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Lecture 12: Real Estate

Real Estate: an Important Asset

Until recent stock market boom, single family
homes value in US approximated value of entire
stock market.
Home mortgages 1999: $4.62 trillion Consumer
credit is only 1.46 trillion. US National debt held
by public is only $3 trillion
(Source: FRB, Balance Sheets for US Economy)

Real Estate Partnerships as the

Major Example of a DPP
Real estate limited partnerships represent the most
important example of a Direct Participation Program
(DPP), a class of investments that also includes oil and gas
exploration programs and equipment leasing programs
Direct participation: DPPs are flow-throw vehicles
and investors can deduct program losses on personal taxes
Tax shelters until the Tax Reform Act of 1986: losses
used to offset passive income. Now, genuine businesses.
DPPs escape the corporate profits tax
IRS requirements, notably limitation of life

Limited Partnership Structure

General partner runs the business, does not have
limited liability
General partner must own at least 1%
Limited Partners are passive investors, with
limited liability, rights to vote, can replace general
General partner or associate usually runs the
offering to sell units to investors
Give additional performance-oriented
compensation to the general partner

Accredited Investors
Regulation D: Accredited investors include
individuals with net worth in excess of $1
million or with income in excess of
$200,000 ($300,000 joint income) in each of
the last two years
National Association of Securities Dealers
(NASD) requires suitability files and
suitability tests for DPPs

Real Estate Investment Trusts (REITs) were
created by US Congress in 1960 to allow small
investors access to real estate investments.
Before 1960, public companies that owned real
estate would be considered businesses, for which
their earnings would be subject to corporate profits
tax. So, until 1960, real estate was typically owned
by partnerships, not suitable for small investors.
Today, institutions invest in REITs too.

Restrictions on REITs
75% of assets must be in real estate or cash
75% of income must be from real estate
90% of their income must be from real estate,
dividend, interest & capital gains
95% of income must be paid out
No more than 30% of income from sale of
properties held less than four years
These prevent regular businesses from being REITS

The 3 REIT Booms

First boom: Late 1960s: interest rates rose above deposit
rate ceilings at banks, depositors fled to mortgage
REITs. But, with recession of 1974, many REITs
defaulted. Economic Recovery Tax Act of 1981 favored
Second boom: Tax Reform Act of 1986 eliminated
advantages of partnerships, so investors switched to
Third boom: Starting 1992, many private real estate
companies found it advantageous to go public as REITs,
specialized REITs developed.

History of Mortgages
In 1920s, 5-year term loans common,
balloon payment due in five years, or
refinance or sell house.
In 1930s, decline in nominal home prices
and rise in unemployment caused massive
Mortgage lending industry turned to longterm annuities

Kinds of Mortgages
Conventional, fixed rate mortgage
Adjustable rate mortgage (ARM)
Price level adjusted mortgage (PLAM) payment
adjusted to inflation so constant in real terms
Dual rate mortgages (DRAMs) same as PLAM but
interest rate floats
Shared appreciation mortgages (SAMs)
First mortgages: on purchase of home
Home equity loans

Conventional Mortgages
Homeowners fixed rate mortgage: an
annuity whose present value equals the
initial loan.
Traditionally, payments are monthly and
compounding is monthly. With maturity m
years and mortgage rate r we have:


12 M
r / 12 r / 12 (1 r / 12)

Mortgage balance monthly payment

New Haven Savings Bank

Founded in 1838 as part of the Savings Bank
Movement that began in UK at begin of 19th
century. A major mortgage lender
Philanthropic mission to protect small savers.
Charter requires conservative investments
No savings bank went bankrupt during great
Savings banks accumulate huge piles of assets,
tempting takeover

Statement from NHSB Directors

In NHSB's case, formidable business risks have been steadily emerging over the last
several years.
The Board has a fiduciary responsibility to make sure that NHSB is successful, and it is
clear to us that the Bank has to grow if it is to break out of its current stagnation. If
NHSB were to rely just on its history and goodwill in the community, it would risk the
very real possibility of becoming obsolete over time.
These are unique challenges, and they call for outstanding leadership. NHSB is fortunate
to have just that in its President and CEO, Peyton R. Patterson, and her executive
management team. The Board brought Ms. Patterson to NHSB based upon her history of
being able to jumpstart momentum at financial institutions, and her strong belief in
community banking. Our confidence in her and her team has been confirmed in
numerous ways, but most notably with the pending acquisitions of Savings Bank of
Manchester and Tolland Bank, and the proposed plans to convert the Bank to public
We are aiming to put more money back into the community -- NHSB is more than
quadrupling the size of its Foundation, by allotting to it $30 million of the stock raised
through a public offering.

CT Banking Commissioner John P. Burke,

Approval of Conversion Jan 2004
The New Haven Saving Bank (NHSB) submitted an
application on September 30, 2003 for the conversion from
a mutual saving bank to a capital stock bank and for the
acquisition of and subsequent merger of the Savings Bank
of Manchester and Tolland Bank with and into NHSB. The
combined entities will operate under the name
NewAlliance Bank.
To address the comments received on the concern the new
institution would be sold in the near future, the approved
plan of conversion restricts the acquisition of more than
10% of any security of the Holding Company without the
prior approval of the Commissioner for a period of 5 years
following completion of the conversion.

NHSB Conversion Plan

As part of the Plan of Conversion, New Haven Savings Bank will
conduct a subscription offering of common stock to eligible
depositors, in accordance with applicable conversion rules. Pursuant to
governing regulations, the common stock is being offered for sale in a
subscription offering, in descending order of priority, to 1) New Haven
Savings Bank account holders with a balance of at least $50 or more
on June 30, 2002; 2) New Haven Savings Bank's tax qualified
employee stock benefit plans, including the employee stock ownership
plan; 3) account holders with $50 or more on deposit as of the quarter
end before receiving approval; 4) New Haven Savings Bank Directors,
officers and employees and 5) New Haven Savings Bank Corporators.

NHSB Shares Likely to Soar

NHSB sent prospectus to its depositors on Feb 19,
Price per share $10, maximum order $70,000
Deadline to order shares March 11, 2004
As many as 102.5 million shares may be sold
SNL Financial report Feb 20, 2004: the stock
price will most likely jump 40 percent to 50% on
the day the company goes public

Fannie Mae
Federal National Mortgage Association, created by
Congress in 1938 to create a secondary market for FHA
approved mortgages. Borrows money, buys & holds
1944 allowed to buy VA (Veteran Admin. Loans)
1954 Congress makes Fannie Mae a mixed ownership
corp., with private owners
1968 Pres. Johnson signs bill making Fannie a fully private
1976 Conventional loans outnumber FHA & VA
Still does not do jumbo loans (above $275000)

Freddie Mac
Federal Home Loan Mortgage Corporation
(Freddie Mac) created by Congress in 1970.
From beginning, it securitized mortgages:
sold pools of mortgages, called a
participation certificate (PC) to investors.
In 1981, Fannie began to compete with
Freddie in pooling mortgages, with its
mortgage backed securities (MBS)

Implicit Govt Guarantee of GSEs

Complaints that the Government Sponsored
Enterprises have unfair advantage
Richard Baker, Chairman of House Banking
Committee, has introduced a bill to regulate
GSEs and limit their business
Stiff opposition

Private Mortgage Insurance

Companies, such as MGIC, insure Fannie & Freddie
against losses on their mortgages
Both Fannie & Freddie require that mortgagors buy
mortgage insurance if down payment is less than 20%.
Controversy: with recent real estate price increases,
LTV has declined below 80% for many homeowners
still paying for mortgage insurance. The PMIs dont
notify them.
Impossibility of PMIs insuring GSEs in a major
downturn is another issue.

Collateralized Mortgage
Obligations (CMOs)
CMOs divide the cash flow of a mortgage
pass-through security into a number of
tranches in terms of prepayment risk.
Sequential-pay CMOs (first created 1983):
First tranche receives first principal
payments, after it is paid off the second
tranche receives principal payments.

Behavior of Single Family Home

Not a random walk, substantial inertia
Occasional booms and busts
Shared movements over wide regions of
country, but not shared over entire country
Boom of late 1980s infected many of largest
cities of world

Characteristics of Real Estate

Case Shiller Surveys of Homeowners 1988,
Surveyed recent homebuyers in Anaheim
CA (boom), Milwaukee WI (no boom) and
Boston MA (post-boom)
Nearly 1000 responses each survey

Long-Term Expectations
On average over the next ten years, how
much do you expect the value of your home
to change each year?
Los Angeles
1988 2003
1988 2003
14.3% 13.1%
7.3% 11.7%

Fears of Being Left Out

Housing prices are booming. Unless I buy
now, I wont be able to afford a house in the
Los Angeles
1988 2003
1988 2003
79.5% 48.8% 27.8% 36.4%
Disagree 20.5% 51.2% 72.2% 63.6%

Perceptions of Excitement
There has been a good deal of excitement
surrounding recent housing price changes. I
Sometimes I think I may have been
influenced by it.
Los Angeles
1988 2003
1988 2003
54.3% 46.1% 21.5% 34.8%
45.7% 53.9% 78.5% 65.2%

Word-of-Mouth Communication
In conversations with friends and associates
over the last few months, conditions in the
housing market were discussed.
Los Angeles
1988 2003
1988 2003
Frequently 52.9% 32.9% 20.0% 27.6%

Stock Market is Best Investment

The stock market is the best investment for long-term holders, who can
just buy and hold through the ups and downs of the market.
Oct 2001
-Feb 2002
1. Strongly agree
2. Agree somewhat
3. Neutral
4. Disagree somewhat 2%
5. Strongly disagree 1%
(U. S. Individual investors; numbers for 2000 are mid-year, after
peak of market.)

Real Estate is Best Investment

Real estate is the best investment for long-term holders, who can just buy
and hold through the ups and downs of the market.
Los Angeles
1. Strongly agree
2. Agree somewhat
3. Neutral
4. Disagree somewhat
5. Strongly disagree



Effects of Real Estate Booms &

Crashes on Financial Institutions
Default rate on mortgages is function of
loan to value ratio, which declines as prices
rise, rises as prices fall.
Mortgage insurance companies suffered
massive losses in 1980s with decline of real
estate prices in Texas. MGIC in great
trouble then.

Real Estate Market Today

Late 1990s have shown solid price increases in
many cities
San Francisco increased 28% 1999 III to 2000 III,
fell 4.5% between 2001-I and 2001-IV .
More low downpayment loans today
Risk of stock market decline harming real estate
market, thereby the PMIs, and mortgage lenders