to assume the existing loan.

Due-on-Sale Clause

Requires borrower to repay loan in full if property is sold.

FHA (Federal Housing Administration)

1934

FNMA (Fannie Mae)

1938

FHLMC (Freddie Mac)

1970

Fixed-Rate Mortgage (FRM)

Loan with fixed interest rate, level payments, and full amortization.

Amortization

Each payment = interest + principal; balance declines over time.

Effective Borrowing Cost (EBC)

True cost of borrowing including fees and discount points.

Discount Points

Upfront fees; 1 point = 1% of loan. Lower rates require more points.

APR

Effective annualized borrowing cost if held to maturity.

Prepayment Penalty

Fee charged if borrower repays early.

Biweekly Mortgage

26 half-payments/year; reduces term and interest.

Interest-Only Mortgage

Borrower pays only interest for a period; principal due later.

Balloon/Reset Mortgage

30-year amortization but balance due earlier (5–7 years).

Prepayment Protection Mortgage (PPM)

Lower rate but with penalties for prepayment.

Extra Payments

Monthly or lump-sum prepayments reduce balance and save interest.

Interest Rate Risk

Loan values move inversely with market rates.