BBA 3RD YEAE 2ND SEMESTER 2020

REAL ESTATE

ANSWER TO THE QWUESTION NO: 01

A. Explain real estate from the fundamental view point?

From a fundamental viewpoint, real estate refers to physical
properties, land, and natural resources. These tangible assets
have intrinsic value and can generate various forms of income or
provide utility to individuals and businesses. Real estate plays a
significant role in the economy, serving as a vital component of
society's infrastructure and providing spaces for living, working,
and conducting commercial activities.
Here are some key aspects of real estate from a
fundamental perspective:
Tangible Asset: Real estate is a tangible asset, meaning it has a
physical presence and can be seen and touched. Examples
include residential properties, commercial buildings, industrial
facilities, agricultural land, and natural resources like minerals
and water bodies.
Land and Improvements: Real estate comprises both land and
the improvements made on it. Improvements can be permanent
structures like buildings, roads, utilities, and landscaping,
enhancing the value and utility of the land.
Economic Value: Real estate has economic value as it can
generate various forms of income. For instance, rental income
from residential or commercial properties, agricultural yield from
farmland, royalties from natural resources, and profits from
property sales contribute to the economic value of real estate.
Long-Term Investment: Real estate is often considered a long-
term investment. It is less liquid compared to financial assets like
stocks or bonds, and its value may appreciate over time, making
it an attractive option for wealth preservation and growth.
Local Market Dynamics: The value and demand for real estate
are influenced by local market dynamics, such as supply and
demand, population growth, economic conditions, and
government policies. Each geographic location can have its
unique real estate market characteristics.
Physical Location: The physical location of real estate is a
critical factor influencing its value and potential uses. Proximity to
amenities, transportation networks, schools, and business centers
can significantly impact the desirability of a property.
Utility and Functionality: Real estate provides utility and
serves various functions based on its type. Residential properties
offer living spaces, commercial properties provide spaces for
businesses, industrial properties support manufacturing, and
agricultural land facilitates food production.
Real Estate Development: Real estate development involves
the process of improving land or constructing new structures to
meet specific needs and demands. This includes residential
housing projects, commercial complexes, and infrastructure
development.
Real Estate Transactions: Buying, selling, or leasing real estate
properties involves significant transactions. Real estate deals
often require legal agreements, property inspections, and
financing arrangements.
Asset Diversification: Real estate can be an essential part of a
diversified investment portfolio, providing a hedge against
inflation and potential stable income, especially through real
estate investment trusts (REITs) and real estate mutual funds.
B. How the real estate markets are different
from the markets for other assets that trade
in well Developed public market.

Real estate markets differ from markets for other assets that
trade in well-developed public markets in several key ways. Here
are some of the primary differences:
Physical vs. Financial Assets: Real estate markets deal with
physical assets, such as land, buildings, and tangible property. In
contrast, other well-developed public markets trade in financial
assets, such as stocks, bonds, commodities, and currencies,
which represent ownership or claims to specific financial rights.
Market Structure: Real estate markets typically operate in
localized physical locations, where buyers and sellers interact
directly or through real estate agents. Other asset markets, such
as stock exchanges, operate electronically on a global scale,
enabling instant trading and price discovery.
Liquidity: Real estate assets generally have lower liquidity
compared to financial assets. Selling a property may take longer,
and the transaction costs can be higher than trading financial
instruments. Financial markets allow for rapid buy and sell
transactions with lower transaction costs.
Valuation: Real estate valuation involves factors like property
location, condition, rental income, and comparable sales.
Financial asset valuation is more standardized and relies on
market demand, earnings, dividends, interest rates, and other
financial metrics.
Regulation: Real estate markets are subject to different
regulations and legal requirements, often involving zoning laws,
property rights, and contractual obligations. Financial markets are
heavily regulated to ensure transparency, fairness, and investor
protection.
Leverage: Real estate investments often involve substantial
leverage through mortgages and loans, allowing investors to
control larger assets with less upfront capital. Financial markets
also offer leverage, but the level of leverage and risk varies
significantly among different financial assets.
Investment Horizon: Real estate investments typically have
longer investment horizons, as properties may appreciate
gradually over time and generate rental income. Financial asset
investments can have shorter horizons, with opportunities for
short-term trading and speculation.
Risk Profile: The risk profiles of real estate investments and
financial assets differ significantly. Real estate investments can
be exposed to market and property-specific risks, while financial
assets face market risk, credit risk, interest rate risk, and other
financial market risks.
Market Sentiment: Real estate markets can be influenced by
local economic conditions, demographic trends, and consumer
sentiment. Financial markets are often influenced by global
economic and geopolitical factors that impact investor sentiment
and overall market performance.
Investor Base: Real estate investments attract a diverse range
of investors, including individual homeowners, institutional
investors, real estate developers, and real estate investment
trusts (REITs). Financial asset markets have a broader investor
base, including individual investors, hedge funds, pension funds,
and sovereign wealth funds.
In conclusion, real estate markets and financial asset markets are
distinct due to the physical nature of real estate, differences in
market structure and regulation, varied investment horizons, and
the unique risk profiles associated with each asset class.
Understanding these differences is essential for investors looking
to diversify their portfolios and make informed decisions across
various asset classes.
C. Commercial real estate rental rates are
determined in local user markets while
property values are determined largely in the
local property market, “Explain the
statement”
The statement highlights the distinction between the
determinants of commercial real estate rental rates and property
values, which are influenced by different market dynamics in the
local real estate industry. Let's delve into each concept:
1. Commercial Real Estate Rental Rates: Commercial real
estate rental rates refer to the amount of money charged by
property owners (landlords) to tenants for the use of their
commercial properties. These properties can include office
spaces, retail shops, industrial warehouses, and other non-
residential spaces. The rental rates are typically established
in the local user market.
Key Factors Influencing Rental Rates in Local User
Markets:
 Supply and Demand: The balance between available
commercial spaces (supply) and the demand from
businesses seeking premises (demand) significantly impacts
rental rates. When demand exceeds supply, rental rates
tend to rise, and vice versa.
 Location: The attractiveness of the location, accessibility,
proximity to transportation hubs, amenities, and target
customer base influences the demand for commercial
spaces and, consequently, rental rates.
 Property Features and Condition: The quality, size,
layout, and condition of the property can affect its
desirability to potential tenants and, hence, its rental value.
 Economic Conditions: The overall economic health of the
region or city, including factors like employment growth,
 GDP, and business expansion, can influence the demand for
commercial spaces and rental rates.
2. Property Values in the Local Property Market: Property
values represent the estimated worth of a commercial
property based on various factors, including its income-
generating potential, future growth prospects, and
comparable sales data. Property values are largely
determined in the local property market.
Key Factors Influencing Property Values in Local Property
Markets:
 Income Potential: The income-generating capability of a
commercial property, such as rental income from tenants or
potential revenue from future development, plays a crucial
role in determining its value.
 Capitalization Rates: The prevailing capitalization rates in
the local market, which reflect the relationship between the
property's net operating income (NOI) and its value,
influence property valuations.
 Comparable Sales: Recent sales of similar commercial
properties in the area provide a basis for comparison and
can help determine the property's value.
 Location and Demand: The property's location and
demand for commercial real estate in the area significantly
impact its value.
 Development Potential: The property's potential for future
development and its adaptability for various uses also affect
its value.
In summary, commercial real estate rental rates and property
values are both crucial factors in the local real estate market, but
they are influenced by distinct factors and mechanisms. Rental
rates are primarily influenced by the local user market's supply
and demand dynamics and the property's attractiveness to
potential tenants. On the other hand, property values are
determined by various factors, including income potential,
capitalization rates, comparable sales, location, and development
prospects, in the local property market. Both aspects are
essential considerations for investors, property owners, and
businesses seeking to engage in the commercial real estate
sector.

ANSWER TO THE QUESTION NO: 02

A. Compare the Suitability of LPM and ARM
under risk.
LPM (Least Present Value of Loss) and ARM (Average Rate of Return Model) are
two different risk management models used to assess and manage risk in
investment portfolios. Let's compare the suitability of LPM and ARM under risk:
Definition:
LPM: LPM is a risk measure that focuses on minimizing the magnitude of the
worst potential loss (the tail risk) that an investment portfolio may experience.
ARM: ARM is a risk measure that calculates the average return of the portfolio
over time and helps in understanding the potential returns the portfolio can
generate.
Risk Perspective:
LPM: LPM is more suitable for risk-averse investors who are primarily concerned
about preserving capital and avoiding large losses. It prioritizes downside
protection by aiming to minimize the probability of extreme negative returns.
ARM: ARM is suitable for investors who are willing to take on more risk and are
interested in understanding the average performance of the portfolio over time,
including both positive and negative returns.
Handling of Extreme Events:
LPM: LPM explicitly focuses on managing extreme events and the tail risk of the
portfolio. It assigns higher importance to minimizing losses during market
downturns or periods of high volatility.
ARM: ARM does not specifically emphasize extreme events. Instead, it provides
an average return figure that incorporates both positive and negative returns,
offering a more balanced view of overall portfolio performance.
Downside Protection:
LPM: LPM provides a better evaluation of downside protection, as it measures the
potential loss during extreme market conditions.
ARM: ARM does not explicitly measure downside protection; instead, it provides a
comprehensive view of the portfolio's average performance.
Sensitivity to Outliers:
LPM: LPM is sensitive to outliers, as it places a significant focus on the tail risk and
the magnitude of potential losses during extreme events.
ARM: ARM is less sensitive to outliers, as it calculates the average return, which is
less affected by extreme values.
Portfolio Adjustments:
LPM: LPM may lead to more conservative portfolio adjustments to avoid extreme
losses, which could potentially result in a less aggressive investment approach.
ARM: ARM may lead to more balanced portfolio adjustments, as it considers both
positive and negative returns in the average calculation.
In summary, the suitability of LPM and ARM under risk depends on the investor's
risk tolerance, investment objectives, and attitude towards downside protection.
LPM is more suitable for risk-averse investors seeking to minimize the potential
for extreme losses and prioritize downside protection. On the other hand, ARM is
more suitable for investors who are willing to take on more risk and are
interested in understanding the overall average performance of their portfolio,
including both positive and negative returns. Each risk management model offers
unique insights into portfolio risk, and investors can choose the one that aligns
better with their risk preferences and investment goals.
B. Why prepayment of a mortgage loan
increase the effective borrowing costs?
Explain and example
Prepayment of a mortgage loan refers to the act of paying off the
loan balance before the scheduled maturity date. While prepayment
may seem like a financially responsible decision, it can actually
increase the effective borrowing costs for the borrower. This is
primarily due to two factors: prepayment penalties and lost interest
income.

Prepayment penalties are charges imposed by lenders to

compensate for the potential loss of interest income resulting from
early loan repayment. These penalties are typically calculated as a
percentage of the outstanding loan balance or a certain number of
months' worth of interest payments. The purpose of prepayment
penalties is to discourage borrowers from refinancing or selling their
property before the loan term ends.

For example, let's say a borrower has a mortgage loan with a

remaining balance of $200,000 and decides to prepay the entire
amount after three years. The lender imposes a prepayment penalty
equal to six months' worth of interest payments, which amounts to
$10,000. In this scenario, the borrower not only has to repay the
principal amount but also incurs an additional cost of $10,000 due to
the prepayment penalty.

Lost interest income is another factor that contributes to the

increased effective borrowing costs when prepaying a mortgage
loan. When borrowers make regular monthly payments on their
mortgage, a portion goes towards repaying the principal amount
borrowed, while the rest covers the interest charged by the lender.
Over time, as more principal is paid off, the interest portion
decreases.

By prepaying the mortgage loan, borrowers effectively shorten the

loan term and reduce the overall interest paid over time. However,
this also means that they miss out on potential interest income that
they would have earned if they had kept their money invested
elsewhere.

For instance, suppose a borrower has a 30-year fixed-rate mortgage

with an interest rate of 4%. After five years, they decide to prepay
the remaining balance of $150,000. By doing so, they save on the
interest payments they would have made over the remaining 25
years. However, if they had invested that $150,000 in a different
financial instrument that yields a higher return, such as stocks or
bonds, they could have potentially earned more in interest income
than what they saved by prepaying the mortgage

ANSWER TO THE QUESTION NO: 03

A. Why is mortgage note an important part of
mortgage loan? What are its contents?
A mortgage note is an essential component of a mortgage loan as it
serves as a legally binding agreement between the borrower and
the lender. It outlines the terms and conditions of the loan, including
the repayment schedule, interest rate, and other important details.
The mortgage note provides protection to both parties involved in
the transaction and ensures that all parties are aware of their rights
and obligations.

The contents of a mortgage note can vary depending on the specific

terms negotiated between the borrower and the lender. However,
there are several key elements commonly found in a mortgage note:

1. Loan Amount: The mortgage note specifies the principal amount

borrowed by the borrower. This is the initial amount that needs to
be repaid over time.

2. Interest Rate: The note includes the interest rate charged on the
loan. This rate determines the cost of borrowing and is typically
expressed as an annual percentage.
3. Repayment Terms: The repayment terms outline how the loan will
be repaid. This includes information about the frequency of
payments (monthly, bi-weekly, etc.), the duration of the loan
(typically stated in years), and any specific provisions related to
early repayment or prepayment penalties.

4. Payment Schedule: The mortgage note provides a detailed

payment schedule that indicates when each payment is due,
including the due date and any grace period allowed.

5. Late Payment Penalties: The note may include provisions for late
payment penalties or fees if the borrower fails to make payments on
time.

6. Escrow Account: If an escrow account is required, the mortgage

note will specify how funds for property taxes, insurance premiums,
or other related expenses will be collected and managed.

7. Default and Foreclosure: The note outlines the consequences of

defaulting on the loan, including potential foreclosure proceedings
initiated by the lender in case of non-payment.

8. Prepayment Options: Some mortgage notes may include

provisions for prepayment options, allowing borrowers to pay off
their loan early without incurring penalties.

9. Rights and Responsibilities: The note outlines the rights and

responsibilities of both the borrower and the lender, ensuring that
both parties understand their obligations under the loan agreement.

10. Governing Law: The mortgage note may specify the jurisdiction
and governing law that will apply in case of any disputes or legal
issues related to the loan.

The mortgage note is a crucial document as it provides legal

evidence of the loan agreement and protects the interests of both
the borrower and the lender. It ensures transparency, clarity, and
accountability throughout the mortgage loan process.

B. Discuss the factors that affect the

mortgage choice.
When it comes to choosing a mortgage, there are several factors
that can influence the decision-making process. These factors can
vary depending on individual circumstances and preferences. In this
comprehensive discussion, we will explore the key factors that affect
mortgage choice.

1. Interest Rates: One of the most significant factors that

borrowers consider when choosing a mortgage is the interest rate.
The interest rate determines the cost of borrowing and affects the
monthly mortgage payments.

2. Loan Term: The loan term refers to the length of time over which
the borrower agrees to repay the mortgage. Common loan terms
include 15 years, 20 years, and 30 years. The choice of loan term
depends on various factors such as financial goals, income stability,
and personal circumstances

3. Down Payment: The down payment is the initial upfront

payment made by the borrower when purchasing a property. It is
usually expressed as a percentage of the property's purchase price.
The size of the down payment can significantly impact mortgage
choice.

4. Credit Score: Lenders assess borrowers' creditworthiness by

evaluating their credit scores. A credit score is a numerical
representation of an individual's credit history and indicates the
likelihood of timely loan repayment. Borrowers with higher credit
scores are generally offered more favorable mortgage terms,
including lower interest rates

5. Debt-to-Income Ratio: Lenders also consider borrowers' debt-

to-income (DTI) ratio when determining mortgage eligibility. The DTI
ratio compares a borrower's monthly debt obligations to their gross
monthly income

6. Type of Mortgage: There are various types of mortgages

available, each with its own features and requirements. Some
common types include conventional mortgages, Federal Housing
Administration (FHA) loans, Veterans Affairs (VA) loans, and jumbo
loans. The choice of mortgage type depends on factors such as
down payment amount, credit score, and specific eligibility criteria.
Borrowers should carefully evaluate the pros and cons of each type
to determine which one best suits their needs.

7. Closing Costs: Closing costs are fees associated with finalizing

the mortgage transaction and transferring ownership of the
property. These costs typically include appraisal fees, title
insurance, attorney fees, and loan origination fees. The amount of
closing costs can vary significantly depending on factors such as the
loan amount, property value, and location.

8. Financial Stability: Borrowers should assess their financial

stability and future plans when selecting a mortgage. Factors such
as job security, income growth potential, and anticipated life
changes (e.g., starting a family, retirement) can influence the choice
of mortgage.

In conclusion, several factors affect the choice of mortgage. These

include interest rates, loan term, down payment, credit score, debt-
to-income ratio, type of mortgage, closing costs, and financial
stability. By carefully considering these factors and evaluating
personal circumstances, borrowers can make an informed decision
that best suits their needs and financial goals.

ANSWER TO THE QUESTION NO: 04

A. Why must the markets value of real
estate be estimated?
The estimation of the market value of real estate is crucial for
several reasons. Firstly, it provides an objective assessment of the
worth of a property, which is essential for various stakeholders such
as buyers, sellers, lenders, investors, and insurers. Secondly, it helps
in making informed decisions regarding buying or selling properties,
determining rental rates, securing financing, and assessing
insurance coverage. Lastly, estimating the market value of real
estate is important for taxation purposes as it serves as a basis for
property tax assessments.

Determining the market value of real estate involves a

comprehensive analysis of various factors. These factors
include the location of the property, its size and condition,
comparable sales in the area, current market trends, economic
conditions, zoning regulations, and any unique characteristics or
features that may affect its value. The process typically involves
conducting a thorough appraisal by a qualified professional who
considers all these factors to arrive at an accurate estimate.

One of the primary reasons for estimating the market value of real
estate is to facilitate fair transactions between buyers and sellers.
When a property is put on the market for sale, both parties need to
have a clear understanding of its value to negotiate a fair price. The
market value estimation helps in setting realistic expectations and
avoiding overpricing or underpricing.

For buyers, knowing the market value of a property ensures that

they are not paying more than what it is worth. It allows them to
make informed decisions based on their budget and investment
goals. On the other hand, sellers benefit from knowing the market
value as it helps them determine an appropriate listing price that
attracts potential buyers while maximizing their return on
investment.

Lenders also rely on accurate market value estimates when

considering mortgage applications. They need to assess the
collateral's worth to determine the loan amount they are willing to
provide. If the estimated market value falls short of the requested
loan amount, lenders may be hesitant to approve the loan or require
additional collateral or higher interest rates.

Investors, both individual and institutional, heavily rely on market

value estimates to evaluate potential real estate investments. By
comparing the estimated value with the purchase price or
development costs, investors can assess the potential return on
investment and make informed decisions about allocating their
capital.

Insurance companies also require market value estimates to

determine the appropriate coverage for a property. The value of the
property directly affects the insurance premium, as it represents the
potential cost of rebuilding or repairing in case of damage or loss.
Accurate market value estimation ensures that property owners
have adequate coverage without overpaying for unnecessary
insurance.

Furthermore, estimating the market value of real estate is essential

for taxation purposes. Property taxes are often based on the
assessed value, which is derived from the market value estimation.
Local governments use this information to determine the tax liability
of property owners and allocate resources for public services and
infrastructure development.
In conclusion, estimating the market value of real estate is crucial
for various stakeholders involved in buying, selling, financing,
investing, insuring, and taxing properties. It provides an objective
assessment of a property's worth based on various factors and helps
facilitate fair transactions, informed decision-making, risk
assessment, and taxation.

B. Discuss the mortgage equity rate and

general constant growth formula for
determining the capitalization rate.
The mortgage equity rate, also known as the mortgage interest rate
or mortgage rate, refers to the interest rate charged on a mortgage
loan. It is the cost of borrowing money to finance the purchase of a
property. The mortgage equity rate is determined by various factors
such as the current economic conditions, inflation rates,
creditworthiness of the borrower, and the term of the loan.

When it comes to determining the capitalization rate, there are

different approaches depending on the type of property being
evaluated. The general constant growth formula is commonly used
for income-producing properties such as commercial real estate or
rental properties. This formula takes into account the expected
future income generated by the property and calculates its present
value.

The general constant growth formula for determining the

capitalization rate is as follows:

Capitalization Rate = Net Operating Income / Property Value

Net Operating Income (NOI) represents the income generated by the

property after deducting operating expenses but before deducting
debt service or taxes. It includes rental income, parking fees, and
any other revenue generated by the property.
Property Value refers to the estimated market value of the property.
It can be determined through various methods such as appraisals,
comparable sales analysis, or income-based valuation approaches.

The capitalization rate is an important metric used in real estate

investment analysis. It helps investors assess the potential return on
investment and compare different investment opportunities. A
higher capitalization rate indicates a higher potential return but may
also imply higher risk or lower property value.

It is worth noting that while the general constant growth formula

provides a basic framework for calculating the capitalization rate, it
may not capture all relevant factors specific to a particular property
or market. Real estate professionals often consider additional
factors such as market trends, location, tenant quality, and future
growth prospects when determining an appropriate capitalization
rate.

In conclusion, the mortgage equity rate is the interest rate charged

on a mortgage loan, while the general constant growth formula is
used to determine the capitalization rate for income-producing
properties. The capitalization rate is an important metric in real
estate investment analysis, helping investors assess potential
returns and compare different investment opportunities.

ANSWER TO THE QUESTION NO: 05

A. Discuss the role played by different
parties involved in the mortgage backed
security creation.
Mortgage-backed securities (MBS) are financial instruments that are
created by pooling together a group of mortgages and then selling
shares or bonds backed by the cash flows from those mortgages.
The creation of MBS involves several parties, each playing a distinct
role in the process. These parties include mortgage originators,
mortgage servicers, investment banks, rating agencies, investors,
and government-sponsored enterprises (GSEs).

1. Mortgage Originators: Mortgage originators are financial

institutions such as banks, credit unions, or mortgage companies
that provide loans to borrowers for purchasing homes or refinancing
existing mortgages. They play a crucial role in the creation of MBS
by originating the underlying mortgages. Originators assess
borrowers' creditworthiness, determine loan terms, and fund the
loans. They earn income through interest payments made by
borrowers.

2. Mortgage Servicers: Mortgage servicers are responsible for

collecting mortgage payments from borrowers on behalf of the
mortgage originators or investors who own the loans. They handle
administrative tasks such as sending monthly statements, managing
escrow accounts for property taxes and insurance, and handling
delinquencies or defaults. In the context of MBS creation, servicers
ensure that cash flows from the underlying mortgages are collected
and distributed to investors holding MBS.

3. Investment Banks: Investment banks play a significant role in

the creation of MBS by acting as intermediaries between mortgage
originators and investors. They purchase pools of mortgages from
originators and then package them into MBS. Investment banks also
structure the MBS into different tranches with varying levels of risk
and return to cater to different investor preferences. They may also
provide credit enhancements such as guarantees or insurance to
make the MBS more attractive to investors.

4. Rating Agencies: Rating agencies assess the creditworthiness of

MBS and assign ratings based on the probability of default. These
ratings help investors evaluate the risk associated with investing in
MBS. Rating agencies analyze the underlying mortgages, the
structure of the MBS, and the credit enhancements provided by
investment banks. The ratings provided by these agencies influence
the pricing and demand for MBS in the market.
5. Investors: Investors are individuals, institutions, or entities that
purchase MBS as an investment. They include pension funds,
insurance companies, mutual funds, hedge funds, and individual
investors. Investors are attracted to MBS because they offer a fixed
income stream backed by mortgage payments. The risk and return
profile of MBS varies depending on the tranche purchased. Investors
bear the risk of default on the underlying mortgages but also benefit
from the interest payments made by borrowers.

6. Government-Sponsored Enterprises (GSEs): GSEs such as

Fannie Mae and Freddie Mac play a significant role in the creation of
MBS. They purchase pools of mortgages from originators and issue
their own MBS backed by these mortgages. GSEs provide liquidity to
the mortgage market by buying mortgages from originators, which
allows originators to make more loans. They also guarantee certain
MBS issued by private entities, reducing credit risk for investors.

In summary, mortgage-backed security creation involves multiple

parties with distinct roles. Mortgage originators provide the
underlying mortgages, mortgage servicers collect and distribute
cash flows from those mortgages, investment banks package and
structure the MBS, rating agencies assess creditworthiness,
investors purchase MBS as an investment, and government-
sponsored enterprises facilitate liquidity and provide guarantees.

B. Why the prepayment risk is important in

valuing the pass through securities?
Pass-through securities, also known as mortgage-backed securities
(MBS), are financial instruments that represent a claim on the cash
flows generated by a pool of underlying mortgage loans. These
securities are created when a financial institution purchases a pool
of mortgages from lenders and then securitizes them by issuing MBS
to investors. The cash flows from the underlying mortgages, such as
principal and interest payments, are passed through to the MBS
holders.
One of the key risks associated with pass-through securities is
prepayment risk. Prepayment risk refers to the possibility that
borrowers will repay their mortgage loans earlier than expected,
either through refinancing or selling their homes. When borrowers
prepay their mortgages, the principal amount is returned to the MBS
holders before its scheduled maturity date. This early repayment
can disrupt the expected cash flow patterns and affect the overall
return on investment for MBS holders.

There are several reasons why prepayment risk is important in

valuing pass-through securities:

1. Cash Flow Uncertainty: Prepayments introduce uncertainty

into the cash flow stream of pass-through securities. The timing and
magnitude of prepayments can vary depending on factors such as
interest rate movements, housing market conditions, and borrower
behavior. This uncertainty makes it challenging for investors to
accurately predict future cash flows and estimate the present value
of these cash flows.

2. Yield Volatility: Prepayment risk can lead to volatility in yields

for pass-through securities. When interest rates decline, borrowers
tend to refinance their mortgages at lower rates, resulting in higher
prepayment rates. Conversely, when interest rates rise, prepayment
rates tend to decrease as borrowers are less likely to refinance.
These fluctuations in prepayment rates can cause significant
variations in yields, making it difficult for investors to assess the true
value of these securities.

3. Extension Risk: Prepayment risk is closely related to extension

risk, which refers to the possibility that borrowers will delay their
mortgage repayments beyond the scheduled maturity date. When
interest rates rise, borrowers are less likely to refinance, leading to
lower prepayment rates and longer average maturities for pass-
through securities. This extension of the average life of the security
can expose investors to reinvestment risk, as they may be locked
into lower-yielding investments for a longer period.
To account for prepayment risk in valuing pass-through securities,
various models and techniques have been developed. These models
incorporate assumptions about prepayment behavior and interest
rate movements to estimate expected cash flows and calculate
present values. Some commonly used models include the PSA
(Public Securities Association) model, the SMM (Single Monthly
Mortality) model, and Monte Carlo simulations.

In conclusion, prepayment risk is an important consideration in

valuing pass-through securities due to its impact on cash flows, yield
volatility, and extension risk. Investors need to carefully assess and
quantify this risk to make informed investment decisions in the MBS
market.

ANSWER TO THE QUESTION NO: 06

A. What condition must be fulfilled by REITs to able to avoid
income taxes?
To be able to avoid income taxes, Real Estate Investment
Trusts (REITs) must fulfill certain conditions.

In the United States, REITs are subject to specific tax regulations

outlined in the Internal Revenue Code (IRC). To qualify for tax-
exempt status, REITs must meet several requirements:

1. Organizational Structure: A REIT must be structured as a

corporation, trust, or association under state law. It must also
have a board of directors or trustees responsible for its
management.

2. Investment in Real Estate: At least 75% of a REIT's total

assets must be invested in real estate, cash, or government
securities. Real estate assets can include properties such as
commercial buildings, residential complexes, hotels, and
mortgages secured by real estate.
3. Income Sources: A significant portion of a REIT's income must
come from real estate-related activities. At least 75% of the
REIT's gross income should be derived from rents, interest on
mortgages secured by real property, gains from the sale of real
estate assets, or dividends from other qualifying REITs.

4. Diversification: A REIT must diversify its investments to

minimize risk. No more than 50% of the value of its shares can be
owned by five or fewer individuals during the last half of each
taxable year.

5. Distribution Requirements: To maintain tax-exempt status,

a REIT must distribute at least 90% of its taxable income to
shareholders annually in the form of dividends. These dividends
are generally taxable to the shareholders at their individual tax
rates.

6. Shareholder Base: A REIT must have at least 100

shareholders and cannot be closely held by a small group of
individuals.

7. Taxable Subsidiaries: If a REIT has subsidiaries that generate

non-qualifying income, such as operating businesses unrelated to
real estate, it may be subject to corporate income tax on that
portion of its income.

By meeting these conditions, REITs can avoid paying income

taxes at the corporate level. Instead, the tax liability is passed
through to the individual shareholders who are responsible for
reporting and paying taxes on their share of the REIT's taxable
income.

B. Using a suitable example show how REIT

can pay more 90% of it income as dividend?
Let's use a hypothetical example to demonstrate how a Real
Estate Investment Trust (REIT) can pay more than 90% of its
income as dividends:

Example: ABC Commercial REIT

Income Sources:
ABC Commercial REIT owns and operates several commercial
properties, including office buildings, shopping malls, and
warehouses. The REIT generates income from rental income,
lease payments, property sales, and interest from mortgages on
the properties.

Gross Income:
Let's assume that ABC Commercial REIT's gross income for a
particular year is $100 million. Out of this, $80 million (80%)
comes from real estate-related activities, such as rental income
and property sales. The remaining $20 million (20%) comes
from other income sources like interest income from mortgages.

Dividends:
Since REITs are required to distribute at least 90% of their
taxable income as dividends, ABC Commercial REIT must pay
out $90 million in dividends.

Adjusted Funds from Operations (AFFO):

To calculate the adjusted funds from operations (AFFO), we
need to account for recurring capital expenditures required to
maintain the properties. Let's assume that after accounting for
these expenses, the AFFO comes to $60 million.
Dividend Payout Ratio:
The dividend payout ratio is calculated by dividing the
dividends paid by the AFFO:
Dividend Payout Ratio = Dividends / AFFO
Dividend Payout Ratio = $90 million / $60 million
Dividend Payout Ratio = 150%

In this example, the dividend payout ratio is 150%. It means that

ABC Commercial REIT is paying out more in dividends ($90
million) than its AFFO ($60 million). This is permissible and
common among REITs since they are required to distribute at
least 90% of their taxable income as dividends.

How is this possible?

The dividend payout ratio can exceed 100% because REITs are
allowed to distribute capital gains to shareholders as dividends.
Capital gains may result from property sales or other real estate-
related activities. In the example, ABC Commercial REIT
generated a significant portion of its gross income from property
sales, which contributed to the higher dividend payout ratio.

It's important to note that while REITs can distribute more than
100% of their AFFO as dividends, they cannot maintain this
indefinitely. Over time, the REIT's income from property sales
may vary, and the dividend payout ratio may fluctuate
accordingly. REITs typically aim to maintain a consistent
dividend payout ratio to provide stable returns to their investor