Copy of AI HW 2

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Fordham University *

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Finance

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Feb 20, 2024

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docx

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Homework #2 1. What are some advantages and disadvantages of investing in real estate? One of the biggest advantages of investing in real estate is the amount of diversification a portfolio can achieve by mitigating the risk associated with only equities and bonds. Owning real estate assets can greatly hedge one’s portfolio exposure against inflation as property prices tend to shoot up during times of inflation. Furthermore, investors have the ability to obtain absolute returns through the appreciation of the property and through rental income. Lastly, real estate assets offer numerous tax advantages (such as deductions for mortgage interest) which helps investors to minimize their tax obligations and increase their after tax returns. On the other hand, there are some disadvantages associated with real estate assets also. Firstly, one aspect that is a disadvantage for real estate assets is that they are highly heterogeneous as every real estate property is unique in terms of its size, location, and condition. This makes it very challenging for investors to assess real estate properties and can give rise to suboptimal decisions. Another disadvantage is lumpiness, that refers to the large amounts of capital associated when acquiring real estate assets. Lastly, real estate assets are illiquid in nature (unlike stocks and bonds) meaning that they can’t be bought or sold without incurring a material amount of transaction fees and delays. 2. What are the investment risks and characteristics of residential mortgages? Residential mortgages usually don’t bring in substantial cash flows as the borrower usually lives in that property. In addition to the property's features, the borrower's income and financial situation determine the credit risk of residential mortgages. Under residential mortgages, there is an inherent interest rate risk. Investors holding mortgages under fixed-rate terms may lose the value of their mortgage when interest rates go up, which can lead to potential losses for investors who are holding these mortgages. Other than this, residential mortgages have liquidity risks as a mortgage can’t be liquidated quickly (compared to securities). Furthermore, there is a prepayment risk under a fixed- rate mortgage as borrowers may refinance their loans when market interest rates are going down, leading to higher prepayment rates. 3. What are the investment risks and characteristics of commercial mortgages? Mortgages on commercial real estate tend to focus on the analysis of the net cash flows from the property. Commercial real estate contains a range of properties (apartments, hotels, offices, etc) which makes trading in secondary markets difficult. Other than this, commercial loans usually entail balloon payments upon maturity as the loan term is significantly shorter than residential mortgages. Developmental loans usually have a short term to maturity as compared to loans for existing properties which have a longer time horizon till maturity. Furthermore, developmental loan funds are withdrawn as required as opposed to loans made out for existing properties where the lump sum amount is drawn. There is a great amount of default risk associated with commercial loans where failure to pay back means risking the ownership of the underlying collateral asset, which is usually the property. Default risk is directly related to covenants and recourse. 4. What are the typical terms of a conventional mortgage?

In a conventional mortgage, the typical terms include the loan amount, the interest rate, the term of the loan (duration), any down payment, and an amortization schedule (principal going down with time). These typical terms vary according to the nature of the loan. For instance, fixed-rate mortgages differ from variable-interest rate mortgages. The payments are not constant under a variable rate mortgage whereas they are fixed and constant under a fixed-rate mortgage. Furthermore, borrowers can usually get a duration of 15, 20, 25, and 30 years to repay the loan. Choosing one term over the other has its potential rewards and drawbacks. A shorter term may lead to higher repayment costs and vice versa. 5. What is an MBS? A mortgage backed security (MBS) is a type of a security that is backed by an asset and is secured by a mortgage or pool of mortgages. Basically a group of similar mortgages are grouped together (having similar interest rates and terms) that gives investors the opportunity to accumulate cash flows being generated through mortgage payments of those loans. As MBS is a financial security, it can be bought and sold in the secondary market. A MBS allows investors to diversify their portfolio and it helps lenders to get more cash that they can use to further make loans. 6. What is a REIT? A real estate investment trust (REIT) is an entity structured similarly to a traditional operating corporation, except that the entity’s assets are almost wholly real estate. REITs provide a liquid and simple way to introduce real estate exposure into an investor’s portfolio. Additionally, REITs allow many smaller investors to invest into real estate properties that would not otherwise be of access to them (Chambers). 7. What is an ARM? An adjustable-rate mortgage (ARM) is a mortgage with an interest rate that can fluctuate. The interest rate can go up or down depending on economic factors as well as the broader market. Typically, ARMs have a lower introductory rate for the first period, and after that period ends, interest rates can cause the monthly payments to rise or fall. Benefits are derived from falling interest rates and risks are present if rates increase. https://www.investopedia.com/terms/a/arm.asp 8. How is real estate valued? What are some of the methods used? Real estate is valued through an estimation of the worth of the property from a variety of perspectives with regard to the price at which investors would be willing to both purchase and sell the property. One method of valuation is the comparable sales price approach, which values real estate based on transaction values of comparable real estate, with adjustments made for characteristic differences. Other valuation methods include the profit approach and the cost approach. The profit approach is used for those properties whose values are driven by the business use of the property. It is a valuation of the business rather than a valuation of the property itself. The cost approach values a property based on its cost and can be further specified by adding the values of any improvements made to the property and applying depreciation if necessary. Next is the income approach, which values real estate by projecting expected cash flows and discounting them over time and for risk in order to form the property’s total value. Finally,

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