This preview shows page 1. Sign up to view the full content.
Unformatted text preview: t 9% interest in exchange for giving up one third of the property appreciation to the lender. The developer is required to pay the lender her share of the appreciation either in 10 years or when the property sells, whichever occurs first. Now suppose the property appreciates 10 percent per year, or doubles in value over the 10 years. At the end of year 10 Problem Buyer owes the lender 1/3 of the $7.5mill appreciation ($2.5 mill). Buyer still has a mortgage balance of $5,365,800. The total debt ($2,500,000 + 5,365,800) of $7,865,800 exceeds the original purchase price of the house, and quite likely the buyer would be forced to refinance the entire $7,865,800 at possibly much higher rate in order to pay off the lender. Advantages and Disadvantages of SAM The advantage of a SAM to the lender is the ability to share in any property appreciation. Property values however, may not appreciate for a long time; for example many parts of the U.S. have not appreciated for almost 10 years in the 80s and early 90s. Some areas may even experience severe losses in property value. Advantages and Disadvantages of SAM Questions regarding SAM: Who determines the price appreciation of the property, the lender or the borrower? How to handle a property improvement made by the property owner? Does the lender also share in any property loss? Is the appreciation payment made to the lender regarded as interest income or long-term capital gain? Is it deductible interest expense or is it subject to capital gain tax? SAM: Agency Problem between the Lender and the Borrower V. Analysis of Residential Finance Incremental Borrowing Cost: Suppose you purchase a $5,000,000 apartment. Bank A is willing to make 60% mortgage for 20 years at 11% while Bank B is willing to make 70% loan for 20 years at 12%. Which mortgage should you choose? 1 − (1 + i ) − n B0 = PMT i 1 − (1 + 11% / 12) −240 ⇒ PMT = 30965.65 3mill = PMT 11% / 12 1 − (1 + 12% / 12) −240 ⇒ PMT = 38538.01 3.5mill = PMT 12% / 12 Analysis
Bank A B Loan 0.6 * 5000000 = 3000000 0.7 * 5000000 = 3500000 500000 Monthly PMTs $30,965.65 $38,538.01 $7,572.36 Addn Loan What does it really mean?? What is the implicit cost for borrowing the additional $500,000 from Bank A? Solving for the monthly interest cost yields 1.4687% per month or 17.62% per year which is higher than the 12% cost from Bank A. The 17.62% interest cost can be regarded as the incremental (or marginal) cost of borrowing. Decision-Making Whether the borrower should go for Bank A or B depends on: Whether he/she has enough for the down payment, Whether he/she can do better than 17.62% in his/her personal investment, and Whether or not he/she can obtain the extra $500,000 at a lower cost than 17.62%. VI. Special Mortgage: Reverse Mortgage Consider a retiree who has no job with very little or even no income. All he has is a property in which he is living. The retiree wants to live in the same property. The retiree still wants to enjoy life as a young man would: Dining out, Movies, Travel, etc etc The retiree needs income to do all these. What...
View Full Document