RE2706 Real Estate and Infrastructure Finance

Week 4

Mingxuan FAN

Department of Real Estate

NUS Business School

February 3, 2023

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Last lecture

▶ Adjustable Rate Mortgage (ARM)

▶ Mortgage products in Singapore

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Interactive questions
▶ Go to: PollEv.com/re2706
▶ OR use the QR code

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Interactive question

Calculate the effective cost assuming you repay the remaining balance at
the end of the 4th year.

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Interactive question

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Interactive question

▶ CF0: 300,000
▶ C01:-1403.91; F01:12
▶ C02:-1650.77; F02:12
▶ C03:-1754.35; F03:12
▶ C04:-2106.9; F04:11
▶ C05: -(2106.9+255321); F05:1
▶ IRR (monthly) =0.283%
▶ IRR (annual)=0.28%*12=3.396%

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Learning objectives

1 Incremental borrowing cost

2 Refinancing decision

3 Effective cost of multiple loans

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Reference

Brueggeman and Fisher (2022) Real Estate Finance and Investments, 17th
ed., Chap 6.

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Learning objectives

1 Incremental borrowing cost

2 Refinancing decision

3 Effective cost of multiple loans

Incremental borrowing cost 9 / 40

Incremental borrowing cost

▶ You are trying to decide how much you should borrow (i.e. LTV) for
your home purchase
▶ Incremental cost: Real cost of borrowing MORE money at a higher
interest rate?

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Incremental borrowing cost: example

▶ Home value: $150,000

▶ Two loan alternatives:
▶ #1: 90% Loan to Value, 8.5% interest rate, 30 years
▶ #2: 80% Loan to Value, 8% interest rate, 30 years
▶ Only 0.5% interest rate difference?

Incremental borrowing cost 11 / 40

Incremental borrowing cost: example

Incremental borrowing cost 12 / 40

Incremental borrowing cost: example

Incremental borrowing cost 13 / 40

Incremental borrowing cost: example

Incremental borrowing cost 14 / 40

Incremental borrowing cost: example

Focusing on the cash flow differences:

▶ Borrowing $15,000 more
▶ Paying $157.51 per month more
What’s the incremental borrowing cost?
▶ PV=15,000
▶ PMT=-157.51
▶ N=360
▶ FV=0
▶ CPT I/Y=1.023
▶ 1.02%*12=12.276%

Incremental borrowing cost 15 / 40

Incremental borrowing cost: example

The real cost of borrowing the extra $15,000 is 12.28%

▶ Can you earn 12.28% investment return on the $15,000 that is saved
by borrowing more to buy a house?
▶ Should you wait and save $15,000 more?
▶ Can you borrow the additional $15,000 elsewhere at a lower cost?

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Effect of LTV ratio on loan cost

Incremental borrowing cost 17 / 40

Incremental borrowing cost: other considerations

▶ Use of discount points

▶ Depending on the points, the cash flow difference at time zero would
change.
▶ In the previous example, the $15,000 difference would change.
▶ Different maturity: example
▶ #1: 90% Loan to Value, 8.5% interest rate, 30 years
▶ #2: 80% Loan to Value, 8% interest rate, 25 years

Incremental borrowing cost 18 / 40

Incremental borrowing cost: other considerations

Incremental borrowing cost 19 / 40

Incremental borrowing cost: other considerations

Cash flow differences:

▶ Borrowing $15,000 more
▶ Paying 1038.03-926.18=111.85 per month more for the first 25 years
or 300 months
▶ Paying 1038.03 per month more for the last 5 years or 60 months
What’s the incremental borrowing cost?
▶ CF0=15,000
▶ C1=-111.85; F1=300
▶ C2=-1038.03; F2=60
▶ IRR CPT=0.8926
▶ 0.8926*12=10.71%

Incremental borrowing cost 20 / 40

Key takeaways

▶ The more you borrow, the higher the interest rate will be.
▶ There is a point at which you should not borrow more money. The
interest rate on the increment will be just too high.
▶ It is not economically rational to borrow as much money as possible.

Incremental borrowing cost 21 / 40

Learning objectives

1 Incremental borrowing cost

2 Refinancing decision

3 Effective cost of multiple loans

Refinancing decision 22 / 40
Loan refinancing

▶ When interest rates are low, taking out a new loan with a different
bank at a lower interest rate
▶ Using a new loan, repay all the remaining balance of the existing loan
to the original bank

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Loan refinancing

Borrower considerations:
▶ Terms on the present outstanding loan
▶ What are the new loan terms?
▶ What are the fees associated with paying off the old loan and
obtaining a new one?
Application of basic capital budgeting investment decision:
▶ What is our return on an investment in a new loan?

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Loan refinancing: example

A borrower has secured a 30 year, $120,000 loan at 7%. Fifteen years

later, the borrower has the opportunity to refinance with a fifteen year
mortgage at 6%. However, the up front fees, which will be paid in cash,
are $2,500. What is the return on investment if the borrower expects to
remain in the home for the next fifteen years?

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Loan refinancing: example

Monthly payment under initial loan:

▶ PV=120,000
▶ N=360
▶ I/Y=7/12
▶ CPT PMT=-798.36
Loan balance 15 years later:
▶ N=180
▶ I/Y=7/12
▶ PMT=-798.36
▶ CPT PV=88,822.64

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Loan refinancing: example

Monthly payment under new loan:

▶ PV=88,822.64
▶ N=180
▶ I/Y=6/12
▶ CPT PMT=-749.54
Cost of refinancing is $2,5000, what is the benefit?
▶ Benefit is the monthly payment saved
▶ 798.36-749.54=48.82

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Loan refinancing: example

Return on investment:
▶ PV=-2,500
▶ FV=0
▶ N=180
▶ PMT=48.82
▶ CPT I/Y=1.885
▶ Return on investment: 1.885% × 12 = 22.62%

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Alternative: effective cost of refinancing

Refinance if the effective cost of refinancing is lower than the initial loan.
▶ Net cash received from new bank:
▶ 88,822.64-2,500
▶ Effective cost of refinancing:
▶ PV=88,822.64-2,500
▶ FV=0
▶ N=180
▶ PMT=-749.54
▶ CPT I/Y=0.537
▶ Effective annual interest rate: 0.537% × 12 = 6.45%

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Alternative: effective cost of refinancing

What is the break-even refinancing cost that makes you indifferent?

▶ I/Y=7/12 (break-even rate of return)
▶ FV=0
▶ N=180
▶ PMT=-749.54
▶ CPT PV=83,390.8
▶ Break-even cost: 88,822.64-83,390.8= 5431.84

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Alternative: effective cost of refinancing

Double check:
▶ Cost:5431.84
▶ Benefit:48.82
What is the return on investment?
▶ FV=0
▶ N=180
▶ PMT=-48.82
▶ PV=5431.84
▶ CPT I/Y=0.606%
▶ Interest rate: 0.606% × 12 = 7%

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Loan refinancing: other considerations

What is the return on investment if the borrower wish to sell off the
property before the end of loan terms?
▶ We need to consider the expected loan balance for the initial vs new
loan at the point of sale
Example: the borrower is considering selling the property in 7 years

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Loan refinancing: other considerations

Loan balance at the end of 7th year for the initial loan:
▶ N=8 × 12 = 96
▶ PMT=798.36
▶ I/Y=7/12
▶ FV=0
▶ CPT PV=58,557.76
Loan balance at the end of 7th year for the new loan:
▶ N=8 × 12 = 96
▶ PMT=749.54
▶ I/Y=6/12
▶ FV=0
▶ CPT PV=57,036.1

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Loan refinancing: other considerations

To calculate the effective cost of the new loan:

▶ PV=-2,500
▶ FV=58,557.76-57,036.1=1,521.66
▶ PMT=48.82
▶ N=84
▶ CPT I/Y=1.745
▶ Interest rate: 1.745% × 12 = 20.94%

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Learning objectives

1 Incremental borrowing cost

2 Refinancing decision

3 Effective cost of multiple loans

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Effective cost of multiple loans

Basic technique:
▶ Compute the payments for the loans
▶ Combine into a cash flow stream
▶ Compute the effective cost of the amount borrowed, given the cash
flow stream.
▶ Compare the cost to alternative financing options.

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Effective cost of multiple loans: example

Compute the payments for the loans:

▶ You need a $500,000 financing package.
▶ $100,000 at 7%, 30 Years
▶ PV=100,000, N=360, I/Y=7/12; CPT PMT = -665.30
▶ $200,000 at 7.5%, 20 Years
▶ PV=200,000, N=240, I/Y=7.5/12; CPT PMT = -1611.19
▶ $200,000 at 8% 10 Years
▶ PV=200,000, N=120, I/Y=8/12; CPT PMT = -2426.55

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Effective cost of multiple loans: example

Combine into a cash flow stream

▶ Monthly cash flow for the year 1-10: 665.30+1611.19+2426.55
▶ Monthly cash flow for the year 10-20: 665.30+1611.19
▶ Monthly cash flow for the year 20-30: 665.30

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Effective cost of multiple loans: example

Compute the effective cost of the amount borrowed, given the cash flow
stream
▶ CF0=500,000
▶ C1=-(665.30+1611.19+2426.55); F1=120
▶ C2=-(665.30+1611.19); F2=120
▶ C3=-665.30; F3=120
▶ IRR CPT=0.6239
▶ Effective cost: 0.6239% × 12 = 7.49%

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Effective cost of multiple loans

Compare the cost to alternative financing options

▶ What are the benefits? When can you get the benefits?
▶ What are the costs? When should you pay the costs?
▶ Is it worth it?

Effective cost of multiple loans 40 / 40