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FIN 3334- Mortgage interest rate notes (lesson 2)

Eriksen lesson2whatdeterminesinterestrates i

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Unformatted text preview: t. 6. You originated a $240,000 30‐year FRM Loan at 7.2% 5 years ago, but the market interest rate for similar loans is now 6%. What is the book and market value of the loan? Additional Practice Problems in Textbook: Review Questions: 2.1, 2.4, 2.7 (both editions) Real Estate Finance Dr. Eriksen Lesson 2: What Determines Interest Rates? I. Demand for Mortgage Debt A. Opportunity Cost of Equity. 1. Risk‐adjusted Return on Next Best Investment Opportunity 2. Select Loan if: i B. User Market Defines Demand for Debt 1. Shape of Demand: 2. Slope of Demand Curve: a) Increase in Rates ‐> b) Decrease in Rates ‐> # of Loans Example 1. You have $10m to invest and able to purchase a $10m apartment building. What is your IRR if you anticipate on average you will sell the property for $11m next year? IRR all Cash: IRR w/ $6m 1‐year IO‐FRM Loan @ 8%: Decision Rule: Overall Portfolio Return By Opportunity Cost 18% 16% 14% 12% No Loan 10% 8% 6% 4% 2% 0% Return on Alternative Investment II. Supply of Mortgage Debt (Capital Markets) A. Why Don’t Banks Invest Themselves in Real Estate? 1. Management: 2. Risk Aversion: a) Loss of Principal: b) Debt Receives: c) Willing to Trade‐Off: Real Estate Finance Dr. Eriksen Example 2. You have $5m to invest and able to purchase a $10m apartment building with a bank contributing $5m for being an equal equity partner (split all cash flows evenly ). What is your IRR if you anticipate you will either sell the property for $12m or $10m next year with equal p robability? IRR if sell for $10m: IRR if sell for $12m: What would be your IRR if the Bank instead offered you a $6m IO Loan at 8%? IRR if sell for $10m: IRR if sell for $12m: Opportunity Cost Practice Problem: You are about to invest in a $750,000 apartment building that...
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