The Determinants of Subprime Mortgage PerformanceFollowing a.docx

The Determinants of Subprime Mortgage Performance
Following a Loan Modification
Maximilian D. Schmeiser & Matthew B. Gross
Published online: 24 February 2015
# Springer Science+Business Media New York (outside the
USA) 2015
Abstract We examine the evolution of mortgage modification
terms obtained by
distressed subprime borrowers during the recent housing crisis
and the effect of the
various types of modifications on the subsequent loan
performance. Using the
CoreLogic Loan Performance dataset that contains detailed loan
level information on
mortgages, modification terms, second liens, and home values,
we estimate a discrete
time proportional hazard model with competing risks to examine
the determinants of
post-modification mortgage outcomes. We find that principal
reductions are particularly
effective at improving loan outcomes, as high loan-to-value
ratios are the single greatest
contributor to re-default and foreclosure. However, any
modification that reduces total
payment and interest (P&I) reduces the likelihood of subsequent
re-default and fore-
closure. Modifications that increase the loan principal—
primarily through capitalized
interest and fees—are more likely to fail, even while controlling

for changes in P&I.
Keywords Mortgage modification . Subprime . Mortgage default
. Foreclosure . HAMP
JEL Classification D12 . G21 . R20 . R28
Introduction
Following the exuberant housing market of the mid-2000s, a
national housing price
collapse that began in 2007 resulted in many borrowers owing
more on their mortgages
than their homes were worth. This inability to pay off a
mortgage with the proceeds
from a home’s sale, combined with widespread unemployment
and declines in income,
made many mortgages unsustainable for borrowers (Mayer et al.
2009). In response to
the resulting millions of homeowners who defaulted on their
mortgages and faced
J Real Estate Finan Econ (2016) 52:1–27
DOI 10.1007/s11146-015-9500-9
The views expressed are solely those of the authors and do not
represent the views of the Federal Reserve
Board, the Federal Reserve System, or their staff members.
M. D. Schmeiser (*)
Federal Reserve Board, Washington, DC, USA
e-mail: [email protected]
M. B. Gross
University of Michigan, Ann Arbor, MI, USA

foreclosure, mortgage modifications were actively pursued by
policymakers, consumer
advocates, and, to a lesser extent, investors and mortgage
servicers as a means of
keeping borrowers in their homes.
Mortgage modifications, whereby the terms of the loan are
altered in order to
promote repayment by a distressed borrower, were relatively
rare prior to the recent
housing crisis. The vast majority of defaults self-cured, and
foreclosure proceedings
offered the lender or servicer a high recovery rate for the
remaining loans (Ambrose and
Capone 1996; Capone 1996; Adelino et al. 2009). This dynamic
was altered during the
housing crisis when mortgage default rates rose dramatically
and the share of self-
curing delinquent mortgages plummeted, particularly among
subprime mortgages
(Agarwal et al. 2011; Sherlund 2008). This increase in defaults,
combined with
plunging home values, changed the relative costs and benefits
of providing alternatives
to foreclosure, including mortgage modifications (Cutts and
Merrill 2008).
Early in the housing crisis, the parameters of mortgage
modifications, including
when they were even offered, varied widely depending on the
mortgage servicer
(Agarwal et al. 2011). Moreover, the mortgage modifications
made in 2008 often
failed to lower monthly payments for the borrower, with
approximately half of all

modifications in the subprime and alt-a market yielding
payment increases (White
2009). Similarly, data from the Office of the Comptroller of the
Currency’s (OCC)
mortgage metrics report, which includes prime loans and covers
approximately
two-thirds of all first-lien mortgages outstanding in the United
States, show that,
in 2008, 32 % of modified loans resulted in an increase in
monthly payments and
42 % in a decrease in the monthly payments (Office of the
Comptroller of the
Currency 2009). As these early mortgage modifications rarely
improved the
affordability of the mortgage payment, the loans were highly
likely to re-default
following the modification: Over 60 % of mortgages modified
in 2008 had re-
defaulted within 12 months (Goodman et al. 2011).
As part of the policy response to the financial crisis, the federal
government allocated
billions of dollars to programs aimed at assisting homeowners
in distress. These
programs included the Home Affordable Modification Program
(HAMP), introduced
in March 2009, which provided incentive payments to mortgage
lenders, servicers,
borrowers, and investors for modifying loans to conform to the
HAMP guidelines. The
primary requirement was that the first lien mortgage payment be
reduced to 31 % of the
borrower’s income; however, the terms of the loan that are
modified in order to achieve
the reduction in payment varied from borrower to borrower. The
intent of the HAMP

payment reduction requirement was to improve the affordability
of the mortgage for
distressed borrowers and thus improve their chances of
remaining in their homes.
Following the introduction of HAMP, an increasing share of
modified loans received
payment decreases, regardless of whether or not they qualified
as HAMP modifica-
tions. In the first quarter of 2009, 53 % of modifications
involved a payment reduction;
by the second quarter of 2009, 78 % of modifications involved a
payment reduction.
Thereafter, the percent of modifications involving a reduction in
the monthly payment
continued to increase, reaching approximately 93 % by the
fourth quarter of 2012
(Office of the Comptroller of the Currency 2013). While many
mortgage modifications
since the implementation of HAMP are not classified as
resulting directly from the
program, the standard terms offered on these proprietary
modifications changed fol-
lowing HAMP’s implementation (Goodman et al. 2011).
2 M. D. Schmeiser, M. B. Gross
The number of mortgage modifications increased substantially
beginning in 2009
and peaked at over 250,000 in the second quarter of 2010
(Goodman et al. 2012; Office
of the Comptroller of the Currency 2011). While the number of
modifications each
quarter has generally decreased since mid-2010, as of the

second quarter of 2014,
2.49 % of residential mortgages were still at some stage of the
foreclosure process and
6.04 % were at least one payment past due but not in
foreclosure (Mortgage Bankers’
Association 2014). Thus, mortgage modifications continue to
play an important role in
the recovery of the housing market, and it is therefore important
to understand what
aspects of modifications are most successful at allowing the
borrower to avoid default
and foreclosure.
Despite the important role that mortgage modifications have
played in the response
to the housing crisis, relatively little research examines which
types of mortgage
modifications are the most successful at avoiding subsequent re-
default and foreclo-
sure. While a handful of studies examined post-modification
loan performance, that
research has either tended to focus on narrow geographic areas
(Voicu et al. 2012a) or
only pre-HAMP loan modifications (Quercia and Ding 2009;
Haughwout et al. 2009;
Agarwal et al. 2011). This study augments the existing literature
by examining post-
modification loan performance for a national sample of
subprime loans using a rich
dataset that includes information on junior liens, current
property valuations, and
detailed information on the parameters of loan modifications.
Specifically, we examine
whether reductions in principal, interest rate, or P&I, are most
effective at reducing
subsequent re-default and foreclosure. Using loan-level data

from CoreLogic’s Loan
Performance Asset Backed Securities (ABS) data on privately
securitized subprime
mortgages originated from 2000 through 2007, we find that
principal reductions are the
most effective type of modification, as they generally lower the
borrower’s monthly
payment and reduce the loan-to-value (LTV) ratio in addition to
having an independent
effect on re-default. However, any modification that improves
the affordability of the
mortgage, such as a reduction in the monthly P&I, reduces the
probability of subse-
quent re-default and foreclosure. Our results provide insights to
loan servicers, mort-
gage investors, and policymakers as to the relative effectiveness
of the various types of
loan modifications, allowing them to more accurately assess the
cost of a modification
relative to the cost of a foreclosure.
Previous Literature
A large body of literature exists on the determinants of
mortgage default for prime
mortgages (Deng et al. 2000; Phillips and VanderHoff 2004;
Quercia and Stegman
1992; Ambrose et al. 1997) and subprime mortgages (Kau et al.
2011; deRitis et al.
2010; Danis and Pennington-Cross 2008) prior to the housing
crisis. However, from the
1990s through the mid-2000s, mortgage underwriting standards
declined substantially,
resulting in an unprecedented national wave of defaults and
foreclosures when house
prices subsequently fell and economic conditions deteriorated

(Demyanyk and Van
Hemert 2011; Haughwout et al. 2008; Mian and Sufi 2009).
With this wave of mortgage defaults, researchers turned their
attention to analyzing
mortgage outcomes for borrowers in default, with an emphasis
on whether the loan
terminated in foreclosure or received a modification. These
studies identified a wide
Subprime Mortgage Performance Post-Modification 3
range of factors that affect mortgage outcomes, with state laws
governing foreclosure,
the amount of home equity, credit scores at origination, and the
presence of junior liens
among the most significant (Voicu et al. 2012b; Chan et al.
2014; Gerardi et al. 2013b).
Interventions, such as mortgage default counseling, were also
shown to substantially
increase the probability that a borrower receives a loan
modification and reduces the
probability of foreclosure (Collins and Schmeiser 2013; Collins
et al. 2013).
While the literature on outcomes for loans in default following
the housing crisis has
provided significant insight into the determinants of receiving a
loan modification, a
much smaller body of literature has examined the parameters of
mortgage modifica-
tions and how they affect subsequent loan performance. Among
the earliest studies of
post-modification loan performance was Quercia and Ding

(2009), who used a national
sample of subprime and alt-a securitized mortgages drawn from
the Columbia Collat-
eral File that were modified in 2008. They found that the
greater the reduction in the
monthly payment, the lower the likelihood that the mortgage
would re-default by
December 2008. Payment reductions achieved through a
combination of rate and
principal reductions were most effective at reducing re-default,
followed by rate
reductions alone.
Many of the subsequent studies focused on analyzing the
performance of pre-
HAMP loan modifications. For example, Haughwout et al.
(2009) used the CoreLogic
Loan Performance data on subprime and alt-a securitized loans
to analyze the deter-
minants of post-mortgage modification re-default prior to the
implementation of
HAMP. Using a proportional hazard framework, they find that
the greater the reduction
in the monthly payment, the lower the likelihood that the
mortgage re-defaults. Further,
they find that having a negative equity position substantially
increases the probability
of re-default.
Agarwal et al. (2011) also focused on mortgage modifications
that occurred prior to
the introduction of HAMP. Using the OCC Mortgage-Metrics
database, they estimate
the probability that a loan re-defaults (60 plus days delinquent)
within six months of a
modification, and find that the probability of re-default declines

the more monthly
payments are reduced, and that re-default rates increase as LTV
increases. They also
find that the servicer of the mortgage has a significant effect on
the ultimate success of
the modifications, even after controlling for the terms of the
modification.
One of the only studies to examine mortgage modifications both
pre- and post-
HAMP was done by Voicu et al. (2012a). Focusing only on the
New York City area,
they find that modifications where the interest rate or principal
are reduced are less
likely to re-default. Further, they find that HAMP modifications
perform better than
proprietary modifications, although they are unable to
determine what aspects of
HAMP yield better loan performance.
Our research expands on this existing literature in several ways.
First, we use a
sample of subprime and alt-a mortgages drawn from across the
United States rather
than one specific geographic area. Second, we examine both
HAMP and proprietary
mortgage modifications from 2008 through 2013 and follow
their performance through
the fourth quarter of 2013. Finally, using a discrete time
proportional hazard frame-
work, we control for the full range of information CoreLogic
collects on the loans,
including the presence and amount of any junior liens, a current
property value
generated using an automated valuation model (AVM), and
detailed terms for the

mortgage modifications.
Data
The data for this study come from CoreLogic’s Loan
Performance ABS data on
privately securitized mortgages. The CoreLogic ABS data
include information on
subprime and alt-a loans but do not include information on
agency-backed securities
or loans held in portfolio.1 As of 2010, these data contained
monthly performance
history for about 20 million individual loans. The CoreLogic
data used in this paper are
only representative of privately securitized subprime and alt-a
loans, not the entire U.S.
mortgage market. While the coverage of these data may limit
the generalizability of our
findings, these loans are of particular interest to investors and
policymakers given the
high incidence of default, foreclosure, and modification in this
population.
The CoreLogic data contain detailed static and dynamic
information on the loans
and their performance. The static data include information from
origination such as date
of origination, the zip code where the property is located, the
borrower’s FICO score,
origination balance, interest rate, P&I amount, and servicer. The
dynamic data are
updated monthly and include information on the current interest

rate, mortgage balance,
payment amount, and loan performance.
CoreLogic also provides two supplemental files that are used in
our analysis. The
first contains detailed information on whether a borrower
received a loan modification,
as well as the parameters of the modification (for example,
reduction in principal,
reduction in interest rate, or change in amortization term).
While CoreLogic does not
explicitly identify a loan as being a HAMP modification, we
infer whether or not the
loan was modified under HAMP by whether the characteristics
of the modification
follow the HAMP program waterfall for reducing the monthly
payment, such as
reducing the interest rate to 2 % and then extending the term of
the loan once the
2 % floor is reached. The second file is the CoreLogic TrueLTV
Data, which matches
the loans in the CoreLogic Loan Performance data to public
records to obtain infor-
mation on subsequent liens taken out on the property. These
data also contain a
monthly estimate of the property’s value from their AVM. The
combination of monthly
data on the value of all liens on the property with the monthly
estimate of the property’s
value from the AVM allows for the computation of a current
combined loan-to-value
(CLTV) ratio.
The ability to include a current estimate of CLTV based on the
inclusion of junior
liens in the loan amount and a value estimated specifically for

that property represents a
major improvement over previous studies. Past research has
largely excluded junior
liens from the loan amount and has been limited to the inclusion
of metropolitan
statistical area (MSA) level price indices or adjusting the
appraised value at origination
by some price index to capture current property value.
Given the number of loans in the CoreLogic ABS data, we
select a 5 % random
sample from the universe of first-lien mortgages. Our data on
modifications and loan
performance cover the period from January 2008 through
December 2013. We restrict
our data to loans originated no earlier than January 2000 and
modifications occurring
after January 2008. To provide economic context for the loan
performance, we merge
in monthly state-level unemployment rates obtained from the
Bureau of Labor
1 CoreLogic also has a separate database on privately
securitized prime and/or jumbo loans; however we
restrict our analysis sample to the subprime and alt-a loan data.
Statistics. Finally, in order to proxy for local housing market
conditions and borrowers’
expectations for future house price changes, we include the
year-on-year percent
change in the property ZIP code’s House Price Index (HPI) from
CoreLogic.

After we merge our 5 % random sample of the CoreLogic ABS
data with the
supplemental loan modification file and drop all observations
for loan identification
(ID) numbers that have no modifications over the course of our
study period, we have
approximately 2.3 million loan month observations from
approximately 64,000 indi-
vidual loans. After dropping observations with missing data, we
are left with 37,027
unique loans. Figure 1 plots the number of mortgage
modifications occurring each
month in our sample over the period from January 2008 to
December 2013. The
number of monthly modifications peaked in early 2009, just
prior to the enactment
of HAMP, before plummeting.2 The number of modifications
increased sharply again
in early 2010, and since then it has largely declined.
Figure 2 plots the terminal outcomes for all of the modified
loans in our data over
time. The graph shows that real estate owned (REO) is the most
likely terminal
outcome for a modified loan in our sample, except for two short
periods in 2012 and
2013. The peak of foreclosure occurred at the end of 2011 and
has fluctuated below that
peak in the time since. Short sales and foreclosure sales
increased to a peak at the end of
2012 and appear to have declined in the months after, while
payoffs have remained
relatively flat over the sample period.
Figure 3 shows a survival graph for the share of loans that

remain current or 30 days
delinquent in the months following a modification. The survival
rates to 60 plus days
delinquent are plotted separately by the year in which the
mortgage received its first
modification to illustrate the substantial variation in subsequent
loan performance. The
rate at which loans become 60 plus days delinquent following a
modification declines
substantially in each successive year from 2008 to 2012. For
loans first modified in
2008, over 60 % had re-defaulted within 12 months of the
modification. In contrast, for
loans first modified in 2012, the 12-month re-default rate had
declined to only 20 %.
The top panel of Fig. 4 shows the percentage of modified loans
receiving either a
principal increase or decrease over the sample period. From
2008 until 2012, a loan
modification was far more likely to result in an increase in the
mortgage principal
balance than to result in a decrease in mortgage principal, as
fees and accrued interest
were often rolled into the modified principal amount. From
2009 through 2010,
approximately 80 % of modifications resulted in the mortgage
principal increasing,
thereafter declining until reaching less than 40 % in late 2012.
The share of modifica-
tions resulting in principal decreases rose steadily throughout
the sample period, and by
mid-2012 actually exceeded the share of loans with principal
increases. Since mid-
2012, the share of modified loans in our sample involving a
principal reduction has

consistently exceeded 40 %.
The bottom panel of Fig. 4 shows the percentage of modified
loans that yield either an
increase or decrease in the monthly payment amount.
Throughout the study period, the
majority of modifications have resulted in a reduction in
monthly borrower payments.
The share of borrowers whose monthly payment was lowered
has increased over time,
rising from around 50 % in January 2008 to just below 80 % in
October 2013.
2 This drop in modifications may be partially attributable to
mortgages qualifying for HAMP modification and
entering their three-month trial period, as HAMP modifications
are not counted until they are made permanent.
As found in the previous literature, the typical modification
received by borrowers
varies substantially over time, with the launch of the HAMP
program corresponding to
a change in the terms of modifications. Prior to the
implementation of HAMP in March
2009, 21 % of modifications resulted in a P&I increase and 73
% a P&I decrease, and
79 % resulted in an increase in the principal balance, while only
4 % resulted in a
reduction in principal. For those whose P&I was reduced, the
average reduction was
17 % of the pre-mod P&I. Post-HAMP, the share of
modifications that resulted in a P&I

increase fell to 11. While 69 % of modifications still resulted in
an increase in the
principal balance following the introduction of HAMP, the
share where the principal
Fig 1 Number of mortgage modifications per month for the
sample
Fig 2 Number of mortgage terminations per month by
termination type, for the sample
was reduced increased to 22 %. Moreover, among those
receiving a principal reduction,
the average amount went from $17,253 pre-HAMP to $65,633
post-HAMP. The share
of loans that involved a reduction in the interest rate increase
only slightly from pre- to
post-HAMP, going from 82 % to 87 % of modifications.
Table 1 presents descriptive statistics for the first modification
experienced by each
mortgage in our analysis sample. We further present summary
statistics separately for non-
HAMP and HAMP modifications. The subprime nature of our
sample is apparent from the
average characteristics at the time of origination: 50 % had low
or no documentation and
the average FICO score was 638. Nearly three-fourths of the
mortgages were originated in
either 2005 or 2006, and 62 % were refinancings. The majority
of first modifications were
performed from 2008 to 2010, with only 29 % occurring in 2011

through 2013. Almost
23 % of the first modifications in our sample are classified as
HAMP modifications.
On average, 15 % of first modifications resulted in a P&I
increase, 80 % resulted in a
P&I decrease, and the remaining 5 % experienced no change in
P&I. For those loans
where the P&I was reduced, the average decrease was $949. The
reduction in P&I was
largely driven by a reduction in the interest rate on the loan,
with an average rate
reduction of 3.9 percentage points. Nearly three-fourths of the
first modifications in our
sample result in an increase in principal balance, consistent
with Fig. 4 and the OCC
Mortgage Metrics reports. Almost 16 % of modifications, and
36 % of HAMP modi-
fications, resulted in a principal reduction, with an average
reduction of $76,000 and
$83,000, respectively, among those loans where the principal
was reduced. The average
principal balance post-modification was $265,000, and 45 % of
the sample had a junior
lien at the time of modification. Overall, the average CLTV
barely changed before and
after the modification, remaining at 115 %, meaning that even
after a modification the
average homeowner was underwater on his mortgage. Moreover,
almost 16 % of those
receiving a modification had a CLTV greater than 150 % after
their modification.
Fig 3 Kaplan-Meier survival graph for mortgage performance,
by year of modification Notes: Failure is
defined as the mortgage reaching 60 plus days delinquent post-

modification. Analysis time begins at the
month of modification.
Empirical Model
We begin our analysis of how the various types of loan
modifications affect subsequent
loan performance by using a simple probit model to estimate the
probability that a loan
reaches 60 plus days delinquent within 12 months following a
loan modification. Our
probit model takes the form:
Pr Yizs ¼ 1ð Þ ¼ f α þ βX i þ γModi þ δCLTVi þ π HPIz þ
θStates þ εisð Þð1Þ
where Y is an indicator for whether or not the loan becomes 60
plus days delinquent
within 12 months and X is a vector of loan characteristics from
origination, including
an indicator for whether the loan was used for a home purchase,
categories for the
Fig 4 Share of sample loan modifications where borrower has
their principal increased/decreased (top) and
payment increased/decreased (bottom), by date of modification
T
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Subprime …
CHAPTER 14 Ten-Plus “Must-Knows” About Foreclosure
221
Chapter 14

IN THIS CHAPTER
» Opening your eyes to your situation
and options
» Knowing the best sources for
objective information and advice
» Understanding the realities of
foreclosure investing
Ten-Plus “Must-Knows”
About Foreclosure
Lenders have a contractual right to take over ownership of a
property (fore-close) if the borrower can’t make required
payments. Even in the best of times, some foreclosures occur,
but the number of foreclosures accelerates
during soft real estate markets or because of risky loans. From
2006 through 2010,
the number of foreclosures increased tremendously as real
estate prices declined
and numerous borrowers found themselves saddled with high-
cost mortgages.
In Las Vegas, home prices plunged by more than 60 percent
from early 2006 to
2011 — the greatest percentage decline in home prices of the 50
largest metro-
politan areas in the nation. With that incredible decrease in
home value, it’s easy
to understand the record number of home foreclosures because
many homeown-
ers who hadn’t owned for long found that they were living in
homes worth less

than the amount they owed on their mortgage.
Having the home in which you’re living end up in foreclosure is
a nasty, unpleas-
ant experience for most folks. In most instances, homeowners
become overex-
tended with their bills or lose some or all of their income(s) and
simply can’t
afford to muster their mortgage payment. Meanwhile, some
homeowners whose
properties end up in foreclosure aren’t in dire financial straits.
Instead, they
choose to walk away from a property that dropped in value and
is worth less than
the outstanding mortgage amount. As we note in Chapter 3,
either course of action
Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage
management for dummies. Retrieved from
http://ebookcentral.proquest.com
Created from apus on 2020-05-21 07:43:19.
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222 PART 5 The Part of Tens
will probably have severe repercussions on your credit score
and ability to borrow
in the future.
In other cases, overextended investors walk away from multiple
properties that
declined in value. (This was the major factor in the Las Vegas
market crash with
more than 40,000 homes being purchased by investors seeking
rapid appreciation
only to see the market plummet.) Instead of continuing to make
payments on
property that’s worth less than they paid for it, some investors
cut and run.
Although we feel sorry for some investors caught up in the pre-
2007 frenzy of
speculative buying of rental homes, this chapter is really geared
to homeowners
who may be in danger of losing their home to foreclosure. Some
tips also apply to
folks attracted to investment opportunities on property in
foreclosure. While the
number of foreclosures is significantly lower throughout the
country since 2010,
some homeowners are going to be unable to meet their loan
obligations and a
short sale or foreclosure is in their future.

Deal with Reality
Just as a lot of folks do when consumer debt (on credit cards
and auto loans) gets
overwhelming, many people falling behind on their mortgage
payments want to
run and hide. Mortgage statements and bills go unopened and
calls from the
lender go unanswered and unreturned. Some folks with
excessive credit card bills
do the same thing. Sticking your head in the sand when it comes
to mortgage pay-
ments does you no good. You’ll lose your home if you don’t
take action now.
The sooner you contact your lender and level with them about
your problems, the
better. Explain your financial situation, debt burdens, and what
you can afford to
pay monthly on your mortgage. That said, don’t allow any
person at a financial
institution to berate or verbally abuse you. Find a way to do the
best you can. Avail
yourself of financial counseling and try negotiating better
mortgage terms (we
cover both of these topics later in this chapter).
Heed this sage advice from veteran mortgage professional Chris
Bruno:
Whether one is in foreclosure, contemplating foreclosure, or
buying a foreclosed
property, getting competent professional help early in the
process is extremely
important for a more favorable outcome. I have seen many
people come to me at
the 11th hour having never responded to the foreclosure

documents from the
lender. Needless to say, it’s very stressful, and the delay only
limited their options
and made the whole process much more expensive.
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223
Review Your Spending and Debts
The first step in taking the bull by the horns when you’re
drowning in mortgage
debt is to zoom out to 30,000 feet and look at your entire

financial situation.
Tabulate all your debts and spending. Identify expenses you can
most easily
reduce. Although your housing expenses are a significant
portion of your total
expenditures, they’re probably less than the majority of your
typical monthly
expenses.
Complete the worksheets in Chapter 1 of this book to help you
identify ways to
reduce your spending and debts, including consumer debts. For
detailed assistance
with analyzing your spending and debts, see the latest edition of
Eric’s Personal
Finance For Dummies (Wiley).
Beware of Foreclosure Scams
Perhaps the only thing worse in the real estate world than
falling behind on your
payments and entering the foreclosure process is falling prey to
the circling vul-
tures trying to take advantage of your hardship and lack of
financial knowledge.
In the late 2000s, increasing numbers of scoundrels and
hucksters made claims
that they could stop foreclosure no matter what the situation.
After charging fees
of $1,000-plus and doing little if anything, in the worst cases,
unsuspecting
homeowners sign over ownership of their property (and begin
making rental pay-
ments) to the con artists!
Only make use of counselors approved by the U.S. Department
of Housing and

Urban Development (HUD). We explain how to find these good
guys and gals in
the “Make Use of Objective Counseling” section, later in this
chapter.
Consider Tapping Other Assets
As long as you’re not going to declare bankruptcy (check out
the “Understand
Bankruptcy” section, later in this chapter), you should make a
list of assets you
might tap to help meet your mortgage payments. These assets
may include bank
saving accounts, mutual funds, stocks, bonds, cash value life
insurance policy
balances, 401(k) plans, unneeded personal property you could
sell, and so on. Be
sure you fully understand all tax consequences before
liquidating any investments
to help make mortgage payments.
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In the unlikely event that you’ll file for bankruptcy protection,
don’t use the pro-
ceeds from your other assets for home payments. The reason:
You may be able to
protect and keep those other assets if you file for bankruptcy.
Make Use of Objective Counseling
A number of nonprofit organizations offer low-cost or free
counseling to home-
owners in danger of losing their homes to foreclosure. The best
way to find those
agencies is to contact the U.S. Department of Housing and
Urban Development
(HUD) “housing counseling agency locator” at 800-569-4287.
Select the option
for mortgage delinquency counseling and then enter your five-
digit zip code to
obtain the name and phone number of approved counseling
agencies near you.
Alternatively, you can visit the HUD website (www.hud.gov)
and then click the
HUD Approved Housing Counseling Agencies link under the
Resources tab on the
home page. In addition to helpful articles, the website enables
you to find multiple

area counseling agencies.
Negotiate with Your Lender
Smart lenders don’t want your property to end up in foreclosure,
especially if the
mortgage balance exceeds what the lender could reasonably
expect to net (after
selling and other expenses) from selling the property. If your
current mortgage
terms appear to doom you to foreclosure, contact your lender
immediately and
plead your case to have your loan modified. Sure, the
modification will hurt your
credit, but it’s likely already damaged if you’re facing
foreclosure. Also, remember
that the modified (lower) payments may help you keep your
home while you
rebuild your credit.
You also may want to see whether you qualify under the
specific and limited con-
ditions for borrowers seeking to restructure or refinance homes
with low equity,
no equity, or negative equity (the home is worth less than the
loan). You may qual-
ify for a government program, such as the Home Affordable
Refinance Program
(HARP), that allows homeowners to refinance their loan. Note
that these pro-
grams are constantly evolving and the terms may change
periodically, so you need
to continually see whether you qualify. For example, the HARP
program started in
2009, but by late 2011, it was modified and referred to as HARP
2.0. Then, Presi-
dent Obama proposed further changes and a revised HARP 3.0,

but Congress never
approved that proposed program. Our point here is that you’ll
hear a lot of hype
about government programs that will solve all your problems.
Be cautious and
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http://www.hud.gov
225
skeptical, but seek the advice of an objective counselor (as we
suggest earlier) as

there may genuinely be some help out there for you.
For ideas on how to customize your current loan terms to help
you afford your
home, consult with a local HUD-approved counselor, as
discussed in the previous
section. Most lenders can make your current loan more
attractive through a modi-
fication (by reducing the interest rate or changing the rate to a
fixed-rate from an
adjustable, for example) if doing so will keep you out of
foreclosure and keep you
making monthly payments.
Understand Short Sales
If your home is worth less than the amount you owe on the
mortgage(s), it is said
to be underwater or upside down. You may think you can’t sell
the home because
you won’t clear enough money to satisfy the lender(s), real
estate agents, and
closing costs, and therefore foreclosure is the only option. But,
thankfully, you can
opt for a short sale.
A short sale means you can sell your house (avoiding
foreclosure) and pay off the
lender(s) for less than what they are owed. The lender(s) is
getting a payoff that
is “short” of what it is owed — hence the name short sale.
The lender has to approve a short sale, but it happens regularly.
Why would the
lender do this? Because it’s easier and less expensive for them
than processing a
full foreclosure. Why would you do this? Because, compared

with foreclosure, it is
better for your credit (see the “Consider the Future Impact to
Your Credit Report”
section later in this chapter.)
Seek Legal and Tax Advice
If you’re confronted with or considering foreclosure, talk to an
experienced real
estate lawyer and tax advisor before you agree to a foreclosure
or short sale (see
the preceding section). In fact, seek their advice before you
even start skipping
mortgage payments. There are state and federal laws involved,
and you need
to know
» If the lender loses money on the foreclosure or short sale, can
they come after
you for the difference (called a deficiency judgment)? This
varies from state to
state and is a question for the attorney.
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» If the lender loses money on the foreclosure or short sale, can
the IRS tax you
on the amount the lender loses? It may sound crazy, but the IRS
may consider
the loss that the lender suffers (which they write off) as a
taxable benefit
to you. It is called debt relief. This may or may not apply at the
time you’re
reading this, so find out by asking your tax advisor.
Understand Bankruptcy
To make the best decision you can, consider a range of options.
When mortgage
and other debt prove overwhelming, bankruptcy is one option
you should explore
and better understand.
Bankruptcy is usually used to eliminate miscellaneous
unsecured revolving debts
(like credit cards) so you have more money with which to make
mortgage pay-
ments and keep the home.
The biggest challenge with considering bankruptcy is finding

unbiased sources of
information and advice. Some supposed counselors won’t
discuss or recommend
it to you; others, such as bankruptcy attorneys, often have a bias
at the other end
of the spectrum. Truly independent or the HUD-approved
counselors recom-
mended earlier in this chapter are a good starting point.
Be careful if the financial counselor or advisor is affiliated with
a “credit repair”
service or a “bankruptcy mill” because his solutions are almost
guaranteed to be
the products offered by his own or an affiliated company.
Consider the Future Impact
to Your Credit Report
Folks who make little if any effort to find a solution to their
housing debt woes and
who choose to walk away from a property that’s proven to be a
loss from an
investment perspective often suffer consequences down the
road. Before taking
this step, think for a moment about the long-term consequences.
If you were a
lender, how motivated would you be to lend money to someone
who threw in the
towel without working to find a solution? And if you did lend
such a person money,
would you give him or her the best loan rates and terms that you
give folks with
excellent credit histories?

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227
Roll up your sleeves and work with your lender and talk with
counselors to find a
solution that will enable you to keep your property. Remember
that the lender is
best served by having the property occupied by an owner who
will continue to prop-
erly maintain the home. Use that argument to your advantage
because the lender
will very likely suffer added costs and expenses (such as
insurance) if the home is
unoccupied for an extended period of time. Many municipalities

are well aware that
these vacant homes aren’t being properly maintained and are an
invitation to squat-
ters and crime. They have passed new laws allowing for
significant fines and penal-
ties if these homes become a blight on the neighborhood. Your
credit report may still
suffer damage, but you can minimize the fallout both now and
in the future.
Two of the biggest questions after a foreclosure, short sale, or
bankruptcy are
» How long before my credit recovers?
» How long before I can get a mortgage again?
Regarding the first question, most lenders don’t want you to
know that it only
takes two to three years (of effort) to rebuild your credit scores
to a level worthy
of a new home loan. As far as credit cards, auto loans, and other
loans? You can get
those very quickly after problems on your credit report.
As for getting a loan to buy another house, different types of
loans require differ-
ent waiting periods before you’re eligible to apply for a new
mortgage. But the
waiting periods are often much less than most people expect.
Check out Table 14-1
to understand the various waiting periods.
TABLE 14-1 Required Wait Times before Applying for a
New Mortgage
Program Foreclosure Bankruptcy Short Sale

Conventional 7 years from
completion
Chapter 7: 4 years from
discharge/dismissal
Chapter 13: 2 years
from discharge/4 years
from dismissal
4 years from completion
FHA 3 years from
completion
date
discharge
Chapter 13: 1 year of
payment period must
have elapsed with
satisfactory payment
performance and
permission
from the court
No waiting period if
* Borrower made all mortgage/installment
payments within the month due for 12 months
before the short sale, and
* Made all mortgage/installment payments
within the month due for the 12-month period
before the date of the loan application for the
new mortgage
3 years of waiting from completion date
required if borrower was in default at time of sale

(continued)
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Understand the Realities of Investing
in Foreclosed Property
You may be considering purchasing a property that’s in some
stage of foreclosure.
Although earning handsome returns on investing in foreclosed
property is an
option, make absolutely sure that you know what you’re getting

into. Doing so
isn’t as easy as some real estate investing cheerleaders may lead
you to think.
Often, property that ends up in foreclosure has physical
problems. So if you rush
to buy without thoroughly inspecting a property inside and out,
you could end up
with more trouble and costs than you expected.
Although a proven way for savvy real estate entrepreneurs to
build their empire,
investing in foreclosures is for sophisticated, experienced
investors only. Finding
and buying a good property at an attractive price (including the
realistic or actual
costs for repairs, renovations, upgrades, plus holding and
marketing costs) takes
a lot of homework and patience. See the latest edition of our
book Real Estate
Investing For Dummies (Wiley) for more details.
Program Foreclosure Bankruptcy Short Sale
VA 2 years from
foreclosure
date
discharge
payment period must
have elapsed with
performance and
permission

from the court
2 years from completion
USDA 3 years from
completion
discharge
payment period must
have elapsed with
performance and
permission
from the court
No waiting period if
* Borrower made all mortgage/installment
payments within the month due for 12 months
before the short sale, and
* Made all mortgage/installment payments
within the month due for the 12-month period
before the date of the loan application for the
new mortgage
TABLE 14-1 (continued)
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Real Estate Finance in the New Economy, First Edition. Piyush
Tiwari and Michael White.
© 2014 John Wiley & Sons, Ltd. Published 2014 by John Wiley
& Sons, Ltd.
Introduction
The purpose of this chapter is to discuss how funds flow to
property. Who
are the investors? Who are the intermediaries, and what
mechanisms do
they use to channelise funds from investors into property?
These mechanisms have evolved within the financial systems as
a way to
allocate risk associated with financing property to those who
can assume
them for returns in commensuration with the risk. Figure 3.1
shows the

flow of funds to property, though it may be flagged here that
property is only
a small component of overall investment space. In a simplified
scenario,
domestic or foreign economic agents such as households, firms
and
government with surplus financial resources in present time (in
terms of
savings) can invest in those domestic or foreign opportunities
(including
property) that require these resources to carry out economic
activities and
earn risk-adjusted return on their investment in the future.
These economic
agents could invest directly in these opportunities (such as
housing and
office buildings for own use purposes) or channelise their
savings into
various opportunities through primary capital markets or
through secondary
financial sectors such as banks, pension funds and insurance
companies for
investment in income-generating properties.
The purpose of the financial system and financing mechanisms
is to
reduce impediments and create opportunities for the flow of
funds from
Financial Systems, Flow of Funds
to Property and Innovations
3
White, M., & Tiwari, P. (2014). Real estate finance in the new
economy : Real estate finance in the new economy. Retrieved

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64 Real Estate Finance in the New Economy
investors to investment opportunities. Property has its own
specific charac-
teristics. An objective of this chapter is to discuss how the
financial system
(and financing mechanisms) have evolved in response to the
characteristics
of property asset class and to what extent various mechanisms
have been
able to address the specificities of property.
Bank-based and market-based financial systems

The mechanisms for financing assets that develop in a country
depend on
the regulatory and institutional environment within which
financial system
operates. There are two types of systems: (i) market-based and
(ii) bank-
based financing system. This does not mean that the
mechanisms that
would evolve in a country would conform only to one system or
the other.
It means that one of these two systems would have predominant
influence
in the evolution of financial mechanisms through which
resources would be
mobilised and investments will take place. Mechanisms
conforming to the
other system will exist in a meaningful but to a lesser extent.
The differences
between the two financial systems arise from the way savings
are mobilised;
investments are identified, made and monitored; and risks are
managed.
The other difference is from the legal perspective. In a bank-
based econ-
omy (Germany and Japan), laws governing financial systems are
enacted and
implemented by the government. These are based mainly on the
civil law
rather than the common law. Market-based financial systems are
found
most often in countries (the United States and the United
Kingdom) that
employ a common law legal system. Common law is less
defined and can
vary from case to case. Instead of government enacting and

implementing
the laws governing financial system, common law-based
regulation is
implemented through courts.
Primary financial
sectors
Households
Firms
Government
Secondary financial
sectors such as banks,
pension funds,
insurance companies
Primary securities
market
Property
Core
Residential
Commercial
Industrial
Non-core
Hotels
Warehousing
Healthcare
Others
Savings Intermediaries Investment

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Financial Systems, Flow of Funds to Property and Innovations
65
In a market-based system, primary securities markets play the
dominant
role. Banks in such a system are less dependent upon interest
from loans and
gain much of their revenue through fee-based services. In
contrast, in a
bank-based financial system, banks play a major role in

channelising
financial flows to investment opportunities through loans.
Interests earned
on loans form the major part of their income. In a market-based
system, a
number of non-banking sources for investments exist.
Investments by
private systems and government often compete with those of the
bank.
In a pure bank-based system, banks mobilise capital, identify
good
projects, monitor managers and manage risk. The risk
management, infor-
mation dissemination, corporate control and capital allocation
are all left to
market forces in a market-based system. In a well-developed
market, any
information that is available is revealed quickly in the public
markets,
which reduces the transaction costs. Some view this as a
shortcoming of
market-based system as the incentives for individual investors
to acquire
information decline (Stiglitz, 1985). Standardisation becomes
the key, and
in this context, there may not be enough incentives to identify
innovative
investment opportunities. In a bank-based system, banks form
long-run
relationships with borrowers (firms), information is private, and
investments
are custom made.
There are other concerns which proponents of the bank-based
system

identify with the market-based system. Liquid markets create a
myopic
investor climate where investors have fewer incentives to exert
rigorous
corporate control (Bhide, 1993). However, powerful banks with
close rela-
tionships with firms can more effectively obtain information
about firms
and manage their loans/investments to these firms than markets.
The view
against bank-based system is that powerful banks can stifle
innovation by
extracting informational rents and protecting established firms
with close
bank–firm ties from competition (Rajan, 1992). Moreover, in
the absence of
appropriate regulatory restrictions, they may collude with firm
managers
against other creditors and impede efficient corporate
governance (Wenger
and Kaserer, 1998). Market-based systems will reduce these
inherent
inefficiencies associated with bank-based systems.
Levine (2001) minimises the importance of the bank-based
versus market-
based debate. He argues that financial arrangements comprising
contracts,
markets and intermediaries arise to ameliorate market
imperfections
and provide financial services. Financial arrangements emerge
to assess
potential investment opportunities, exert corporate control,
facilitate risk
management, enhance liquidity and ease savings mobilisation
(Levine

2001). Finance is a set of contracts. These contracts are defined
and made
effective by legal rights and enforcement mechanisms. From
this perspec-
tive, a well-functioning legal system facilitates the operation of
both
market- and bank-based systems. While focusing on legal
systems, it is not
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inconsistent with banks or markets playing an important role in

the econ-
omy. With financial innovations and their export that has
accompanied
globalisation, the coexistence of bank-based and market-based
system has
further got reinforced.
The mechanisms that develop for financing or investment in an
asset take
root in the efficiency of the market. Though a detailed
discussion on market
efficiency is out of the scope of the present book, it is important
to mention
the key elements of an efficient market. According to Fama
(1970), an
efficient financial market is one in which security prices always
fully reflect
the available information. This hypothesis rests on three
arguments which
progressively rely on weaker assumptions. First, investors are
assumed to be
rational and hence value securities rationally for its
fundamental value. Any
new information is quickly factored in the price. As a result, all
available
information is captured in the price. Second, to the extent that
some
investors are not rational, their trades are random and therefore
cancel each
other out without affecting prices. Third, to the extent that
investors are
irrational in similar ways, they are met in the market by
arbitrageurs who
eliminate their influence on prices (Shleifer, 2000).
Given the aforementioned definition of the efficient markets,

property
markets are not efficient. Trading on this asset is infrequent
(one property
does only few times during its life), transactions take time to
materialise,
and the transaction costs are high. Information on transaction
price, rental
and lease terms are highly private, and hence, third party
valuation plays a
key role in guiding buyers’ and sellers’ decisions. Participants
in the market
are few and most deals are negotiated deals. Property being
local in nature,
laws and local planning regulations play a very important role
in determin-
ing the value of the property. Importance to understand these
local norms
for the participants makes the market thin.
The role of financial system is to evolve mechanisms that can
take into
account characteristics of property asset class and create
opportunities for
investors to invest in this asset class. Hence, the question to ask
in case of
property investment is what bank-based and market-based
mechanisms
have evolved for channelising savings from the real economy
for financing
of property development and investment in property as an asset
class. As
would be discussed later, to a large extent, property is financed
through debt
instruments, mainly debt from commercial banks. In the last two
to two
and half decades, innovations in financial mechanisms have

taken place to
enhance the role of the market-based financing in the sector.
Figure 3.2
presents the flow of funds to the property.
Though various mechanisms would be discussed in detail in the
next sec-
tion, it is important to observe here that both bank-based and
market-based
systems are operative in any economy. The extent to which an
economy is
able to use these mechanisms depends on the depth and maturity
of its
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67
banking system and primary markets as well as regulatory
environment
within which intermediaries and investors operate. It is also
important to
observe from the aforementioned figure that in a fully
developed system,
bank-based and market-based systems interact and innovate to
provide
mechanisms to fund property assets and new developments.
Property investors and intermediaries
There are four major types of investors: institutional investors,
unregulated
investors, households and proprietors and corporations. Motives
for invest-
ment in property differ for different investors. Even for
investors in the same
type, as described earlier, motives could differ. There are those
who invest
in property for financial reasons, that is, they are looking for a
return on
their investment, and there are those whose intention is to
invest in prop-
erty for occupation purposes. Figure 3.3 presents the further
breakdown of
investors in each type.
Following are the two distinct and mutually exclusive
investment objec-
tives (Geltner et al. 2007): (i) the growth (savings) objective,

which implies a
relatively long time horizon with no immediate or likely
intermediate need
to use the cash being invested, and (ii) the income (current cash
flow) objec-
tive, which implies that the investor has short-term and ongoing
cash
requirements from his investments. There are other
considerations that
affect investors in the property markets. Risk is an important
factor in the
Households
Firms
Government
Primary securities
market
Primary sectors
Secondary sectors
Commercial banks
Mutual funds
Savings institutions
Insurance companies
Pension funds
Government
Equity
instruments
Debt
instruments

Equity
Equity
Property asset
market
Existing properties
Office
Retail
Commercial
Residential
Industrial
Hotels
Warehouses
Others
New property
Development
Loans
Figure 3.2 Typical flow of funds to property.
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decision for investment in real estate. This arises from the
concern that
future investment performance may vary over time in a manner
that is not
entirely predictable at the time of investment. Time horizon, for
which
investor wants to stay invested, itself is a factor. Liquidity, that
is, the ease
with which the asset could be bought or sold at full value
without much
affecting the price of the asset, is another consideration.
Investor expertise
and management burden that investment in property pose
determines the
ability and desire of investor to invest in property. Minimum
size of invest-
ment required also determines the willingness and ability of an
investor to
invest in property.
Considering that investor space is heterogeneous, an elaborate

invest-
ment system with a number of intermediaries and mechanisms
through
which funds flow to property has emerged. While the
investment mecha-
nisms will be discussed in the next section, it is interesting to
see the range
of intermediaries that operates in the property investment
markets
(Figure 3.4). These intermediaries are the conduits between
investors and
investment, and the investment mechanisms are the products
through
which investment is made.
Investment mechanisms
Figure 3.5 presents a highly simplified version of real estate
investment sys-
tem with main mechanisms depicted there. The figure does not
cover
investment mechanisms exhaustively, as given the range of
possibilities
that exists, it will be highly ambitious to attempt here.
Institutional
Banks
Savings and loan
corporations
Pension funds
Insurance
companies
Finance and
securities firms
REITs
Personal trust

Government
Unregulated
investors
Religious
organizations
Private and
personal trusts
Non-profit
organizations
Households,
Proprietors
Persons
Families
Limited
partnerships
Sole
proprietorship
Corporations
Publicly traded
companies
Private
companies
Property investment
Figure 3.3 Commercial real estate investors.

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69
Private investment mechanisms
Debt The private investment mechanisms (Figure 3.5) for debt
and equity
are the traditional ways of financing property during its
development phase
and later when it is an income-generating asset. These two
together form
the major share of investment flow in property. The finance for
development
is short term and takes the form of a loan or an overdraft
facility. Since
during the time the construction is on, there is no cash flow to

repay the
debt, the repayment is a bullet payment of accumulated interest
and
principal at the time of when the project development ends. In
the United
Mutual funds,
real estate funds
Commercial banks,
specialized mortgage
institutions
Securities dealers
REIT companies,
listed property
funds
Asset backed
securities
Savings institutions
Insurance
companies, pension
companies
Private equity,
venture capitalists
Governments,
sovereign funds

Figure 3.4 Intermediaries in the property investment market.
Property in physical form (e.g. offices, retail, industrial, hotels)
Limited partnerships/
property funds/private
REITs/sovereign wealth
funds: own equity in properties:
LP shares privately held and
privately traded
Direct
investors
High net worth
individuals,
developers,
individuals
Bank loans for
development/
commercial mortgages/
mortgage debentures:
Senior (debt) claims – privately
held and traded
REITs
Issue publicly traded shares,
may own underlying assets,
LP units by UPREITs,
mortgages, CMBS
CMBS
Publicly traded securities
based on a pool of
mortgages

Initial listing, rights issue,
stock split
Property
derivatives
Private
investment
mechanisms
Traditional
Public
investment
mechanisms
Innovative
Public
investment
mechanisms
Bonds/commercial
papers issued by
property companies
Figure 3.5 Investment mechanisms.
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Kingdom, 30 years ago, the term of the loan coincided with the
length of the
construction period, but later, lenders have started to look at the
loan period
up to the first rent review (usually after 5 years of completion
of project) as
the expectation is that the property would have stabilised and a
better value
for refinancing or sale could be achieved for owners at this
stage. The loan
for development is provided by one bank or a syndicate of
banks.
In the United Kingdom, which is a market-based system, during
the prop-
erty boom period of 1980s, property companies were able to
assemble a
panel of banks with the help of an underwriter who would
compete on inter-
est rates for an opportunity to lend. Property companies had the

opportunity
to raise debt finance on very competitive rates from different
lenders up to
an agreed limit (Lizieri et al., 2001). However, during the
1990s, when the
property downturn began, the lending market became very
conservative in
their lending (Lizieri et al., 2001). These loans from banks are
secured on
company assets or development project assets and/or other fixed
and float-
ing charges that borrowers could provide. During 1970s, the
interest rates
used to be fixed but the interest rate risk for lenders was too
high to assume,
and hence, these were replaced by floating rates based on
London Interbank
Borrowing Rate (LIBOR) or some other floating rates plus a
margin that
banks charged to assume risks associated with the development
and the bor-
rower (Lizieri et al., 2001). In that sense from the risk
perspective, each
development project and borrower is different and the interest
rates charged
to them is different. This is where complication arises, and the
importance
of a bank-based system assumes importance as banks with
relation with
borrowers are supposedly able to assess their risks better.
Commercial mortgages represent the senior claim on any cash
flow (called
senior debt) that is generated by stabilised property (i.e.
development is over
and property has been let out and is receiving cash flows in the

form of rent and
other incomes) and provide lenders/investors (typically banks or
insurance
companies) with fixed tenured, contractually fixed cash flow
streams.
Traditionally, the mortgage is a long-term loan (typically 15–25
years tenure)
kept as a ‘whole loan’ on the balance sheet of investors to
maturity, meaning
that it is not broken into small homogeneous shares or units
such as corporate
bonds that are traded on stock exchanges. However, over the
last three–four
decades, a number of variants of mortgages have also emerged
first in response
to the low loan-to-value (LTV) ratio for property lending and
the low valuation
accorded to property for lending purposes (the practice is that
the property is
valued on the basis of ‘vacant possession’) and the second the
comfort that
banks have gained with property investment. As per the Basel
Accord,
commercial property lending carries full risk weighting, and
hence, other types
of mortgage instruments have emerged that combine the
balance-sheet and
off-balance-sheet lending. These mortgage instruments, more
prevalent in the
United States, take the form of profit sharing mortgages such as
participating

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71
or convertible mortgages. These mortgages are usually more
prevalent
during weaker markets to unlock more capital for borrowers.
Participation loans, also called equity participation loans, are a
combina-
tion of loan and equity that a lender take in a project. Though it
is called
equity participation, but the lender does not acquire ownership
interest in
the project. Lender’s interest is only limited to the participation
in the cash
flows, and this participation kicks in only after property has

starting gener-
ating cash flows (Brueggeman and Fisher, 2008). Lenders
receive a percent-
age of potential gross income or net operating income or cash
flow after
regular debt service, as may be agreed for their participation. In
return for
receiving participation, lenders charge lower interest rates on
their loans.
Participations are highly negotiable between lenders and
borrowers, and
there is no standard way of structuring them (Brueggeman and
Fisher, 2008).
A convertible mortgage gives lenders an option to purchase full
or partial
interest in the property at the end of some specified time period.
This pur-
chase option allows lenders to convert their mortgage to equity
ownership.
Lenders may view this as a combination of mortgage loan and
purchase of a
call option, which gives them an option to acquire full or partial
equity
interest for a predetermined price on the option’s expiration
date (Brueggeman
and Fisher, 2008). Here again, lenders accept a lower interest
rate in exchange
for the conversion option.
Equity The source of equity capital for property development
and asset
investment is provided by two types of investors: those who
want to actively
involve in management and operation of underlying property
asset such as

property companies (e.g. developers, institutions and high net
worth
individuals) and others who want to invest in property to
diversify their
investment portfolios but do not want hands on involvement. A
number of
mechanisms have emerged to meet the needs of these investors
with the
needs for equity for property investment. Examples of these
passive equity
investment mechanisms are units in real estate equity funds
such as real
estate limited partnerships (RELPs), commingled real estate
funds (CREFs)
and private Real Estate Investment Trusts (REITs – whose units
are not
publicly traded); companies; and mutual funds, though passive
equity
investment mechanisms provide investors with an ownership
interests in
the underlying asset but give limited governance authority over
the assets
and are not traded in the liquid public exchanges.
The greater part of the pan-European market is concentrated in
non-
REIT form including limited partnerships, companies and
mutual fund
vehicles. REITs are quite popular in the United States.
Partnerships are
very popular as they allow even the most complex arrangements
to be
structured through a partnership agreement rather than under a
company
law (Brown, 2003).

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The fund sponsor for a real estate equity fund is usually an
affiliate of a
developer or professional investment organisation. The
investors generally
provide most, if not all, of the investment. The structure of the
fund has at
least one general partner and any number of limited partners.
The general
partners, who are the fund sponsors, provide ‘sweat equity’ and
have the

responsibility for management of partnership assets. They may
have a small
equity contribution. Limited partners are very restricted in
management of
a joint venture, and their personal liability is limited. However,
limited
partners insist on having approval rights over a variety of major
decisions
ranging from refinancings, sales, leases and budgets to
insurance, service
contracts and litigations (Larkin et al., 2003). Some funds also
have invest-
ment committees that include limited partners with role to
provide advice
to general partners on issues such as conflicts of interest and
valuation of
fund assets (Larkin et al., 2003).
The legal form of the fund is largely determined by the tax
efficiency of
the form chosen and familiarity of the fund structure to
prospective inves-
tors (Larkin et al., 2003). These funds though structured to be
tax efficient,
are not generally tax shelters, in that they do not attempt to
accelerate tax
deductions to shelter unrelated incomes (Larkin et al., 2003).
The investment
objectives of real estate private equity funds can be either
capital apprecia-
tion or income. The investment cycle varies depending on the
strategy of
the fund, target assets and needs of the investors. For example,
while real
estate opportunity funds typically have 2–3-year investment
period, 1–2-year

monitoring period, a fund organised for acquisition of a typical
asset may
just have duration of 2–3 years. These funds will typically
leverage each real
estate investment by borrowing money to finance a portion of
the purchase
price and securing the debt by granting direct lien on the
property assets
owned by the fund.
RELPs were popular in the United States prior to 1986 due to
tax advan-
tages associated with them. Passive investors could offset their
other
incomes with property (tax) loss from investment in limited
partnerships.
With these advantages gone with the Tax Reform Act of 1986,
their popularity
has declined. Moreover, many of the funds in the United States
were organ-
ised under the laws of the State of Delaware or tax heavens like
Cayman
Islands. In Europe, though, there is no one jurisdiction of
choice for real
estate private equity funds, and the choice of jurisdiction
depends on the
nature of investors, tax residency of the investor and the likely
jurisdiction
of the property assets (Larkin et al., 2003).
Another important source of equity capital, in recent times, is
the
Sovereign Wealth Funds (SWFs). These funds are wholly owned
government
entities that invest nation’s surplus wealth in broad array of
investments

overseas. A number of governments, such as Abu Dhabi, Qatar,
Kuwait,
Norway, Singapore, Australia and China, have floated these
funds. SWFs are
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73
commonly active investors or passive asset managers. Though
the asset
holding of SWFs is not easily available, their property holdings
are about

5–10%. A number of SWFs have taken controlling positions in
large property
assets (Langford et al., 2009).
Public investment mechanisms
Property companies and developers access markets by issuing
bonds and
commercial paper for debt and through initial public offer (IPO)
or rights
issue or stock split for equity funding. The problem, however, is
that given
the risk perceived by the market (arising from …

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