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Chapter 1: Overview of Real Estate Finance


Definitions:
Real Estate
Real Property
Real Estate
Finance

Land and all natural part of the land and attachments to the land e.g.
buildings, etc
All rights, interests and benefits related to ownership of real estate
The study of the institutions, markets and instruments used to transfer
money and credit for purpose of developing or acquiring real property
- Contract results in mutual benefits
- Inherent risks to one/both parties

Air Rights
Surface
Rights
Land

Characteristics (Read
notes):
- Physical
- Institutional
- Economic

Real Estate
(physical)

Mineral
Rights
Fixtures
To-the-land

Right to
Use

Real
Property
Ownership
rights
(legal)

Improvements
On-theland

Right to
Possess
Right to
exclude ppl
Right to
dispose

See Notes for Overview of Capital Market

Real Estate Market

Space Market (Tangible)


Supply: Property
Owners
Demand: Property Users

Asset Market (Intangible)


Supply: Investors willing to
sell
Demand: Investors willing
to buy

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Chapter 2: Institutions & Instruments of Financial Markets


Financial
Legal claim to future cash flow
Assets
Financial
Forum for trading funds where suppliers and demanders of funds interact to
Market
transact business
Money Market Arena for trading short-term funds e.g. marketable securities
Capital
Forum for trading in equity and long term debts e.g. long-term
Market
securities
Real Estate
Forum for trading legal claims to future cash from real estate assets
Financial
Market
Financial Assets
Properties of Financial Assets: See Notes for full explanation
-

Moneyness

Divisibili
ty
Currency

Convertibili ty
Role of Financial Assets
-

Reversibility

Cash flow & Return


Predictability

Term to
maturity
Complexity

Liquidity

Tax Status

Transfer funds from those with surplus to invest on those who needs funds.
Redistribute risk generated by tangible assets among seekers and providers of funds

Financial Markets
Major Institutions in financial markets
-

Households
Depository institutions
(banks)
Investment banks

Governments
Insurance companies

Nonfinancial Corporations
Asset management firms

Non-profit organizations

Foreign investors

Service Provided by Financial Institutions


-

Transform financial assets into a different, and more widely preferable type of asset
Exchange financial assets both for customers and own account
Assist in creation of financial assets for customers and selling these assets
Provide investment advice and manage portfolio of other market participants

Instruments of Financial Markets (Asset Class)


-

Common Stock

Bonds
o Residential MBS
o Commercial MBS
o CDOs

Derivatives (Value
depends on assets)

Financial Intermediaries
Role of Financial Intermediaries
-

Flow of funds for Financial Institutions & Markets


Transform less desirable financial assets into other financial assets preferred by public by:
(See Notes)
o Maturity Intermediation
o Risk reduction via diversification (doesnt work, only redistribute but not reduce risk)
o Reducing costs of contracting the information processing

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Providing payment mechanism

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Chapter 5: Mortgage Markets I


Mortgage

Mortgage
document
Promissory
Note

Special form of debt that uses real estate as a security for the loan
Gives lender a lien on the property
- If property is sold, owner not entitled to cash proceeds until loan amount
and interest accrued have been paid off
- Owners interest subordinate to lenders interest
Pledges the property as collateral for the loan

Written document of agreement detailing financial and legal details of


transaction
See Notes for its contents
Mortgage Loan A contractual document that protects mortgagees interest w.r.t. 3 rd party
claims on collateral
Clarify purposes and proof of borrowers and lenders intent
Mortgagor Borrower
Mortgagee Lender
Default and Foreclosure
Lien
A charge upon the property for the discharge of a debt
Lien status Indicates loans seniority in the event of a foreclosure
Delinquency
Non-payment of a mortgage payment due
Default
- Occurs when borrower fails to perform one or more duties under terms of
note
- Occurs when borrower missed 90 days installment
Acceleration
Provision that enables lender to demand payment of entire outstanding
Clause
when first monthly payment is missed
Due-on-sale
Provision allowing lender to demand full repayment if borrower sells
Clause
property
Foreclosure
- Judicial foreclosure: Obtain court order to sell
- Non-judicial foreclosure: trustee sale without court order
- Notice of foreclosure
- Public auction followed by private sale if property wasnt sold
Loan
Terminology
Loan-to-value
Loan
LTV =
ratio
min ( Market Value of Property , Selling Price of Property)
Loan Principal

- Amount actually borrowed


- Remaining Balance of loan
Debt Service
Periodic payments for interest and principal
Interest Rate
Rate charged for use of money
Market i/r
Rate that clears the market for loanable funds
Contracted Rate specified in contract for purpose of calculating interest charges
i/r
Nominal i/r
Rate stated in a particular currency
Real i/r
Rate in purchasing power
Loan Duration
Time given to borrower to repay loan
Loan
Regular, periodic repayment of principal
Amortization
r1 ,

Mortgage Interest Rate (See Notes for Demand VS Supply)

Real rate
of Interest

f 1 , Inflation

Expectation

p1 , Risk

Premiums

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i t=r 1+ p1 + f 1

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Amortization Scheme
Constant Payment Mortgage: Loan is fully amortized with level payments
Graduated Payment Mortgage: Loan is fully amortized with rising payments
Constant Amortization Mortgage: Loan balance reduced by a constant amount each
period
Borrower took on a $500,000 loan at 5% interest for 30years
Constant Payment Mortgage
Constant Amortization Mortgage
1) Compute Monthly Debt Service
1) Compute constant amortization
5
amount

PV =500,000 ; n=360 ; i=

12

; FV =0

Amortization=

PMT =$ 2,684.11

500,000
360

$ 1,388.89

2) Compute monthly interest on loan


balance

2) Compute Loan Outstanding End of


Month1

5
12

5
PMT =2,684.11 ; n=359 ; i= ; FV =0
12

i month 1=500,000

PV =499,399.23

i month 2=498,611.11

3) Difference between PV is the Principal


Paid

5
12

$ 2,077.55

3) Compute Total Months Payment

M 1=1388.89+ 2083.33

Principal Paid=$ 600.77

4) Difference between principal payment


and PMT is Interest Payment

$ 2,083.33

$ 3,472.22

4) Repeat for all 360 months

Interest Paid =$ 2,083.33

5) Repeat for all 360 months


$60,000 loan for 30years at 12% interest. 3% origination fee and 3% prepayment
penalty on outstanding balance.
Loan Fees and Borrowing Costs
1) Compute monthly loan payments

PV =60,000 ; n=360 ; i=

12
; FV =0
12

PMT =$ 617.17

2) Calculate net cash disbursed (Loan amount Origination fee / Discount points =
Net disbursed)

Net cash disbursed=60,000 ( 13 )

58,200

3) Compute effective i/r

PV =58,200; n=360 ; PMT =617.17

i=1.034
Monthly

Early repayments and Prepayment Penalty


Simple
- Loan Balance EOY5 = $58,597.93
-

Outstanding + Prepayment Penalty = 1.03%

Monthly Debt Service = $617.17


Net Cash Disbursed = $58,200

$58,597.93 = $60,355.87

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Holding period = 5 years

PV =58,200; FV =60,355.87, PMT =617.17 ; n=60

i=1.1043

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Chapter 6: Alternative Mortgage Instruments


Type
Adjustable-Rate
Mortgage
See Notes for ARM
Variables and Index

Usage
Allows lender to adjust contract i/r to
reflect changes in market i/r. Change in
rate reflected by change in monthly
payment

Mathematics
Loan Amount =
$100,000
Index = 1 year
Margin = 2.50
See Notes for computation
Term
=
30
years
i n=min ( Index + Margin , in 1 +Cap)
2/6 i/r caps
Teaser Rate = 5%
Graduated Payment Mortgage designed to offset tilt effect by lowering payments on an FRM early on
and increasing over time

GraduatedPayment
Mortgage
Price-Level
Adjusted
Mortgage

Solves tilt problem and interest rate risk


by separating real rate of return and
inflation rate:

i=constant ror +inflation rate

$100,000
30years,
6%
interest

PMT in Year
1
4% inflation

PV =100,000 ; n=360 ; i=

6
12

PMT =$ 599.55
Year 2
4% inflation

PV =98,772 1.04 ; n=348 ; i=

6
12

PMT =$ 625.53
Year 3
-3% inflation

PV =101,366 0.97 ; n=336 ; i=

6
12

PMT =$ 604.83
Year 4
2% inflation

PV =96,929 1.02 ; n=324 ; i=

6
12

PMT =$ 616.92
Year 5-30
0% inflation

PV =98,868 ; n=312; i=

6
12

PMT =$ 612.92
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Shared
Appreciation
Mortgage

GEK2013 REAL ESTATE FINANCE

Low initial contract rate with inflation


collected in a lump sum based on house
price appreciation

Appreciation amt. computed when house is sold or


appraised in future

a=

V
, a :share of appreciation , V : LTV , :reductionloan
1t
'

t :lende r s tax rate


Reverse Annuity
Mortgage
Pledged Account
Mortgage /
Flexible Loan
Insurance
Program
Type
Fixed Rate
Mortgage

Disadvantages

Future housing costs are known with relative certainty

Default rates are generally low, simplicity and


standardization encourage securitization, easier to
police
Default rates are lower because payment shocks are
avoided
If interest rates are expected to fall in the future, good
for borrowers
Provides lower initial rate and payment than FRMs
Allows lenders with short-term liabilities to manage
interest rate risk
Future housing costs are known with relative certainty
Easier to qualify for lower income households to take
advantage of future earning power
Lower monthly payments early in mortgage
Default rates are lower because payment shocks are
avoided
Solves tilt effect

GraduatedPayment
Mortgage

Advantages

Adjustable-Rate
Mortgage

Borrower receives a series of payments


$200,000 at 9% for 5 years, annual payments
and repays in a lump sum at some future
n=5; i=9 ; FV =200,000
PMT =$ 33,418.49
time i.e. Reverse Mortgage
Combines a deposit with lender and fixed rate loan to form a graduated-payment structure
Deposit in pledged as collateral

Young households with lower incomes may not qualify


for loans with the different ratios in play / Interest
rates will be higher for those on mortgages with
unstable payments
Exposes lenders with short-term liabilities to severe
interest rate risk

Greater uncertainty about future mortgage payments


Difficult to understand. Subject to possible large
increases in future payment
Default rates are higher than on FRMs. Diversity
discourages securitization
Interests larger than fixed rate mortgage to make up
for the risk of rising mortgage outstanding
Payments will be higher in later stages of the loan
(must be confident that income will rise)
Long duration makes management of interest rate
risk difficult
Negative amortization

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Price-Level
Adjusted
Mortgage

Shared
Appreciation
Mortgage

Reverse
Annuity
Mortgage

Flexible Loan
Insurance
Program
Flexible
Maturity
Adjustable Rate
Mortgages

GEK2013 REAL ESTATE FINANCE

While borrowers may face large payments at end of


mortgage, its actual buying power is similar to initial
payment if real income increases, then burden is
reduced
Lenders are protected against sudden inflation and
enjoy relatively constant rates of returns
Solves tilt effect and interest rate risks
Relatively low interest rate and monthly payments

Way to access home equity without having burden of


repayment
Creates income
Owners enjoy tax-free annuities
Continue to live in the house and benefit from
appreciation and property deductions
May result in lower payments for borrower and thus
greater affordability and lower risk for default

Future payments are known in advance


Rate increases do not cause payment problems for
borrowers resulting in defaults

Interest rates changes doesnt reflect changes in


income levels
Mortgage balance increases faster than price
appreciation
Sudden inflation would result in large payments,
increasing default risk
Not feasible in regions with declining home values
Buyer may not be able to buy out lender when
specified payoff time arrives; buyer would be forced
to refinance or sell the house
Reduces value of estate (accumulating debt)
Home must be sold after death to repay mortgage if
liquid assets not sufficient
Annuities may place owners above certain welfare
schemes

Initial payment is higher. Payoff period is uncertain


Loan duration is not known in advance

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Chapter 7: Financing Decisions


House Value = $100,000
80% LTV, 12% i/r, 25 years
90% LTV, 13% i/r, 25 years
Down payment 20 100,000=20,000

Down payment 10 100,000=10,000

PV =80,000 ; n=300; i=12 /12

PV =90,000 ; n=300; i=13 /12

PMT =$ 842.58

PMT =$ 1,015.05

Compute internal rate of return, irr


Borrow $10,000 more but pay $172.47 more per month

PV =10,000 ; n=300 ; PMT =172.47

i=1.7142 12=20.570

Evaluate this percentage. Would you pay 20.57% interest just to borrow an extra
$10,000?
Assume borrower relocates after 5 years
Loan Outstanding EOY5 76,522.56

Loan Outstanding EOY5 86,639.88

Difference in loan outstanding 86,639.8876,522.56=10,117.32 n=60 ; PMT =172.47

PV =10,000 ; FV =10,117.32 ;

i=1.73596 12=20.832
With 2% origination fee

Loan disbursement 98 80,000

Loan disbursement 98 90,000

$ 78,400

$ 88,200

Difference at time zero $ 88,200$ 78,400=$ 9,800


Borrow $10,000 more but pay $172.47 more per month

PV =9,800 ; n=300; PMT =172.47

i=1.750 12=21.00

Assume Alternative #2 changed to 30 years


80% LTV, 12% i/r, 25 years
90% LTV, 13% i/r, 30 years
Down payment 20 100,000=20,000

Down payment 10 100,000=10,000

PV =80,000 ; n=300; i=12 /12

PV =90,000 ; n=360; i=13 /12

PMT =$ 842.58

PMT =$ 995.58

Difference at time zero $ 10,000


Difference in monthly payment: First 300 months: $153.00; Final 60 months: $995.58

irr (10,000, {153, 995.58 } , { 300,60 } )=1.5720 12=18.864

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Loan Refinancing
$80,000 loan at 15% for 30 years 5 years ago
Stick
Switch
Refinance at 14% for 25 years, 2%
prepayment penalty and upfront fee
payable to $2,525
Year 0
EOY5

PV =80,000 ; n=360; i=15 / 12

PMT =$ 1011.56

Loan outstanding EOY5 $ 78,976.50

PV =78,976.50 ; n=300 ; i=14 /12

PMT =$ 950.69
new monthly payment =$ 950.69
Returns from Refinancing Investment

Cost refinance=Prepayment Penalty +Upfront Costs

2 $ 78,976.50+2,525=$ 4,104.53

Benefit refinancing=Initial Monthly PaymentNew Monthly Payment

PV =4,104.53 ; n=300 ; PMT =60.87

$ 60.87

i=1.464 12=17.569 >14 cost of new borrowing

Effective Cost of Refinancing

PV =78,976.504,105.53=$ 74,871; n=300 ; PMT =950.69

i=1.238 12=14.857 <15 cost of original loan


Buyer plans to relocate after 10 years of refinancing or not refinancing
Loan Outstanding EOY10 $ 72,275.26

Loan Outstanding EOY10 $ 71,386.86

Difference in loan outstanding $ 888.4

PV =4,105 ; FV =888.4 ; n=120, PMT =60.87

i=1.1842 12=14.21 <17.569 irr if stay all the way

Two or more Loans


Financial Package
$500,000:

Individual Loans
$100,000 at 7%, 30 years
$200,000 at 7.5%, 20 years
$200,000 at 8%, 10 years

Payment of individual
loans

PMT =$ 665.30

PMT =$ 1,611.19
PMT =$ 2,426.55

irr (500,000, { 4703.04,2276.49, 665.30 } , {120, 120, 120 } )=0.6239 12=7.4873

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Chapter 9: Controlling Default Risk


Loan Underwriting: Process of determining and controlling default risk, evaluate
borrowers loan request in terms of profitability and risk
See Notes for Underwriting Process
Type

Formula

Loan-toValue (LTV)

Loan
LTV =
Property Value

Payment to
Income
Ratio
-ORMortgage
Servicing
Ratio
Debt
Coverage
Ratio
Breakeven
Ratio

Example

Property Value=$ 500,000


Loan=$ 400,000

Total Mortgage Expense


PIR/ MSR=
Gross Monthly Income
Variation :

DCR=

CashTopup ( CPF)
Debt Service

LTV =0.8

Jacks gross income is $5,500


Monthly loan payment is $4,540

PIR=

4540
=0.8255>TDSR
5500

See Notes for variation in this ratio

Net Operating Income


Debt Service

Debt Service+Operating Expense


Effective Gross Income
How much can a buyer finance?
Gross household monthly income
$7870
Car Loan

$150
0
Car Insurance
250
Credit Card
700
Personal Loan
500
Property tax & Insurance
300
Bank to grant 25-year 80% LTV at 3.5% p.a. with monthly payments subject to HEIR
30% and TDSR 60%
Gross Monthly Income
$7,7
80
Times: HEIR
0.30
Max Permissible long term obligations
$2,3
Housing61
Expense to
Less: Property tax & insurance
300
Income
Max Principal & interest payment
$2,0
Ratio
61

PMT =2061; n=300 ; i=3.5 /12

PV =$ 411,687

maxloan=$ 411,687
Total Debt
Service
Ratio

Gross Monthly Income


Times: TDSR
Max Permissible long term obligations

$7,7
80
0.60
$4,7
22
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Less: Property tax & insurance


Less: Payments on long-term debt
Max Principal & interest payment

PMT =1472; n=300 ; i=3.5 /12

300
2950
3,25
0
$1,4
72

PV =$ 294,033

maxloan=$ 294,033

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Chapter 11: Asset-Backed Securities


Securitizatio
n
Asset-backed
Security
Bankruptcy
Remote

Process by which assets are packaged into securities sold on


organized exchanges
A security created by pooling loans

A bankruptcy remote company is a company within a corporate group


whose bankruptcy has as little economic impact as possible on other
entities within the group
Two types of assets used as collateral existing and future
Securitization Structure
Amortizing Assets (Self-liquidating
Structure)
Periodic payments consisting if principal
& interest
Amortization schedule on a pool/loan
level

Non Amortizing Assets (Revolving


Structure)
- No amortizing schedule
- Lockout/revolving period
No fixed period, only minimum payment,
e.g. credit card

See Notes for further explanation


Fixed Rate
Floating Rate
Possibility of mismatch between cash flow characteristics of underlying asset and
liabilities. Interest rate derivatives are used to mitigate the risk
Asset Classification
Asset Backed
Security

Others

- Customer
loans
- Credit Card
Receivables
- Leasing
Receivables
-Future cash
flows

Asset Risk
-

Underlying borrowers
ability to pay and
service loans
Experience of

Mortgage
Backed
Security
- RMBS
- CMBS
(income
producing)

Collateralized
Debt Obligation

- Collateralized
Loan Obligation
- Collateralized
Bond Obligation

Credit Risks
Structural Risk
Can Cash Flow satisfy all
obligations?
- Loss allocation
- Cash flow allocation

Third-Party
Providers
Credit
guarantors
(bond
insurers)
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originators
Concentration of loans:
a single huge loan
borrower?
Assessment of most
likely lost via weighted
average loss &
variability of loss

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Interest rate spread


Potential of occurrence of trigger
events
Changes in credit enhancement

Servicer
Trustee
Lawyer

See Notes for Subordination Principle &


Cash Flow Waterfall

Credit Enhancement (See Notes for Credit Enhancement)

Senior
Subordinate
d Structure+
Internal
Credit
Enhanceme
nt

Excess
Spread
Overcollateraliza
tion

External

Monoline
Insurance*

*Monoline Insurance: An insurance company that provides guarantees to issuers to


enhance the credit of the issuer. Issuers will often go to monoline insurance
companies to either boost the rating of one of their debt issues or to ensure a debt
issue does not become downgraded.
+

Main motivation is to maintain ratio of senior-subordinate: Redirect prepayments


disproportionately from subordinate to senior to ensure no deterioration of credit
protection for senior bond class
Residential Mortgage Backed Securities
Prepayment Risk
Conditional Prepayment Rate
Single-Monthly Mortality rate (SMM)

SMM =1( 1CPR )

1
12

Monthly Prepayment =SMM ( beginning bal for month tscheduled principal payment for month t)
Default Risk
1) Conditional Default Risk (CDR)
Annualized value of unpaid principal balance of newly defaulted loans in a month as
percentage of unpaid balance of pool

CDR M =

defaulted loanbalance
beginning bal for month tscheduled principal payment month t

CDRY =1( 1CDR M )12


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2) Cumulative Default Rate


Commercial Mortgage Backed Securities
- Prepayment terms
- Role of servicer: transference of loan to special servicer when borrower is in
default, imminent default, or in violation of covenants
- Role of buyers: junior bond buyers

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Special Purpose Vehicle


A Special purpose vehicle is a legal entity created to fulfil a Specific or temporary
objective. SPVs are typically used by companies to isolate the firm from financial risk.
They are also commonly used to hide debt, hide ownership, and obscure relationships
between different entities which are in fact related to each other
Some of the reasons for creating Special purpose entities are as follow:
-

Securitization: SPVs are commonly used to securitise loans. For example, a bank
may wish to issue a mortgage-backed security whose payments come from a pool of
loans. However, to ensure that the holders of the mortgage-back securities have the
first priority right to receive payments on the loans, these loans need to be legally
separated from the other obligations of the bank. This is done by creating an SPV,
and then transferring the loans from the bank to the SPV.
Risk sharing: Corporates may use SPVs to legally isolate a high risk project/asset
from the parent company and to allow other investors to take a share of the risk.
Finance: Multi-tiered SPVs allow multiple tiers of investment and debt.
Asset transfer: Many permits required to operate certain assets (such as power
plants) are either non-transferable or difficult to transfer. By having an SPV own the
asset and all the permits, the SPV can be sold as a self-contained package, rather
than attempting to assign over numerous permits

Asset-Backed Securities
When a consumer takes out a loan, their debt becomes an asset on the balance sheet
of the lender, collecting principal and interest payments from borrowers. The lender can
then sell these assets to a trust or special purpose vehicle, which packages them into
an asset backed security (ABS) that can be sold in the public market. The interest and
principal payments made by consumers pass through to the investors that own the
asset backed securities.
ABS benefit lenders because they can be removed from the balance sheet, allowing
lenders to acquire additional funding as well as greater flexibility to pursue new
business. 1) Investors of ABS and MBS are usually institutional investors and they use
ABS to obtain higher yields than comparable-maturity U.S. Treasury securities among
triple-A rated assets, as well as to provide a way to diversify their portfolios and
augment their portfolio diversification. 2) ABS are one of the most secure investment
vehicles from a credit standpoint. Predictable cash flow. The certainty and predictability
of cash flow for many types and classes of ABS are well established. Investors can buy
these securities with considerable confidence that the timing of payments will occur as
expected. (Prepayment uncertainty). 3) Because ABS are secured by underlying assets,
they offer significant protection against event-risk downgrades, particularly in contrast
to corporate bonds. A major concern investors have about unsecured corporate bonds,
no matter how highly rated, is that the rating agencies will downgrade them because of
some disruptive event affecting the issuer. Such events include mergers, takeovers,
restructurings and recapitalizations, which are often undertaken by corporate managers
trying to boost shareholder value.

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Name
Simple
Interest

GEK2013 REAL ESTATE FINANCE

Formula

Usage
Interest earned on
principal amount only

i=Principal i /r

Total amount accumulated E


interest:

Total amount =1,000+2 1


Future Value

Present Value

Future Value
Annuity

FV =PV

PV =FV

FVA=PMT

1
i

Compute compound
interest

Total amount accumulated E

Value of an investment in
todays money

Present value of obtaining $

Future value of a series of


constant payments

Investor pays $200 per mon

FV =1,000 ( 1+0.07 )2=$ 11

FVA=100

Sinking Fund
Factor
(PMT)

Present Value
Annuity

PMT =FVA

i
1

Arrears

1
PVA=PMT

=PMT

1PV
i

PVA=PMT ( 1+ i )
Mortgage
Constant

Compute PMT to accumulat

How much to pay for an


investment that hands
out constant payments

Investment pays out $300 e


p.a., how much to pay?

10
12
PMT =33,100
3 12
10
1+
12

1
PVA=300

1
8
1+
12
8
12

PMT =PVA

5 12

8
1
12
=
8
12

1+

Amount set aside to be


invested in order to
accumulate desired
future amount

Advance

1
=
( 1+ 0.07 )1

PV =105,000

Debt service necessary to


amortize a present
mortgage loan amount

You raised a mortgage of $1


7% p.a.

PMT =100,000

1
1
n= years
(1+7 )1

Loan
Outstanding

Loan Outstanding EOY1

Same PM

Outstanding mortgage Loan


Effective
Rates
VS
Nominal Rates

Convert nominal quotes


to effective rates

i
1
m

( )

EAR= 1+

Future Value Factor , =( 1+i )n ; Discount rate=

Effective annual rate of 1%


Simple interest rate of 1% p

EAR= 1+

12
12

12

) 1=0.126

1
1+r
20