Real Estate Finance © JR DeLisle, Ph. D. Lecture 3: Residential Mortgage Life Cycles by James R. DeLisle, Ph.D. January 12, 2010

Real Estate Finance

© JR DeLisle, Ph. D.

Lecture 3: Residential Mortgage Life Cycles

byJames R. DeLisle, Ph.D.

January 12, 2010

Real Estate Finance


Lecture Overview

• Mortgage Life Cycles– Mortgage Process– Mortgage Risk Management– Legal Concepts in Mortgages

• Life Cycle Management– Planning– Origination– Operation– Disposition

Real Estate Finance


Current Crisis

Real Estate Finance


Individual Mortgage Life Cycle

• Planning/Application• Acquisition• Operation• Disposition

Planning/Application

Acquisition

Operation

Disposition

Real Estate Finance


Components of a Mortgage

Components of a Mortgage

Priority of Claim

Nature of Real Estate

Pledged

Security Device

Method of Repayment

Nature: Recourse or

Non-recourse

Real Estate Finance


Key Elements of Mortgage Transactions

• Parties of Interest– Formal Names– Roles

• Consideration– Economic transfers– Real estate as underlying collateral

• Contractual obligations– Terms & Payments– Conditions

• Termination provisions– Repayment or Prepayment– Assumption

Real Estate Finance


Mortgage Collateral: Property, Interests and Estates

• Property Rights– Possession– Use– Quiet enjoyment (legal term)– Disposal

• Interests– Possessory – Non-possessory (easement, mortgage)

• Estates– Freehold: fee simple, life, future life (reversion, remainder)– Non-Freehold: estate for years, estate from year-year (period)

Property Rights & Estates

Property Rights

Interests in Real Estate

Estates

Real Estate Finance


Elements of a Mortgage Note

• Economics– Loan Amount– Contract Interest Rate– Payment Rate or pattern– Timing– Term– Amortization Period

• Provisions– Early termination: prepayment provisions– Penalties for late payment– Definition of default

Real Estate Finance


Mortgage Risks: Planning/Application Stage

• Sourcing Deals– Marketing Channels: type of applications– Origination System: correspondents, delegation of authority

• Processing Deals– Application Process: standard forms– Preliminary Commitment: interest rate lock


Acquisition

Operation

Disposition

Real Estate Finance


Strategic Market Analysis

• Role– Important to conduct or secure market research reports– Goal: verify and confirm rents and vacancy rates– Explore factors influencing future rental demand as well as new

supply– Test reasonable assumptions behind the proforma

• Sources– Analysis info provided by data vendors– Actual market forecasts– Use in conjunction with local broker reports

• Relevant market info may include:– Demographic and Economic Base Trends– Rental and vacancy rates, absorption, new supply coming online– Transportation trends and analysis

Real Estate Finance


Consumer Protection in Mortgages

• Real Estate Settlement and Procedures Act (RESPA)– Premise: information supports choice– Emphasis on consumer information

• Nature & Timing: Advance disclosure of settlement• Uniform settlement statement

• Other Protections– Title insurance– Prohibition of kickbacks and referral fees– Escrow deposits

• Truth in Lending Act– Effective cost of mortgage credit (since 1968)– Commercial real estate transactions excluded– APR is the most important required disclosure

Real Estate Finance


Mortgage Risks: Acquisition Stage

• Evaluative Process– Underwriting: borrower will and ability– Due Diligence: collateral integrity, quality and quantity

• Existence of value– Appraisal: value of underlying asset– Collateral Commitment: clear title, deed

• Claim on value– Priority of Claim; no intervening liens, recording– Title Assurance/Insurance


Acquisition

Operation

Disposition

Real Estate Finance


Due Diligence

• Overview– Purpose of DD is to discover in detail any problems that exist

on the property which may affect future returns and liabilities – Requires a careful analysis

• entire process of reviewing an investment opportunity• contracting to purchase and pre-closing details

– Occurs when a tentative purchase contract has been drawn up and buyer has time to affect possible modifications/ adjustments

• Categories:– Market Due Diligence– Property Due Diligence – People Due Diligence– Contractual Due Diligence

Real Estate Finance


Underwriting Risks to Lender

• Borrower– Will to pay– Ability to pay

• Real Estate– Existence of assets– Future value of assets– Continuity of rights to use– Marketability: liquidity

Underwriting

Borrower

Property

Real Estate Finance


People Due Diligence

• Role– People can mess up whether or not contracts are binding– Determine if everything else seems to be as represented

• Ability to Pay– Who is really signing all contracts?– Income and net worth as primary source– Competing liabilities– Are personal guarantees worth anything?

• Will to Pay– What is the track record of owners and parties involved?– Are known risks enforceable or backed? – Are there escrow accounts and trustworthy people involved?

Real Estate Finance


FICO Scores and Mortgage Rates

http://www.myfico.com/

$300,000 Mortgage $800,000 Mortgage

http://www.myfico.com/

Real Estate Finance


Property Due Diligence

• Records– Title search and abstract verifying ownership, authority to

transfer– Ability to secure title insurance– Property tax records, mortgage liens, mechanics liens if any

• Quality– The accurate “as built” survey of the building– Operating: mechanicals including equipment

• Compliance– Environmental studies– American with Disabilities Compliance– Zoning and building code conformity, easements – Property management review

Real Estate Finance


Existence of Collateral

• Security Device– Deed: Warranty, special, quitclaim, trust– Specify rights and warranties

• Interests– Specification of possessory, non-possessory– Clarify rights/collateral

• Estates– Freehold or less-than-freehold– Signify type of estate

• Title Opinion/Insurance– Opinion: Attorney statement based on good faith/best practice– Insurance: Against defects, unknown liens

Transfer of Title

Recording

Title Assurance

Title Abstact

Title Insurance

Real Estate Finance


Collateral Elements

• Content of Collateral– Personal Property

• Specification of items included• Match expectations at closing

– Approvals• Usage permits, liquor licenses• Ensure continued operation/value

• Access to Collateral– Priority of Initial Claim

• Subordination clause• Avoid intervening liens

– Future Advances: treated as initial payment priority

Real Estate Finance


Contractual Due Diligence

• Several contracts of importance– Sales/Purchase– Leases– Options

• Dimensions– Costs– Time– Dispute resolution

• Key questions will include:– What are the deadlines for each step prior to closing? – Who is responsible for each unresolved issue?– Who will take charge of resolving disputes?– How will time delays affect the price and terms?

Real Estate Finance


Mortgage Risks: Operation Stage

• Management of Financial Obligations– Loan Processing: collection, posting, record-keeping– Loan Servicing: disperse payments of taxes, insurance

• Protection of Asset Value– Periodic Inspection: property maintained, covenants honored– Restrict Encumbrances: preclude/manage total debt, liens


Acquisition

Operation

Disposition

Real Estate Finance


Operating Covenants

• Financial Performance– Promise to pay

• What: Specification of payments, dates, penalties• Strategy: Clarify expectations on cash flows

– Escrow clause• What: Borrower periodic payments for insurance and property tax • Strategy: Decrease financial risk; budget

• Covenants to avoid removal of Asset/Collateral Value– Covenant Against Removal

• What: Personal Property• Strategy: Ensure property value not gutted

– Covenant Against Partial Sale• What: Restricts sale of portion of real property• Strategy: Protect against reduction in collateral value

Real Estate Finance


Operational Risk Management: Asset Protection

Protection of Asset

Good repair clauseRequires borrower to maintain property to certain standard of care

Ensure maintenance to preserve collateral

Borrower Occupancy Clause Requires borrower to use as primary residence

Ensure "will" to pay; avoid investor flipping

Hazard Insurance Insure propery value vs fire, storm, flood, etc. Ensure value protected from trajedy

Right to Inspect Lender's right to enter, with notice Ensure compliance with covenants

Sale in One ParcelPrevents borrower from breaking up property and selling in parcels Protect Lender from dilution of asset

Real Estate Finance


Mortgage Risks: Disposition Stage

• Timing and Life Cycle Returns– Duration: actual term vs. contract term– Prepayment Penalties: yield maintenance

• Termination– Transfer

• Loan assumption: timing, risk, borrower substitution• Repayment

– Foreclosure: monitor, manage and pursue/protect claims


Acquisition

Operation

Disposition

Real Estate Finance


Transfer/Termination

Transfer

Voluntary

Involuntary

Assumption

"Subject to" Transfer

Real Estate Finance


Risk Management at Disposition: Voluntary

Voluntary TransferPrepayment Clause Borrower right to pay off MobilityPrepayment Specifies required payment to retire debt Yield Maintenance

Due on Sale ClauseRequires borrower to repay loan upon property sale Terminate

Release ClauseSpecifies conditions for freeing property from loan security Clean title

Partial ReleasesSpecifies requirements for freeing portions of property from security Allow orderly sale & 1st Lien for buyer

Mortgage Transfer

Assignment ClauseSpecifies right of lender to sell, transfer, securitize Portability or Secondary Market

Estoppel CovenantBorrower certifies debt to provide certainty for secondary market Risk Mgmt by Transfer; Liquidity

Assumption ClauseSpecifies right of borrower to transfer mortgage to new buyer Borrower liquidity & Pricing

Voluntary Transfer of Asset/Collateral

Voluntary Transfer of Mortgage

Real Estate Finance


Involuntary Mortgage Transfer

• Trigger– Delinquency– Default: economic or covenant

• Event Response– Acceleration: due in full in case of breach; avoid sue for each

payment– Foreclosure Process– Lender in Possession: take over and collect rent prior to

foreclosure

Real Estate Finance


Loss Mitigation

• Loan modification– Lowering the interest rate, reducing the principal balance, increase term– ‘Fixing' adjustable interest rates,– Forgiveness of payment defaults & Fees

• Forbearance– Forgive portion of debt– Permanent or temporary

• Short sale– Lender reduces the principal balance of a homeowner's mortgage in order to

permit sale for the actual market value of the home.– Applies to upside down borrowers

• Short refinance– Lender reduces the principal to permit refinance with a new lender.– Reduction in principal is designed to meet the Loan-to-value guidelines

http://en.wikipedia.org/wiki/Interest_rate

http://en.wikipedia.org/wiki/Market_value

http://en.wikipedia.org/wiki/Refinance

http://en.wikipedia.org/wiki/Loan-to-value

Real Estate Finance


Foreclosure Process

• Delinquent and default events– Notice of late, register letter– Make decision to foreclose– Petition Court

• Judicial Proceeding– Judicial foreclosure sale– Taxes: priority claim that mortgagee may pay to release– Other secured claims in priority order– Deficiency Judgment

• Redemption Period– equitable period: prior to sale– statutory period: set by states,

Real Estate Finance


Managing Involuntary Transfer

Severity of Loss

Senior liens Avoid liens with priority over mortgage Prevent involuntary subordinationCovenant to Avoid Priority Liens

Restirction against creation of liens with priority over mortgage Protect access to collateral value

Mortgage Insurance Private mortgage insurance, FHA or VA Reduce severity of loss

Joint & Several Liability Identifies parties and specifies obligations Recover loss beyond collateralExculpatory clause Makes loan non-recourse against borrower Protect Borrower

Acceleration ClauseTriggers entire outstanding balance due based on certain conditions

Access to capital without additional litigation

Lender in PossessionAllows lender to step in, take over and collect rents

Preclude borrower from skewing funds

Propensity to Default

Post-ForeclosurePost-foreclosure

Deficiency Creates possible claim against other assets Recover loss gap after liquidationEquitable Period of Redemption Borrower's right to reinstate by common law Allow borrower to common law cureStatutory Period of Redemption Borrower's right to reinstate by statute

Protect borrower from unreasonable action

Judicial Foreclosure Sale Lender's right to sieze and sale

Specifies process and disposition of proceeds

Real Estate Finance


Alternatives to Formal Foreclosure

• Restructure– Recast: change terms, permanent or temporarily– Extension of term to reduce payments– Grant forbearance; outright foregiveness

• Transfer mortgage– To new party– Voluntary conveyance to lender

• deed in lieu reduce first mortgagee claims• Junior claims: not released, only in foreclosure

• Collaborative Approaches– “Friendly foreclosure,” quitclaim and hold harmless– Prepackaged bankruptcy: agree with all creditors on asset

turnover for releases

Alternatives to

Foreclosure

Restructure

Transfer

Friendly Foreclosure

Real Estate Finance


Chapter 7/11 Bankruptcies

• Liquidation (Chapter 7)– Objective: give debtors a fresh start– Process: voluntary by debtor or involuntary by creditors– Trustee: appointed by court to oversee liquidation, allocate

proceeds– Mortgage: generally takes priority if sufficient proceeds

• Reorganization or Rehabilitation (Chapter 11)– Objective: preserve assets while allowing debtor to restructure

or reorganize– Strategy: restructure or reduce debt to make debtor solvent– Process: debtor petitions court, develops plan, seeks 2/3 creditor

approval– Cramdown: if creditors not agree, court can force settlement

Real Estate Finance


Alternative Mortgages

Real Estate Finance


Lecture Review

• Risk Management– Definition of Risk– Risk Management Process

• Mortgages– Mortgage Process– Mortgage Risk Management– Mortgage Concepts– Mortgage Transfer, Foreclosure & Bankruptcy

Documents

Real Estate Finance © JR DeLisle, Ph. D. Lecture 3: Residential Mortgage Life Cycles by James R. DeLisle, Ph.D. January 12, 2010