Residential Property Financing

1
Residential Property Financing

• Lecture Map
• Lenders Underwriting Process
• Appraising Residential Property
• The Borrowers Decision Process

2
Loan Underwriting

• Evaluation of risk and profitability
• Essentially the lenders due diligence process
• Property review
• Physical condition and value
• Financial market analysis
• Interest rates, mortgage terms and conditions
• Ability to sell off the loan
• Analysis of borrowers financial condition

3
Loan Underwriting (cont.)

• Three Key Lender Decisions
• Determine the elements of risk
• Do we make the loan?
• Pick the right mortgage vehicle
• Determine need for additional collateral
• i.e., beyond the mortgage on the property

4
Loan Underwriting (cont.)

• Two Basic ratios behind the underwriting and
  decision process
• Payment to income ratio
• Tests ability of borrower to make the payments
• Similar to the DCR test in commercial loans
• Loan to value ratio
• Relates loan amount to appraised value of
  property
• Similar to the LTV test in commercial loans
• Higher the ratios higher risk profile of loan

5
Property Evaluation

• Assessment of the market value of property
• Market Value highest price the market will pay
  on a cash basis
• Assuming normal financing conditions
• Based on the expected time of trade
• Answers the following question
• What can the property be sold for to satisfy the
  mortgage in the event of default?
• This is the price that will transfer title at a
  point in time
• Price MAY NOT equal value in all cases at all
  times

6
Property Evaluation (cont.)

• Market Value is determined by an appraisal
• Three basic appraisal methods
• Sales comparison approach
• Reproduction cost approach
• Income approach

7
The Sales Comparison Approach to Value

• Compares subject property to other recent
  transactions of similar property
• Involves judgment
• Selection of the right comps
• Adjusts comps for differences in physical
  attributes and transaction details
• Remember the definition of market value
• cash basis trade and timing of trade

8
  
     
9
The Reproduction Cost Approach to Value

• What does it cost to replicate the property?
• Land value
• Cost of the improvements
• Qualitative assessment of design, materials,
  obsolescence
• Property age makes this not the best approach in
  many cases
• Example wear and tear on a 20 year vs. a 5 year
  old home in the same subdivision

10
The Income Approach

• DCF or PV of the cash flows
• In residential analysis, look for rental comps
  and see value is implied by those rental rates
• Rents should produce a market yield on the value
  of the asset
• Gross Income Multiplier
• Ratio of sale price to monthly rental income
• Not the best evaluation tool

11
Using the Appraised Value

• Reconcile the three approaches
• Based on experience
• Lenders will take the LESSER of the propertys
  sale price or appraised value to use in
  underwriting loan amount(s)
• Assumption is that property values will increase
  over time relative to loan amounts
• With or without amortization

12
Financial Market Assessment

• Current market interest rates
• Other competitive underwriting terms and
  conditions
• Price level for publicly traded mortgage vehicles
• Based on type of mortgage vehicle used
• Based on underlying source of funds

13
Types of Residential Mortgage Loans

• Conventional
• Not backed by government, other program
• Typically large loans
• Negotiated terms
• 10-20 minimum equity downpayment
• Insured Conventional
• LTVs typically greater than 80
• Insurance covers default risk on loans principal
  in excess of 80 of of value
• Insurance payment is part of the loan escrow

14
Types of Residential Mortgage Loans (cont.)

• FHA Insured Loans
• Designed to insure availability of funds to lower
  income households
• Higher loan to value ratios
• Insurance premiums are higher than those for
  conventional loans
• Why? FHA assumes entire risk of default, not
  just the excess, so they charge a greater premium

15
Types of Residential Mortgage Loans (cont.)

• VA Loans
• Part of the Veterans entitlement program managed
  by the V.A.
• Set up as a loan guarantee, generally 25 of loan
  amount
• Not insurance
• Program is a guarantee of payment in event of
  default
• Guarantee is based on a form of appraisal
  certificate of reasonable value and can not
  exceed 90 of CRV
• Program is self-sustaining today

16
Analysis of Borrowers Financial Condition

• Four key measurements of borrowers financial
  strength
• 1. Income analysis
• Current/past employment, ability to pay
• 2. Asset analysis
• Balance sheet composition
• Capacity to make the downpayment
• Part of the evaluation of long term default risk

17
Analysis of Borrowers Financial Condition (cont.)

• Four key measurements of borrowers financial
  strength (cont.)
• 3. Credit history
• Payment record
• Bankruptcies, past defaults
• 4. Estimated housing expense analysis
• Establishing the payment to income ratio
• The sum of home financing expenses relative to
  total income based on loan request

18
Analysis of Borrowers Financial Condition (cont.)

• Other underwriting criteria
• Aggregate borrower obligations
• Not just home loan expense
• All living expenses
• Other fixed obligations
• Lender judgment
• Compensating factors
• Need for additional collateral
• More typical in commercial transactions
• Mortgage insurance is one example of this