Liquid and Fixed-Income Real Estate Flashcards Preview

CAIA Level 1 2020 march > Liquid and Fixed-Income Real Estate > Flashcards

Flashcards in Liquid and Fixed-Income Real Estate Deck (50)
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1
Q
  1. List three potential disadvantages of real estate as an investment
A
  • Heterogeneity • Lumpiness

* Illiquidity

2
Q
  1. Provide an example of a common real estate investment for each of the three styles of real estate investing.
A

• Core real estate: A large office building or apartment complex
• Value-added real estate: Hotels, resorts, assisted-care living facilities, low-income housing,
outlet malls, hospitals
• Opportunistic real estate: Development of raw property, redevelopment of property that is in
disrepair, or acquisition of property that experiences substantial improvement in prospects through major changes, such as urban renewal.

3
Q

3.Define mortgage

A

• A mortgage loan is a loan secured by property.

4
Q
  1. How do unscheduled principal payments affect the lender of a fixed-rate mortgage at different levels of market interest rates?
A

• Unscheduled principal payments cause a wealth transfer between the borrower and the lender, depending on the relationship between the mortgage’s interest rate and current market interest rates. When market rates are lower than the mortgage rate, unscheduled principal payments generally benefit the borrower and harm the lender. The lender receives additional cash flows that if reinvested at prevailing interest rates will earn less return than the mortgage offers. Borrowers can make unscheduled prepayments to reduce the total interest costs of their mortgage by an amount greater than the amount that they could earn from interest income in the market. Thus, borrowers have an incentive to make prepayments on mortgages when interest rates decline below the mortgage’s rate.

5
Q
  1. How does increased interest rate volatility affect the borrower of a fixed-rate mortgage in which the borrower can make unscheduled principal payments?
A

• The option to prepay is a call option in which the mortgage borrower, much like a corporation with a callable bond, can repurchase its debt at a fixed strike price. Mortgage borrowers, like all call option holders on fixed income securities, benefit from increased interest rate volatility.

6
Q
  1. How does the interest rate risk of a variable-rate mortgage compare to that of a fixed-rate mortgage from the perspective of the lender?
A

• A variable-rate type of mortgage to a lender protects the lender from the valuation fluctuations due to interest rate changes experienced with fixed-rate mortgages. To the extent that rates adjust quickly and completely, the variable-rate loan tends towards having little or no interest rate risk.

7
Q
  1. What is the “option” in an option adjustable-rate mortgage loan?
A

• An option adjustable-rate mortgage loans (option ARM) is an adjustable-rate mortgage that provides borrowers with the flexibility to make one of several possible payments on their mortgage every month. The payment alternatives from which borrowers may select each month typically include an interest-only payment, one or more payments based on given amortization periods, or a prespecified minimum payment amount.

8
Q
  1. Are investors in commercial mortgages typically more or less concerned than investors in residential mortgages about: (a) rental income, (b) default risk, and (c) prepayment risk?
A
  • More concerned (residences are owner-occupied)
  • More concerned (residential mortgages are usually insured)
  • Less concerned (commercial loans are less subject to prepayment without penalty).
9
Q
  1. Why are conditional prepayment rates important in the pricing of mortgage backed securities?
A

• Conditional prepayment rates are important to the pricing of mortgage backed securities because they provides a measure of the speed of prepayments which in turn drives the longevity of the cash flows of the underlying mortgages.

10
Q
  1. Describe the three major advantages of REIT ownership relative to direct real estate ownership.
A

• REITs provide management services in the selection and operation of properties.
• REITS provide liquid access to an illiquid asset class. Investors can add to or trim their exposure
to real estate quickly and easily through purchase and sale of shares in REITs.
• REITs avoid taxation of income at the corporate level. This would be an advantage to an investor
otherwise holding the real estate in a taxable corporation.

11
Q

amortisation

A

Reduction in principal due to payments

12
Q

balloon payment

A

is a large scheduled future payment.

13
Q

Collateralized mortgage obligations (CMOs)

A

extend this
MBS mechanism to create different security classes, called
tranches, which have different priorities to receiving cash
flows and therefore different risks.

14
Q

commerical mortgage loans

A

are loans backed by commercial
real estate (multifamily apartments, hotels, offices, retail and
industrial properties) rather than owner-occupied residential
properties.

15
Q

Commercial mortgage-backed securities (CMBS)

A

are
mortgage-backed securities with underlying collateral pools
of commercial property loans.

16
Q

conditional prepayment rate (CPR)

A

The annualized percentage of a mortgage’s remaining

principal value that is prepaid in a particular month

17
Q

core real estate

A

includes assets that achieve a relatively high
percentage of their returns from income and are expected to
have low volatility.

18
Q

covenants

A

are promises made by the borrower to the lender,
such as requirements that the borrower maintain the property
in good repair and continue to meet specified financial
conditions.

19
Q

cross-collateral provision

A

In order to mitigate the risk to which they are exposed,
lenders commonly use this, wherein
the collateral for one loan is used as collateral for another
loan.

20
Q

debt service coverage ratio (DSCR)

A

which is the ratio of the property’s net operating income to all
loan payments, including the amortization of the loan.

21
Q

Equity REITs

A

invest predominantly in equity ownership

within the private real estate market.

22
Q

fixed charges ratio

A

is the ratio of the property’s net
operating income to all fixed charges that the borrower pays
annually.

23
Q

fixed-rate mortgage

A

has interest charges and interest
payments based on a single rate established at the initiation
of the mortgage.

24
Q

fully amortized

A

when its principal is reduced to

zero.

25
Q

idiosyncratic

A

Factors affecting prepayment decisions other than interest rates
or other systematic factors

26
Q

index rate

A

is a variable interest rate used in the

determination of the mortgage’s stated interest rate.

27
Q

interest coverage ratio

A

which
can be defined as the property’s net operating income divided
by the loan’s interest payments.

28
Q

interest rate cap

A

is a limit on interest rate adjustments

used in mortgages and derivatives with variable interest rates.

29
Q

loan-to-value ratio (LTV ratio)

A

is the ratio of the amount
of the loan to the value (either market or appraised) of the
property.

30
Q

lumpiness

A

describes when assets cannot be easily and
inexpensively bought and sold in sizes or quantities that
meet the preferences of the buyers and sellers.

31
Q

margin rate

A

is the spread by which the stated mortgage rate
is set above the index rate. (This should not be confused with
the same term used to describe a rate associated with margin
debt in a brokerage account.)

32
Q

mortgage

A

loan can be simply defined as a loan secured by

property.

33
Q

Mortgage REITs

A

invest predominantly in real estate–based

debt.

34
Q

Mortgage-backed securities (MBS)

A

are a type of asset-backed
security that is secured by a mortgage or pool of
mortgages.

35
Q

negative amortisation

A

occurs when the interest owed is
greater than the payments being made such that the deficit is
added to the principal balance on the loan, causing the
principal balance to increase through time.

36
Q

opportunistic real estate

A

properties are expected to derive
most or all of their returns from property appreciation and
may exhibit substantial volatility in value and returns.

37
Q

option adjustable-rate mortgage (option ARM)

A

adjustable-rate mortgage that provides borrowers with the
flexibility to make one of several possible payments on their
mortgage every month.

38
Q

pass-through MBS

A

is perhaps the simplest MBS and
consists of the issuance of a homogeneous class of securities
with pro rata rights to the cash flows of the underlying pool of
mortgage loans.

39
Q

the borrower’s prepayment option

A

The ability of the borrower to make or not make unscheduled

principal payments is an option to the borrower

40
Q

Public Securities Association (PSA) established the PSA benchmark which is?

A

a benchmark of prepayment speed that is based
on the CPR and that has become the standard approach used by
market participants.

41
Q

real estate investment trust (REIT)

A

is an entity structured
much like a traditional operating corporation, except that the
assets of the entity are almost entirely real estate.

42
Q

recourse

A

is the set of rights or means that an entity such as a

lender has in order to protect its investment.

43
Q

refinancing burnout

A

Reduced refinancing speeds due to high levels of previous

refinancing activity

44
Q

residential mortgage loans

A

are typically taken out by
individual households on properties that generate no explicit
rental income, since the houses are usually owner occupied.

45
Q

residential mortgage-backed securities (RMBS)

A

market

is backed by residential mortgage loans.

46
Q

styles of real estate investing

A

refer to the categorization of
real estate property characteristics into core, value added, and
opportunistic.

47
Q

subprime mortgages

A

Uninsured mortgages with borrowers of relatively high credit

risk

48
Q

unscheduled principal payments

A

which are payments above and beyond the scheduled mortgage
payments, the mortgage’s balance will decline more quickly
than illustrated in Exhibit 14.1, and the mortgage will
terminate early. In traditional mortgages, payments that exceed
the required payment reduce the principal payment but do not
lower required subsequent payments until the mortgage is
paid off.

49
Q

value-added real estate

A

includes assets that exhibit one or
more of the following characteristics: (1) achieving a
substantial portion of their anticipated returns from
appreciation in value, (2) exhibiting moderate volatility, and
(3) not having the financial reliability of core properties.

50
Q

variable-rate mortgage

A

has interest charges and interest
payments based on a rate that is allowed to vary over the life
of the mortgage based on terms established at the initiation of
the mortgage.