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Assignment 1: Real Estate Capital Markets

You are welcome to work on this assignment in a group of up to three people, and submit a
group answer. You should submit your final answer via NYU Classes by Wednesday, March
1. Please clearly indicate the name of each of your group members on your assignment, and
use the same group members throughout the semester.

It is your responsibility to make sure your group submits the assignment on time. Late
assignments will not be accepted.

Feel free to use Excel (and/or other programs, as you like).

In answering the written questions, be concise and choose your words carefully. In general,
you should be able to answer the questions in a paragraph or two, and in most cases a few
sentences or bullet points will be enough to get the key points across.


Shorter questions:

1. Read the Wall Street Journal article posted on NYU Classes for Week 1, titled Mortgage-
Rate Rise Hits Coastal Property Markets Hardest. Answer the following short questions
based on the article and the material from class:

A. What is the key reason why the effect of the post-election rise in mortgage rates is having
different effects on mortgage payments in different areas? (e.g., San Francisco vs Cochran
County TX).

B. Based on the simple Hubbard and Mayer cap rate model we discussed in class, would you
expect this rise in mortgage rates to have different effects on home price appreciation in
these different parts of the country? If so, in which direction? (Ignore any differences due to
taxes when answering this part of the question).

C. Can you think of any real world factors or complications that would alter your answer
from part B? What effect would they have and why? [be brief, just a paragraph or two at

2. After graduating from NYU Stern, you join the CRE originations business at a large
commercial bank. In your first deal, your bank originates a $35m fixed rate commercial
mortgage with a 4.75% annual interest rate, 10 year term, 30 year amortization period, and
monthly payments. What is the size of the balloon payment due on this mortgage?

Please calculate the answer using the two approaches we showed in class:

- where the balloon payment is calculated as the future value of the cash flows
between months 0 and 120.
- where the balloon payment is calculated as the present value of the payments over
the remaining amortization period from months 121 to 360.

[Although not required, we recommend you also check that you can calculate these
answers both in Excel and on your financial calculator, to make sure you can do it both

3. Your good friend Jennifer is very optimistic about the housing market and believes that
house prices can never go down. (Jennifer didnt pay much attention to what happened
between 2006 and 2012). As a consequence, she wants to buy the most expensive home
she can possibly afford, with the idea of selling this home at a profit in a few years. She has
$4,000 per month that she can spend on the mortgage payment (and her parents offered to
help out with the down payment).

Jennifers lender has offered her three types of mortgages: a standard 30 year FRM, a 5/1
ARM with standard amortization, and a 5/1 ARM with a 5-year interest-only period. Jennifer
asks you for help.

[Note: For simplicity, ignore taxes and tax deductions for this question].

A. Which mortgage type do you think is best given her objective?

B. Go to to find the current interest rates on FRMs and 5/1 ARMs (assume
both the 5/1 ARMs have this same interest rate). Based on this information, what is the size
of the mortgage she would receive under the option you recommended in part A?

C. What would be the size of her mortgage if she took out the worst of the three options
given her objective (again based on the interest rates you pulled from

4. Your uncle has had a standard 30-year FRM with a 5% interest rate for 2 years (24
months); the original principal was $200,000. One day he calls you up, very excitedly: My
bank offered to refinance my mortgage to a new 30-year ARM with a 2.5% interest rate.
This is awesome since the interest rate is cut in half, my monthly payment will also be cut
in half!

A. Is the second part of his statement correct? By how much does his payment go down? In
addition to showing a calculation, please try to briefly explain intuitively what is going on.

B. How would your answer to part (a) change if your uncle had had his old mortgage for 20
years (240 months) instead?

C. How would your answer to part (a) change if the new mortgage has an initial interest only

5. Property mogul Ronald Prumt considers buying a multi-family property at a cap rate of
5%. Consider the simple user cost model seen in class and assume that the after-tax
mortgage rate at which Prumt can finance the purchase is 6%/year and the maintenance
expenditure is 2%/year. What is the minimum expected future price appreciation such that
this would be a winning deal for Prumt?

Problem 1: The Mortgage Interest Deduction

[Note: For parts (i) and (ii) below, you may need to do a little independent reading (although
please dont spend too much time on this and keep your answers to these parts brief). If
you are looking for some good additional references on the topic, please click here, here
and here.]

As you may have read in the news, the new Trump administration has made some noises
about capping or eliminating the mortgage interest deduction (e.g., see here).

A. What is the mortgage interest deduction? Which types of mortgage borrowers benefit
most from it, and why?

B. The mortgage interest deduction is often criticized by economists and others. What are
some of the key problems or issues which are highlighted by these critics? Can you think of
any counterarguments?

C. Thinking about the user cost model we studied in class, what effect would cutting or
eliminating the mortgage interest deduction have on the cap rate for residential real estate.
Would this effect be larger when interest rates are low or when rates are high? Explain.

D. Using the Wheaton DiPasquale model from class, what effect would reducing the
mortgage interest deduction have on the housing market overall (prices, construction, rents
etc.). Draw the diagram, and also provide a brief intuitive explanation for what you find.

E. How would your answer to part D be different if construction was very unresponsive
to home prices? Again, back up your answer graphically using the four sector Di
Pasquale and Wheaton model. Whats an example of a city or geographic area where

this might be a reasonable assumption? Whats an example of a city / area where it
would be a bad assumption? Which type of city is likely to have more volatile home

Problem 2: Fixed rate mortgage

You take out a 15 year fixed rate mortgage for $410,000, and buy down the interest rate by
purchasing two points. After the points, the interest rate you agree to is 4.125% per annum.
You subsequently retain this mortgage for 3 years, before prepaying it. You incur a $6,000
prepayment penalty when you prepay the loan, because of a clause in the mortgage note

A. What is the monthly payment on this mortgage? How much of the initial payment is
interest, and how much is principal?

B. Over the three years, what is the total of all the interest payments you make on this loan?
What is the total value of the principal payments?

C. What is the effective interest rate (or yield) on this mortgage, given that you decided to
prepay the loan after three years?

D. Given that you paid off the loan after three years, would you have been better off (in
terms of the effective interest rate) if you hadnt paid points but taken a 4.5% interest rate?
How would this answer change if you had held the loan until maturity instead?

E. What types of borrowers would generally not want to buy points on a fixed rate

F. Is a prepayment penalty common for this type of loan? Explain.

[Although not required, we recommend you check that you can calculate these answers
both in Excel and using your financial calculator.]

Problem 3: Adjustable Rate Mortgages

Carefully examine the mortgage contract attached to the end of this problem set. This is for
a mortgage originated on October 1 2005, for which the first payment was due on
November 1 2005. (Be particularly careful in reading the information in sections 1-4,
describing the interest rate, reset dates, caps and floors etc. it is a bit tricky).

Using the information in the contract, answer the following questions by constructing an
Excel spreadsheet showing all the payments on this mortgage over time.

Note #1: In case not clear, please interpret the language in the mortgage contract as
- The interest rate is fixed for the first 3 years (i.e. covering the first 36 payments --
occurring on Nov 1 2005, Dec 1 2005 ... Oct 1 2008).
- The interest rate then adjusts based on the Libor rate on October 1 2008*. This new
interest rate should be applied when calculating the Nov 1 2008 payment as well as the
following five payments (Dec 2008 through April 2009).
- The interest rate then changes again, effective for the May 2009 payment as well as the
following five payments. It then continues to change every six months (each May and
* October 1 is the first business day of the month immediately preceding the month of the
first change date.
Note #2: You will need some information on the six month Libor rate in order to answer the
questions. Please use the spreadsheet containing Libor data that is posted on NYU Classes.
(In practice you can also obtain this data from the Wall Street Journal, Bloomberg, FRED

A. Using the common nomenclature of ARMs, how would you refer to this mortgage (i.e., it
is a x/y ARM, what are x and y in this case)?

B. What are the initial payments on this mortgage? (This is the amount highlighted in yellow
in section 3.B of the contract which is not filled in, but instead replaced with $????.??).

C. What is the balance outstanding on this loan at the time the interest rate first adjusts?

Assume the borrower performs on this mortgage, making scheduled interest and principal
payments for five years, before prepaying the remaining balance on October 1 2010.

D. Construct a table that summarizes the interest rate the borrower pays at each point in
time over this five year period, taking into account all the features of the contract.

E. Build a cash flow model in Excel showing for each month showing the mortgage balance,
and the principal payment and interest payments. Using your model, calculate the effective
interest rate on the mortgage, taking into account the fact the borrower prepays the
remaining balance after five years.

F. Was this borrower lucky or unlucky regarding the date on which their mortgage
interest rate first reset? What was going on during this period?

G. For how long did the market interest rate at the first reset date affect the contract rate
on the mortgage? Would things have been substantially different if the mortgage rate was
linked to a different index, other than Libor?

Note contract for long problem 3

Loan Number:


(LIBOR Six-Month Index (As Published in The Wall Street Journal) Rate Caps)



Cranford, NEW JERSEY 07016

(Property Address)


In return for a loan that I have received, I promise to pay U.S. $550,000.00, (this amount
is called Principal), plus interest, to the order of Lender. The Lender is Show Me the
Money Inc.

I will make all payments under this Note in the form of cash, check or money order. I
understand that Lender may transfer this Note. Lender or anyone who takes this Note
by transfer and who is entitled to receive payments under this Note is called the Note

Interest will be charged on unpaid principal until the full amount of Principal has been
paid. I will pay interest at a yearly rate of 7.190%. This interest rate I will pay may
change in accordance with Section 4 of this Note.

The interest rate required by this Section 2 and Section 4 of this Note is the rate I will
pay both before and after any default described in Section 7(B) of this Note.

(A) Time and Place of Payments
I will pay principal and interest by making a payment every month. I will make my
monthly payments on the 1st day of each month beginning on November 1, 2005. I will
make these payments every month until I have paid all of the principal and interest and
any other charges described below that I may owe under this Note. Each monthly
payment will be applied as of its scheduled due date and will be applied to interest
before Principal. If, on October 1, 2035, I still owe amounts under this Note, I will pay
those amounts in full on that date, which is called the Maturity Date.

I will make my monthly payments at

Show Me the Money Inc.

1370 Subprime Avenue
New York, NEW YORK 10001

or at a different place if required by the Note Holder

(B) Amount of My Initial Monthly Payments

Each of my initial monthly payments will be in the amount of U.S. $?,????. This amount
may change.

(C) Monthly Payment Changes

Changes in my monthly payment will reflect changes in the unpaid principal of my loan
and in the interest rate that I must pay. The Note Holder will determine my new interest
rate and the changed amount of my monthly payment in accordance with Section 4 of
this Note.

(D) Application of Payments

Payments received by the Note Holder will be applied in the following order: (i)
prepayment charges due under this Note; (ii) amounts payable under paragraphs 2 of
the Security Instrument (defined below); (iii) interest due under this Note; (iv)
principal due under this Note; and (v) late charges due under this Note.


(A) Change Dates

The interest rate I will pay may change on the 1st day of November, 2008, and on that
day every 6th month thereafter. Each date on which my interest rate could change is
called a Change Date.

(B) The Index

Beginning with the first Change Date, my interest rate will be based on an Index. The
Index is the average of Interbank offered rates for six-month U.S. dollar denominated
deposits in the London market (LIBOR), as published in The Wall Street Journal. The
most recent Index figure available as of the first business day of the month
immediately preceding the month in which the Change Date occurs is called the
Current Index. If the Index is no longer available, the Note Holder will choose a new
index that is based upon comparable information. The Note Holder will give me notice
of this choice.

(C) Calculation of Changes

Before each Change Date, the Note Holder will calculate my new interest rate by
adding FIVE AND ONE TWENTY-FIFTH percentage point(s) (5.040%) to the Current
Index. The Note Holder will then round the result of this addition to the nearest one-
eight of one percentage point (0.125%). Subject to the limits stated in Section 4(D)
below, this rounded amount will be my new interest rate until the next Change Date.
The Note Holder will then determine the amount of the monthly payment that would be
sufficient to repay the unpaid principal that I am expected to owe at the Change Date in
full on the Maturity Date at my new interest rate is substantially equal payments.
The result of this calculation will be the new amount of my monthly payment.

(D) Limits on Interest Rate Changes

The interest rate I am required to pay at the first Change Date will not be greater than
10.190% or less than 6.190%. Thereafter, my interest rate will never be increased or
decreased on any single Change Date by more than ONE percentage point(s) (1.000%)
from the rate of interest I have been paying for the preceding SIX months. Furthermore,
my interest rate will never be greater than 13.190%, or less than 6.190%.

(E) Effective Date of Changes

My new interest rate will become effective on each Change Date. I will pay the amount
of my new monthly payment beginning on the first monthly payment date after the
Change Date until the amount of my monthly payment changes again.

(F) Notice of Changes

The Note Holder will deliver or mail to me a notice of any changes in my interest rate
and the amount of my monthly payment before the effective date of any change. The
notice will include information required by law to be given to me and also the title and
telephone number of a person who will answer any question I may have regarding the


I have the right to make payments of principal at any time before they are due. A
payment of principal only is known as a prepayment. When I make a prepayment, I
will tell the Note Holder in writing that I am doing so.

I may make a full prepayment or partial prepayments without paying any prepayment
charge. The Note Holder will use all of my prepayments to reduce the amount of
Principal that I owe under this Note. If I make a partial prepayment, there will be no
changes in the due dates of my monthly payments unless the Note Holder agrees in
writing to those changes. My partial prepayment may reduce the amount of monthly
payments after the first Change Date following my partial prepayment. However, any
reduction due to my partial prepayment may be offset by an interest rate increase.

If a law, which applies to this loan and which sets maximum loan charges, is finally
interpreted so that the other loan charges collected or to be collected in connection with
this loan exceed the permitted limits, then: (a) and such loan charge shall be reduced by
the amount necessary to reduce the charge to the permitted limit: (b) any sums already
collected from me that exceeded permitted limits will be refunded to me. The Note
Holder may choose to make this refund by reducing the Principal I owe under this Note
or by making a direct payment to me. If a refund reduces Principal, the reduction will be
treated as a partial Prepayment.


(A) Late Charges for Overdue Payments
If the Note Holder has not received the amount of any monthly payment by the end of
the FIFTEEN calendar days after the date it is due. I will pay a late charge to the Note
Holder. The amount of the charge will be 5.000% of my overdue payment of Principal
and interest. I will pay this late charge promptly but only once on each late payment.

(B) Default
If I do not pay the full amount of each monthly payment on the date it is due, I will be in

(C) Notice of Default

If I am in default, the Note Holder may send me a written notice telling me that if I do
not pay the overdue amount by a certain date, the Note Holder may require me to pay
immediately the full amount of Principal that has not been paid and all the interest that
I owe on the amount. The date must be at least 30 days after the date on which the
notice is mailed to me or delivered by other means.

(D) No Waiver By Note Holder

Even if, at the time when I am in default, the Note Holder does not require me to pay
immediately in full as described above, the Not Holder will still have the right to do so if
I am in default at a later time.

(E) Payment of Note Holders Costs and Expenses

If the Note holder has required me to pay immediately in full as described above, the
Note Holder will have the right to be paid back by me for all of its costs and expenses in
enforcing this Note to the extent not prohibited b Applicable Law. Those expenses
include, for example, reasonable attorneys fees.

Unless applicable law requires a different method, any notice that must be given to me
under the Note will be give by delivering it or by mailing it by first class mail to me at
the Property Address above or at a different address if I give the Note Holder a notice of
my different address.

Unless the Note Holder requires a different method, any notice that must be given to the
Note Holder under this Note will be given by mailing it by first class mail to the Note
Holder at the address stated in Section 3(A) above or at a different address if I am given
a notice of that different address.


If more than one person signs this Note, each person is fully and personally obligated to
keep all of the promises made in this Note, including the promise to pay the full amount
owed. Any person who is a guarantor, surety or endorser of this Note is also obligated
to these things. Any person who takes over these obligations, including the obligations
of a guarantor, surety or endorser of this Note, is also obligated to keep all of the
promises made in this Note. The Note Holder may enforce its right under this Note
against each person individually or against all of us together. This means that any one of
us may be required to pay all of the amounts owed under this Note.

I and any other person who has obligations under this Note waive the rights of
Presentment and Notice of Dishonor. Presentment means the right to require the Note
Holder to demand payment of amount due. Notice of Dishonor means the right to

require the Note Holder to give notice to other persons that amounts due have not been


This note is a uniform instrument with limited variations in some jurisdictions. In
addition to the protections given to the Note Holder under this Note, a Mortgage, Deed
of Trust or Security Deed (the Security Instrument), dated the same date as this Note,
protects the Note Holder from possible losses that might result if I do not keep the
promises that I make in this Note. That Security Instrument describes how and under
what conditions I may be required to make immediate payment in full of all amounts I
owe under this Note. Some of those conditions read as follows:

Transfer of the Property or a Beneficial Interest in Borrower: As used in this Section 18,
Interest in the Property means any legal or beneficial interest in the Property,
including, but not limited to, those beneficial interests transferred in a bond for deed,
contract for deed, installment sales contract or escrow agreement, the intent of which is
the transfer of title by Borrower at a future date to a purchaser.

If all or any part of the Property is sold or transferred (or if Borrower is not a natural
person and a beneficial interest in Borrower is sold or transferred) without Lenders
prior written consent, Lender may require immediate payment in full of all sums
secured by this Security Instrument.

However, this option shall not be exercised by Lender if exercise is prohibited by

Applicable Law. Lender also shall not exercise this option if: (a) Borrower causes to be
submitted to Lender information required by Lender to evaluate the intended
transferee as if a new loan were being made to the transferee; and (b) Lender
reasonably determines that Lenders security will not be impaired by the loan
assumption and that the risk of a breach of any covenant or agreement in this Security
Instrument is acceptable to Lender.

To the extent permitted by Applicable Law, Lender may charge a reasonable fee as a
condition to Lenders consent to the loan assumption. Lender may also require the
transferee to sign an assumption agreement that is acceptable to Lender and that
obligates the transferee to keep all the promises and agreements made in the Note and
in this Security Instrument. Borrower will continue to be obligated under the Note and
Security Instrument unless Lender releases Borrower in writing.

If Lender exercises the option to require immediate payment in full, Lender shall give
Borrower notice of acceleration. This notice shall provide a period of not less than 30
days from the date the notice is given in accordance with section 15 within which
Borrower must pay all sums secured by this Security Instrument. If Borrower fails to
pay these sums prior to the expiration of this period, Lender may invoke any remedies
permitted by this Security Instrument without further notice or demand on Borrower.