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 Overview Mortgage Life Cycles –Mortgage Process –Mortgage Risk Management –Legal Concepts in Mortgages Life Cycle Management –Planning –Origination –Operation –Disposition

Real Estate Finance © JR DeLisle, Ph. D. Current Crisis

Real Estate Finance © JR DeLisle, Ph. D. Individual Mortgage Life Cycle Planning/Application Acquisition Operation Disposition Planning/ Application Acquisition Operation Disposition

Real Estate Finance © JR DeLisle, Ph. D. Components of a Mortgage

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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)

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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 Planning/ Application Acquisition Operation Disposition

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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 Planning/ Application Acquisition Operation Disposition

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. FICO Scores and Mortgage Rates $300,000 Mortgage $800,000 Mortgage

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. 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 Planning/ Application Acquisition Operation Disposition

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. Operational Risk Management: Asset Protection

Real Estate Finance © JR DeLisle, Ph. D. 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 Planning/ Application Acquisition Operation Disposition

Real Estate Finance © JR DeLisle, Ph. D. Transfer/Termination

Real Estate Finance © JR DeLisle, Ph. D. Risk Management at Disposition: Voluntary Voluntary Transfer of Asset/Collateral Voluntary Transfer of Mortgage

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. Loss Mitigation Loan modification –Lowering the interest rate, reducing the principal balance, increase terminterest rate –‘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.market value –Applies to upside down borrowers Short refinance –Lender reduces the principal to permit refinance with a new lender.refinance –Reduction in principal is designed to meet the Loan-to-value guidelinesLoan-to-value

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. Managing Involuntary Transfer Propensity to Default Post-Foreclosure

Real Estate Finance © JR DeLisle, Ph. D. 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

Real Estate Finance © JR DeLisle, Ph. D. 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 © JR DeLisle, Ph. D. Alternative Mortgages

Real Estate Finance © JR DeLisle, Ph. D. Lecture Review Risk Management –Definition of Risk –Risk Management Process Mortgages –Mortgage Process –Mortgage Risk Management –Mortgage Concepts –Mortgage Transfer, Foreclosure & Bankruptcy