Consider a construction loan made to Middleton Development Co.

| February 14, 2018

1. Consider a construction loan made
to Middleton Development Co. The loan amount is $6 million, which will be drawn
evenly (i.e., a $1,000,000 monthly draw) during the next six months to
redevelop an existing apartment building. Note that each disbursement occurs at
the end of the month. The annualized interest rate is expected to remain the
same at 6% for the first three (3) months. For the next three (3) months, the
annualized interest rate will be 8%. What is the total loan amount (including
interest) required to finance this project and what is the total interest
carry?

Month

Draws

Interest
Carry

Cumulative
Loan Bal.

1

2

3

4

5

6

Total

2. A multifamily property is expected to produce the following income
stream over the next three years:

Year

NOI

1

$575,000

2

600,000

3

625,000

A lender is willing to make a $6,000,000 participation mortgage, at
6% interest rate, a 30 year amortization period, with a balloon payment at the
end of year 3. For simplicity, annual compounding for this mortgage is
assumed. In addition, the lender gets10% of each year’s
net operating income, and 20% of thenet
sales proceeds (note: the net sales proceeds will be calculated as: the sales
proceeds – the selling expenses – the mortgage balance). The purchase price of
the property is $8 million. The investor of the property expects to sell the
property for $9 million at the end of the third year with the selling expenses
of 5.5% (based on the sales price).

a)

Calculate the before-tax mortgage yield for the loan, assuming
that the loan is held for 3 years. (5 pts)

b)

What is lender’s before-tax mortgage yield if the property ends up
with selling for $8million at the end of the third year, instead of selling for $9
million? (5 pts)

c)

Why do lenders issue participation loans? What are the benefits
and risks associated with this type of loans for borrowers and lenders?
Briefly discuss. (5 pts)

You are a mortgage banker at TD
Bank in Miami. One borrower wants to borrow money from your bank to
finance his new home. He just finds
a new job and plansto buythe house at a price of$300,000. Hewants to borrow a 80% loan to purchase the home.You
tell himthat a constant payment, 30 year
amortization period, fully amortizing loan (FRM) is
available. The interest rate for
the loan is 4.5%, which is the same as the market interest rate. Moreover, you will charge a loan
origination fee of 3% for the loan.

(a) What
is the monthly payment for the loan? [3 pts]
(b)What
is the effective interest rate,assuming the mortgage is paid off after 30
years? [3 pts]
(c) If the borrower plans to repay the loan afterthreeyears, what is the effective interest
rate? [3 pts]
(d) If the borrower wants to
borrow a 90% loan, the loan rate will be 5.5%. Everything else being equal (i.e., he prepays
the loan after 3 years, with the 3% loan fee), would you recommend him to
borrow the 90% loan? [3 pts]
(e) Suppose the borrower can get
a loan with a below-market interest rate from the homebuilder. This fully
amortizing FRM loan will have a 80% LTV, 4% interest rate, 30 years
amortization period, and with no loan fees. At what price should the
homebuilder sell the home to the borrower in order to earn the market rate of
interest (4.5%) on the loan? Assume the borrower would hold the loan for the
entire term of 30 years and the home would normally sell for $300,000 without
any special financing. [3 pts]

3. Wells Fargo issues a CMBS
security. The mortgages in the pool are interest only loans, with a total loan
amount of $15 million. For simplicity, assume that the interest rate for the
mortgages is 11%, and the loan maturity is 4 years. Further, assume that the
mortgages are annually compounded.

The
bank issues three tranches of securities based on the mortgage pool: i) Senior
Class or Tranche A, with an amount of $10 million at 8% coupon rate; ii)
Subordinated Class or Trance B, with an amount of $3 million at 10% coupon
rate; and iii) Residual tranche, with an amount of $2 million. These securities
have a maturity of four years.

Suppose that there is no
default in the mortgage pool over the four year period. Calculate the returns
for the investors who purchase the three tranches of securities. (5 pts)
Now assume that the value of
the properties associated with the mortgage pool at the end of the fourth
year is only 80% of the outstanding loan balance. What are the returns for
the investors for the three tranches of securities? (5 pts)

a.)

Year

CF from
the pool

Senior
Class

Subordinated
Class

Residual
Class

1

2

3

4

Return
=

b.)

Year

CF from
the pool

Senior
Class

Subordinated
Class

Residual
Class

1

2

3

4

Return =

4. Bank of America issues a MBS
security based on a mortgage pool with the following terms:

Mortgage pool value $25,000,000
Mortgage interest rate 6.5%
Loan Term 3 years

a)
Suppose that the MBS has only one class of security, i.e., the basic
MBS discussed during the class. What is the price of this MBS if the market interest
rate is 6%? Assume annual compounding
as well as a constant annual prepayment rate of 10% (based on the outstanding
loan amount at the beginning of each year, the same as we discussed during the
class). (5pts)

b)
Why is MBS considered a “callable” bond? How can this callable feature
affect MBS pricing? Briefly discuss. (5 pts)

Now, another
investment bank suggests that, instead of issuing the single-class MBS security
as above, two classes of securities can be issued based on the same mortgage
pool, i.e., an IO and a PO security.

c)
Determine the price of the IO and PO security, assuming that there is no
prepayment. Further assume that the IO investors require a market rate of
return of 4.5% and the PO investors require a market return of 6%.(5 pts)
Now
suppose future interest rate will fall, so there is a 15% prepayment for each
year (again, prepayment calculation is based on the loan balance at the
beginning of the year). The IO and PO investors require a market rate of return
of 4% and 5.5%, respectively. Determine the prices of the IO and the PO
security. (5 pts)

5.
Luistook a mortgage
loan 5 years ago for $120,000 at 7% interest for15 years, to be
paid in monthly payments. Now,a
lender is offering hima new mortgage loan at 5% for10 years.
The new loan amount
is $92,895, the outstanding loan balance of the existing loan. Suppose that a
prepayment penalty of3
% must be paidif Luis refinances the existing loan.
Moreover,the lender who is making the new loan
requires an origination fee of $3,000. Luis plans to hold the property for10 years. Note: in this case, Luis has to
pay the refinancing fees (i.e., the origination fee and the prepayment penalty)
out of his pocket.

(a) Whatisthetotal financingcost (not include the loan amount itself)if Luis decides
to refinancetheoldloan?
[2 pts]
(b) Given the information provided here, should Luis refinance?
Please support your
answer by calculating the effective interest rate of the new loan. [5 pts]
(c) Now suppose
that Luis’s current income is low. The new lender allows him to pay a monthly
payment of $200 for the new loan (i.e., the actual monthly payment to the
lender is only $200, while the loan interest rate is 5%). In this situation,
negative amortization occurs. What will be the accrued interest or the amount of increased loan balance for
the loan three years later from now? [3 pts]
(d) Assume that
Luis has to borrow two loans in order to refinance. That is, he has to borrow a
new mortgage ($70,000) at 5% for 10 years (i.e., the loan maturity and the
amortization period are the same, 10 years) and another mortgage ($22,895) at
9% for 5 years (the loan maturity and the amortization period are the same, 5
years). In this case, with the same
origination fee of $3,000 and the prepayment penalty of 3%, should Luis go
ahead with the refinancing plan? Please show the step to support your answer?
[5 pts]

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