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					Real Estate Finance and Economics
Final Exam 2003
Tom Davidoff

All questions equal weight. You have 30 minutes to complete the exam.


1. Office tenants tend to renew their leases at below market rents. Why?

There are two reasons why office tenants tend to renew their leases at below market
rents. First, lease contracts usually contain renewal options for tenants, which give
them the right, but not the obligation to renew their leases at a pre-specified level after
a short term of perhaps five years. Granting this right, however, means that the
landlord will most not likely benefit from an increase in market rents, but will be
exposed to downturns in market rents. Second, there is always a sunk investment
involved for the landlords to remodel the office spaces, so tenants can threaten to leave
to demand for a rent decrease. However, this does not always work if there is tight
demand for space or high transaction costs for tenants.

2. Which of the following statements makes the least sense?

a. XREIT wanted to increase its FFO over time, so it converted a parking lot into extra
retail space in a high rent market.

b. XREIT wanted to increase its FFO over time, so it decided to switch from fully
amortizing to interest only mortgage debt on its newly acquired properties.

c. XREIT wanted to increase its FFO over time, so it acquired a property that it believed
was undervalued.

d. XREIT wanted to increase its FFO over time, so it developed a property in a market
that it believed was underserved.

Note a, c, d are all alternatives to enhance the revenue generation ability of the XREIT.
However, simply switching mortgage types in b has no effect on revenues of XREIT.
Moreover, switching to interest only mortgage actually increases the interest expense of
XREIT and decrease FFO.
3. Which product exposes the lender to greater interest rate risk and why?

a. Mortgage A is a fixed rate mortgage with a fixed interest rate of 7%. There is constant
amortization (declining payments) over 30 years. Loan amount is 100,000 and balance is
zero at the end of 30 years.

b. Mortgage B is a fixed rate mortgage with a fixed interest rate of 7%. There are
constant payments (increasing amortization) over 30 years. Loan amount is 100,000 and
balance is zero at the end of 30 years.

Remember the graphs shown in the excel solutions to the mortgage questions? With a
constant amortization mortgage the outstanding balance decreases linearly, the
outstanding balance of a constant payment mortgage decreases much more slowly.
Interest rate changes would affect the lenders (as well as the borrowers but in opposite
direction) more if the outstanding balance is higher. Hence Mortgage B has more risk.

4. Consider an adjustable rate mortgage with a payment cap of $25,000 per year and
ANNUAL payments. There are no interest rate caps. Negative amortization is allowed.
If the outstanding balance at the beginning of the year with 5 years remaining until the
end of the loan term is $130,000 and the interest rate is 12% this year, what will be the
outstanding balance due at the end of the year? Hint: the payment on a $130,000 fixed
rate mortgage with a term of 5 years, annual payments and an interest rate of 12% is
$36,063.27, of which $15,600 is interest and $20,463 is principal.

If there is no cap the outstanding balance would be reduced by the principal repayment,
hence outstanding balance at end of year is $130,000 – 20,463 = 109,537. However, the
cap would restrict the payment with the difference between payments and interests
added to the loan balance. The payment is $25,000, which covers the principal $20,463
and only $4,537 of the interests incurred. Hence the difference $15,600 - 4,537 needs to
be added back to loan balance => outstanding balance at end of year is 109,537 +
11,063 = 120,600.
5. Consider a moderate income librarian with a fairly stable income and a high income
casino executive whose income is largely bonus driven and follows the casino industry.
Both live in Las Vegas, the US’s casino capital. For which person does the US tax code
make homeownership relatively more attractive? For which person do risk
considerations make homeownership more attractive. Explain

   (1) Buying is better the larger the tax rate => this is mainly due to the tax deduction
       of mortgage interests which depends on the size of the mortgage and the tax
       rate of the individual. Hence US tax code make homeownership more attractive
       for the casino executive (who has larger wealth and mortgage with higher tax
       bracket).
   (2) Buying is better the less the wealth tracks house prices => The income of casino
       executives is tied to the wellbeing of the casino industry, and the casino industry
       in LV actually affects housing prices. As a result, the wealth of casino executive
       and house prices are highly correlated. So risk considerations make
       homeownership less attractive for the casino executive.

				
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