REAL 5100 Random Questions Exam 2

True or False:  Recourse for a lender reduces the value of the put option for the mortgage borrower.

True. In mortgages, the default option is considered a “put” option and the prepayment option is considered a “call” option. In the above question, because the lender can go after the borrower’s other assets in the case of default, this makes the default option less valuable to the borrower.

A borrower owes $150,000 on a property that is currently worth $125,000. He lost his job and currently does not have the income to service the debt, but he does have money in a retirement account he could use to make up any shortfall on mortgage. His costs of default are $15,000. Should the borrower default or repay the loan?

Compare benefit of walking away (defaulting) with cost of default

($150,000 - $125,000) vs. $15,000

$25,000 > $15,000  should default and let the lender foreclose

True or false: All else equal, if the lender expects potential default to occur sooner, the lender needs to charge a higher rate to get the same expected return

True. Earlier default hurts the lender (because the PV of the loss is higher). To counter this, the lender needs to charge a higher rate to get the same expected return.

Explain any potential issues with the following statement: If a lender increases the contract rate on the loans it offers, the expected return will be higher as well

Higher interest rates might increase the probability of default, which, in turn could actually lower the expected return.

Also, if the lender increases rates, it’s possible that the best borrowers will select out of the pool (e.g., not take a loan) because they can get a better loan elsewhere. This remaining borrowers that want a loan will be riskier on average, and the increase in interest rates may be offset by additional losses on default.

Which is more important on commercial mortgage underwriting: the borrower or the property?

The property is generally more important than the borrower on commercial mortgage underwriting

because the property is the main source of CFs to service the loan and commercial mortgages are

usually non-recourse

True or false: The BTCF is also known as the property’s dividend?

False, NOI is generally referred to as the property’s dividend

Potential gross income is the amount of income the property could generate after accounting

for vacancies and collection

False

Is a cap rate the same as an IRR? Which is generally greater? Why?

No. The cap rate is the relationship between the current NOI and present value. The IRR is the

return on all future cash flows from the operation and sale of the property. Usually the IRR is

greater than the cap rate

What are the primary considerations that should be made when refinancing?

The borrower must determine whether to present value of the savings in monthly payments is greater than the

refinancing costs (points, origination fees, costs of (1) appraisal, (2) credit reports, (3) survey, (4) title insurance, (5)

closing fees, etc.

Why might the market value of a loan differ from its outstanding balance?

The balance of a loan depends on the original contract rate, whereas the market value of the loan depends on the

current market interest rate

What is a buydown loan? What parties are usually involved in this kind of loa

A buydown loan is a loan that has lower payments than a loan that would be made at the current interest rate. The

payments are usually lowered for the first one or two years of the loan term. The payments are “bought down” by

giving the lender funds in advance that equal the present value of the amount by which the payments have been

reduced

Assuming the borrower is in no danger of default, under what conditions might a lender be willing to accept a

lesser amount from a borrower than the outstanding balance of a loan and still consider the loan paid in full?

If interest rates have risen significantly, the market value of the loan will be less. Thus, the lender may be willing

to accept less than the outstanding balance of the loan, especially if the lender still receives more than the market

value of the loan. The lender can then make a new loan at the higher market interest rate.

What is meant by the incremental cost of borrowing additional funds?

The incremental cost of borrowing funds is a measure of what it really costs to obtain additional funds by getting a

loan with a higher loan-to-value ratio that has a higher interest rate. This measure is important because the contract

rate on the loan with the higher loan-to-value ratio does not take into consideration the fact that this higher rate must

be paid on the entire loan - not just the additional funds borrowed. Thus, the borrower should consider the

incremental cost of the additional funds to know what it is really costing to borrow the additional fun

What does the evidence suggest about shopping for a mortgage?

Shopping and understanding are both important for avoiding costly mortgage mistakes

Choosing a 15-year mortgage instead of a 30-year mortgage mainly does what? (all else equal)

Lowers interest rate, reduces the total interest paid over the life of the loan, forces faster principal repayment

In the 15 vs. 30-year example we just went through, why does slower amortization NOT make the borrower worse off?

The borrower invests freed-up cash at a higher return than the cost of borrowing

Making extra principal payments on a 30-year mortgage is economically most similar to:

Choosing a shorter effective loan term

In incremental borrowing cost (IBC) terms, comparing two mortgages with different LTVs is best interpreted as:

Choosing how much to borrow at the margin

$120,000 at 6% vs. $135,000 at 7%

Without calculating anything, what do you expect the IBC to be?

IBC > 7%

All else equal, which situation makes the homeowner MORE WILLING to refinance after a small drop in rates rather than waiting?

Expects to stay 25 years

Suppose you already have a 30-year FRM at rate r_c. Market rates remain centered at r_c, but become more volatile. What happens to the value of your prepayment option?

it increases

Holding everything else constant, higher house price volatility should:

Increase the value of waiting before default

Holding everything else constant, if the probability of default increases:

Expected return decreases

If a lender raises mortgage interest rates to try to increase expected return, which effect may occur?

Default probability rises

Two income producing properties both have $180,000 PGI.

Property A has expenses of 30% of PGI

Property B has expenses of 50% of PGI

Should they have the same value? (select the best answer)

No. Although they could, it is HIGHLY unlikely.

If a property has an 8% cap rate, the investor's expected total return is:

It depends

Value Estimate from Direct Capitalization = $1.061m

Value Estimate from DCF = $1.060m

Direct capitalization and DCF give nearly identical values in this example because:

Income follows a constant growth pattern

A property has very low NOI in year 1 due to a temporary vacancy, but leases are signed and income will rise sharply in year 2.

Which method is more likely to undervalue the property?

Direct Capitalization

A major tenant unexpectedly does not renew their lease in an office building in Buckhead and vacates the space.

What is the most immediate risk to the lender?

Liquidity driven default

If DSCR = 1.25, approximately how much can NOI decline before debt service is no longer covered?

20%

Which of the following changes would NOT affect the Debt Yield Ratio of a property? Assume the loan is an interest only ARM.

Interest rate increase

All else equal, if a lender increases the required DSCR from 1.2 to 1.3, what happens to the maximum allowable leverage (loan amount)?

Decreases

Which loan should the borrower choose if the opportunity cost of capital is 4% and there are no financial constraints.

Option 1

$75,000 loan

20 year FRM

5.125%

1 point

Option 2

$82,000 loan

23 year FRM

5.4%

No points

Neither since both options are greater than 4%.

5.125% > 4%
5.4% > 4%