Ch6. Real Estate Finance — Mortgages, Interest Rates, and Loan Structures

Overview of Real Estate Finance

Real estate finance: The process of raising and structuring capital for acquiring, developing, or operating real property.

Primary financing instruments:

Residential mortgages (conventional, FHA, VA, USDA)
Commercial mortgages
Construction loans
Real Estate Investment Trusts (REITs)
Commercial Mortgage-Backed Securities (CMBS)

Mortgages

Mortgage: A loan secured by real property. The borrower (mortgagor) pledges the property as collateral to the lender (mortgagee).

Mortgage structure:
Borrower ──── Principal + Interest payments ────→ Lender
         ←── Loan proceeds ────────────────────
         ──── Property as collateral ──────────→

Underwriting Ratios (Review)

Metric	Definition	Formula
LTV	Loan-to-Value	Loan Amount ÷ Appraised Value × 100%
DTI	Debt-to-Income	Monthly Debt Payments ÷ Gross Monthly Income × 100%
DSCR	Debt Service Coverage	NOI ÷ Annual Debt Service (commercial)

Common Loan Types

Conventional loan: Not government-backed; conforms to Fannie Mae / Freddie Mac guidelines
FHA loan: Insured by Federal Housing Administration; lower down payment (3.5%)
VA loan: Guaranteed by Veterans Affairs; no down payment for eligible veterans
USDA loan: For rural properties; no down payment for qualifying borrowers

Interest Rate Structures

Fixed-Rate Mortgage (FRM)

Interest rate stays the same for the entire loan term
Advantage: Predictable payments; no exposure to rising rates
Disadvantage: Initial rate is higher than comparable ARMs

Adjustable-Rate Mortgage (ARM)

Rate is tied to an index (SOFR, 1-year Treasury, etc.) and adjusts periodically
Advantage: Lower initial rate; benefits if rates fall
Disadvantage: Payment can increase significantly if rates rise

Hybrid ARM

Fixed rate for an initial period (3, 5, 7, or 10 years), then adjusts annually
Example: A 5/1 ARM is fixed for 5 years, then adjusts every year

Rate comparison:
Fixed-rate: stability ↑, initial cost ↑
ARM: initial cost ↓, rate risk ↑
Hybrid: middle ground — short-term certainty + long-term flexibility

Amortization Methods

Level Payment (Fully Amortizing) — Most Common

Monthly payment is the same throughout the loan. Early payments are mostly interest; later payments are mostly principal.

Monthly Payment = P × [r(1+r)^n] / [(1+r)^n − 1]

P = Loan principal
r = Monthly interest rate (annual rate ÷ 12)
n = Number of payments (years × 12)

Advantage: Predictable; easy to budget
Disadvantage: Total interest paid is higher than with accelerated methods

Straight-Line Principal Reduction

Principal is reduced by an equal amount each month; interest component declines over time.

Monthly Principal = Total Loan ÷ Number of Payments
Monthly Interest = Remaining Balance × Monthly Rate
→ Total payment is highest in month 1, declining each month

Advantage: Less total interest paid
Disadvantage: Higher early payments

Interest-Only Loan

Borrower pays only interest for a set period; no principal reduction.

Level vs Straight-Line Comparison

Example: $300,000 loan, 4% annual interest, 30-year term

Level payment (fully amortizing):
  Monthly payment: approximately $1,432
  Total interest over 30 years: approximately $215,600

Straight-line principal reduction:
  Month 1: $833 principal + $1,000 interest = $1,833
  Month 360: $833 principal + ~$3 interest = $836
  Total interest: approximately $150,750

Reverse Mortgage

Reverse mortgage: Allows homeowners age 62+ to borrow against home equity and receive monthly payments without making loan payments.

Traditional mortgage: Borrow money to buy home → make monthly payments
Reverse mortgage: Use existing home equity → receive monthly income (loan balance grows)

HUD’s HECM (Home Equity Conversion Mortgage):

Most common reverse mortgage product in the US
Borrower must be 62+ and occupy the home as primary residence
Loan becomes due when borrower sells, moves out, or dies
FHA-insured; no income or credit score requirements

Commercial Real Estate Finance

Construction Loan: Short-term, interest-only loan that finances building construction; converts to a permanent mortgage upon completion.

CMBS (Commercial Mortgage-Backed Securities): Pools of commercial mortgage loans packaged into bonds sold to investors.

Sponsor/Developer ─── CRE loan ──→ Bank/Lender
                                 → Loans pooled into CMBS
                                 → Sold to institutional investors

Bridge Loan: Short-term loan used to “bridge” a gap — e.g., while arranging permanent financing or completing a renovation.

REITs (Real Estate Investment Trusts)

REIT: A company that owns income-producing real estate and distributes at least 90% of taxable income as dividends.

Investors → Capital → REIT → Acquires/operates real estate
          ←── Dividends ←──

Key features:

Must distribute ≥ 90% of taxable income as dividends (tax transparency)
Traded on major exchanges (equity REITs) or non-traded
Types: Equity REIT (owns property), Mortgage REIT (holds loans), Hybrid

Fully Amortizing (Level Payment) Mortgage ★★★★★ : Equal monthly payments throughout the loan term. Formula: P × [r(1+r)^n] / [(1+r)^n−1]. Interest portion is highest at the start. Memory tip: Level payment = same every month; interest-heavy at first

Reverse Mortgage (HECM) ★★★★☆ : Age 62+; borrow against home equity and receive income. No monthly payments required. Loan balance grows and is settled when the home is sold. Memory tip: Reverse = no payments; equity shrinks over time

Hybrid ARM ★★★★☆ : Fixed rate for an initial period (3, 5, 7, or 10 years), then adjusts annually. Balances stability and lower initial cost. Memory tip: 5/1 ARM = 5 years fixed, then annual adjustment

Practice Quiz

Q. A borrower takes out a $200,000 loan at 6% annual interest for 20 years using straight-line principal reduction. What is the first month’s total payment?

Principal = $200,000 ÷ 240 =$ 833. Interest = $200,000 × 6% ÷ 12 =$ 1,000. Total month 1 payment = $1,833.

Q. Name two advantages of a REIT over direct real estate ownership.

① Diversification with lower capital: investors can own a fractional interest in a diversified portfolio with as little as one share. ② Liquidity: publicly traded REITs can be bought or sold on a stock exchange at any time, unlike physical real estate which may take months to sell.