Real Estate Finance: Mortgage Markets, Risks, and Instruments

What happens in the primary mortgage market?

Where loans are originated; borrowers and lenders interact directly; also called the retail or "street" market; includes banks, credit unions, and mortgage bankers.

What happens in the secondary mortgage market?

Where existing loans are resold and securitized; lenders sell loans to investors (Fannie Mae, Freddie Mac, Ginnie Mae); creates liquidity and standardization; wholesale or investor market.

Difference between a mortgage and a promissory note

A promissory note is the borrower's written promise to repay; a mortgage (or deed of trust) pledges the property as collateral and secures the note.

How lenders view risk in property cash flow and appreciation

Lenders focus on predictable cash flow for repayment; less concerned with appreciation; assess default, interest rate, liquidity, and legislative risks; price risk through interest rate spreads, fees, and covenants.

How equity investors view risk in property cash flow and appreciation

Equity investors seek both income and appreciation; tolerate higher volatility; higher risk for higher potential return.

Basic risks for lenders and tools to price risk

Default, interest rate, liquidity, legislative risks; tools: loan terms, interest rate premiums, fees, covenants, proceeds limits.

Why investors use debt to capitalize real estate investments

To leverage equity, increase returns, diversify capital, and limit exposure per property.

Positive leverage vs. negative leverage

Positive leverage: property return > cost of debt → increases equity returns; negative leverage: property return < cost of debt → decreases equity returns; leverage magnifies gains and losses.

Difference between market risk and financial risk

Market risk = changes in property income/value; financial risk = added by using debt; no debt → only market risk, with debt → both market and financial risk.

Difference between term to maturity and term for amortization

Term to maturity = when full balance due; amortization term = period to pay down principal.

Full vs. partial amortization

Full = loan fully repaid by maturity; partial = remaining balloon balance due at maturity.

Fixed vs. floating interest rates

Fixed = constant rate; floating = adjusts with index (SOFR, Prime, etc.).

Interest-only loan

Payments cover only interest for a period; principal repaid later, often as balloon.

Origination fees

Upfront lender charges to cover processing and funding costs.

Discount points

Prepaid interest to lower long-term interest rate.

Prepayment penalties

Fees for paying off loan early; protect lender's yield.

Foreclosure

Lender legally takes property after borrower default.

Foreclosure process

Default → lender files → property auctioned or repossessed.

Alternatives to foreclosure

Loan modification, short sale, deed-in-lieu of foreclosure.

Three "C's" of underwriting

Collateral, Creditworthiness, Capacity to pay.

Assessing the three "C's" risk

Collateral = property value; Creditworthiness = credit score/history; Capacity = debt-to-income ratio.

Debt to Income Ratio (DTI) formula

(Total housing expenses + long-term debts) ÷ gross monthly income.

GSEs and their role

Fannie Mae, Freddie Mac, Ginnie Mae; buy/securitize mortgages to provide liquidity and standardization.

Conforming conventional mortgage

Meets GSE standards; easier to sell; lower interest rates.

Hybrid adjustable-rate mortgage (ARM)

Fixed rate for initial period then adjusts; e.g., 3/1, 5/1, 7/1, 10/1.

30-year vs. 15-year fixed rate mortgage

30-year rate higher due to longer term and inflation risk.

Hybrid ARM vs. fixed rate mortgage

ARM rates lower because borrower bears interest rate risk after reset.

Depository bank vs. mortgage banker

Bank accepts deposits and holds loans; mortgage banker originates/sells loans and may service them.

Mortgage-backed security (MBS)

Pool of mortgages securitized into bond-like instruments; investors receive pass-through cash flows.

Why MBS yield is lower than underlying loans

Servicing and guarantee fees reduce investor yield.

Collateralized mortgage obligation (CMO)

MBS divided into tranches with different risks and maturities; allocates payments sequentially.

Why banks sell mortgages in secondary market

To gain liquidity, reduce balance sheet risk, and free up capital.

Why banks buy mortgage-backed securities

To earn steady fixed-income returns from diversified pools.

Key risks of commercial mortgages

Default, refinance, interest rate, and market risks.

Loan to Value (LTV) measure of risk

LTV = Loan ÷ Property Value; higher LTV → higher lender risk.

Debt Service Coverage Ratio (DSCR) and risk

DSCR = NOI ÷ Debt Service; measures borrower's ability to pay; lower DSCR = higher risk.

Debt Yield and risk

Debt Yield = NOI ÷ Loan Amount; shows lender return if foreclosed; lower = higher risk.

Loan sizing using LTV

DSCR, and Debt Yield,Calculate all three; choose loan amount satisfying all minimum thresholds.

Why lenders prefer partial amortization

Reduces credit risk but preserves borrower flexibility.

Prepayment penalties (commercial)

Fees for early payoff; protect lender's expected return.

Two types of default

Payment default (missed payments); technical default (violated covenants).

Recourse provision and why required

Borrower personally guarantees repayment; reduces lender risk if collateral insufficient.

"Bad Boy" Carve-Outs

Exceptions to non-recourse protection for fraud, misrepresentation, or misconduct.

Short-term commercial financing types and risks

Construction and bridge loans; risks: project completion, lease-up, refinance.

Long-term/permanent commercial financing risks

Interest rate, default, property obsolescence, and market condition risks.