Real Estate Finance
University of Pennsylvania
The Moral Hazard of Renting
• Renting a house creates a serious moral hazard problem
for the owner since the renter has little incentives to
maintain the house.
• Renting also creates a monitoring and screening
problem since it is difficult and costly to evict a renter
that has defaulted on rental payments.
• Owner occupied housing solves both problems, but
creates a financing problem.
• Most owners cannot afford to buy a house without
receiving a loan or some sort of financing from a bank.
• Home financing creates additional complications.
• A mortgage is a secured, nonrecourse loan.
• A secured loan is a loan in which the borrower pledges some asset (the
house) as collateral for the loan, which then becomes a secured debt owed
to the creditor who gives the loan.
• The debt is thus secured against the collateral.
• In the event that the borrower defaults, the creditor takes possession of the
house used as collateral.
• The creditor may sell it to regain some or all of the amount originally lent to
the borrower (foreclosure of a home.)
• A nonrecourse loan is a secured loan where the collateral is the only
security or claim the creditor has against the borrower.
• The creditor has no further recourse against the borrower for any deficiency
remaining after foreclosure against the property.
• If you default on a mortgage you do not have to declare personal
• The buyer of the call option has the right, but not the obligation to buy an
agreed quantity of a particular commodity from the seller of the option at a
certain time (the expiration date) for a certain price (the strike price).
• The price of a call option is difficult to compute since it depends on the
expectations about the future price of the asset.
• Even if the call is out of the money, i.e. if the current price of the asset is
below the strike price, the call option still has a positive value, since it is
possible that the price of the asset will rise over the strike price before the
expiration date of the option.
• Pricing call options is difficult since we need to make assumptions about the
law of motion of the price of the underlying asset.
• In finance we use continuous time stochastic processes to model asset
prices and then use stochastic calculus to price derivatives such as options.
Buying a House is Buying a Call
• To understand a transaction in which an individual buys a home
using a large mortgage, it is useful to think about it in terms of
buying a call option.
• The bank “owns” the house and rents the house to the “owner.”
• The owner can buy the house back from the bank at any time by
paying off the mortgage. (purchase option)
• Effectively, the owner does not own the house until he has paid off
the mortgage, but owns a call option.
• The initial down-payment is the price of the call option.
• The monthly interest payments are the rental payments.
• The strike price is the remaining principal.
• Each monthly payments reduces the strike price of the call.
• Suppose you buy a house worth $500,000 putting 10 percent down.
• The bank provides a 30 year mortgage with a 5 percent interest rate.
Your monthly payment is $2,415.70.
• Property taxes can easily add another $500-1,000 to your monthly
payment. Home owners insurance will add another $100.
• But the good news is that you can deduct local taxes and mortgage
interest payment from your income when you compute federal income
• Over the course of the 30 years, you will pay $419,651 in interest
payments and $450,000 in principal payments.
• The price of the call option is $50,000.
• As a rule of thumb, the home value-to-income ratio should be
approximately 3. You need to make $167,000 in household income.
• After-tax income is approximately $10,000. You monthly payments
are $3,000 which means you spend 30 percent of your income on
Primary Mortgage Market
• In a traditional loan, a bank lends money to an individual
to buy a home using funds deposited with that bank.
• The credit or default risk is entirely born by the local
• The main advantage of this arrangement is that there is
little moral hazard since local banks have strong
incentives not to make bad loans.
• This arrangement has three disadvantages:
(1) small or growing markets may not have enough liquidity;
(2) borrowing may shut down if local banks are in trouble;
(3) local banks hold an undiversified portfolio and are thus exposed
to risk that could be diversified.
• The secondary mortgage market is the market for the
sale of securities or bonds collateralized by the value of
• Intermediaries buy loans from local banks and
repackage loans for resale via mortgage-backed
• Investors can buy and hold a diversified portfolio of
mortgage backed securities.
• The local banks can also pass the mortgage risks to the
investors in the secondary market.
• The main players in the secondary market are
government sponsored enterprises.
Fannie Mae and Freddie Mac
• To create additional demand in the secondary market, the federal
government created two agencies which were later converted into publically
traded companies. These are also known as government-sponsored
• Federal National Mortgage Association (FNMA), commonly known as
Fannie Mae, was founded as a government agency in 1938 as part of
Franklin Delano Roosevelt's New Deal to provide liquidity to the mortgage
• The Federal Home Loan Mortgage Corporation (FHLMC) , commonly
known as Freddie Mac, was created in 1970 to expand the secondary
market for mortgages and create competition to Fannie Mae.
• Fannie Mae and Freddie Mac are the leading buyer in the U.S. secondary
mortgage market. Currently, Fannie and Freddie hold or guarantee about
50% of the nation’s outstanding home mortgages.
Private Mortgage Insurance
• Lenders sometimes want to insure themselves of the default risk
and require borrowers to pay for this insurance.
• Private Mortgage Insurance is insurance payable to a lender for a
security that may be required when taking out a mortgage loan.
• Historically all home purchasers that bought a house with a down-
payment less than 20 percent were required to buy PMI.
• PMI is expensive: typical rates are $55/month per $100,000
• In our example, suppose you buy the $500,000 without a down-
payment, you will have to pay an additional $275 to your monthly
• Of course, there is no guarantee that you will be approved by the
insurance company to qualify for PMI. In that case, you will not
obtain the mortgage and you will not be able to buy the house.
Public Mortgage Insurance
• Since PMI is expensive and hard to get for low income
households, the federal, the federal government also
offers public mortgage insurance.
• To obtain public mortgage insurance from the Federal
Housing Administration in the United States, you must
pay a mortgage insurance premium (MIP) equal to 1
percent of the loan amount at closing.
• Fannie Mae then essentially makes up any missed
payments to the bondholder that the borrower misses.
• It also makes up for any loss for the loan not being fully
repaid either by the borrower or from the sale of the
• The risk of a downturn in housing markets is shifted to
the taxpayers that guarantee the GSEs.
• GSE’s hold a large fraction of the undiversified risk in the
housing market. The other fraction is held by
• Local banks have few incentives to screen mortgage
applicants since they no longer bear the risk, they just
make commissions from selling mortgages.
• Investors of MBS have often little knowledge about the
exact type of mortgages that they are holding.
• As a consequence they have a hard time evaluating the
risk associated with the investments,
• Credit Rating Agencies may not be of much help and
may provide bad incentives if they misclassify
• As long as housing prices keep on rising, none of this
Measuring Housing Prices
• It is difficult to compute housing price indexes since only a small fraction of
all houses is sold each period.
• We thus do not have transaction prices for the vast majority of houses at
each point of time.
• The indices are calculated from data on repeat sales of single-family
homes, an approach developed by economists Karl Case, Robert Shiller
and Allan Weiss.
• To construct a repeat sales index you need to observe housing two
• Of course, housing transactions are not random events and this
methodology is especially problematic during a housing market crisis in
which the sample of houses that are transacted are clearly not a random
sample of the underlying housing stock.
• Of course, the main competitor of the repeat sales index that is based on
the median housing price is even worse!
Some Personal Advice
• If you want to gamble or speculate in real estate, don’t do it with your
• Instead you should invest into real estate investment trusts (REIT).
These are mutual funds that are offered by many different
companies. Leave the investment decisions to professional real
• If you still want to gamble in real estate, get an MBA in Real Estate
Finance from Wharton or any other decent Business School. Then
try to make a career out of it.
• Follow the 3 to 1 rule to determine whether you can afford to buy a
• Whatever house you buy, remember that there will come a day when
you will have to sell again.