Chapter 6: Underwriting & Financing Residential Properties

1. Chapter 6: Underwriting & Financing Residential Properties • Underwriting = evaluating the profitability & risk of a loan. • Tools of the loan officer • Loan application • Appraisal Borrowers may need MortgageInsurance, with < 20% down.

2. Types of Mortgage Insurance • Conventional (Ex. United Guaranty) • Government • FHA {Federal Housing Admin.} • VA {Veterans Admin.} a gov’t guarantee program. Types of Mortgage Loans: - Conventional - Conventional Insured - FHA - VA

3. Loan Qualification Example: Sales Price = $125,000, Loan = $100,000, interest = 8.5% for 30 years • Lender Calculates Monthly Payments (PITI): • $768.91 (principal & interest) • 116.80 (tax escrow) • 54.00 (insurance escrow) • $939.71 PITI (total monthly payment) • Borrowers gross monthly income (GMI) calculated by dividing annual household income (from all sources) by 12: $55,000 / 12 = $4,583.33

4. Calculate Ratio 1: ratio of PITI to GMI $939.71 / $4,583.33 = 20.5% Ratio 1 must be less than 28% • Determine borrower’s other long-term debt: $340.00 car payment 75.00 credit card payments 100.00 child support payment $515.00 total monthly debt • Add monthly debt to PITI = Monthly PMTs $515.00 + $939.71 = $1,454.71

5. Calculate Ratio 2: Divide total monthly payment by GMI $1,454.71 / $4,583.33 = 31.7% This ratio must be less than 36% • Ratio 1 & Ratio 2 are the 28/36 rule. This is a general rule used for conventional loans. • FHA & VA often have more lenient standards • Conventional standards can be more lenient, but may require a higher rate.

6. The next step is a credit check of the borrower. Lenders will usually consult a credit bureau or rating agency to get a credit score which represents the probability of default. Individual lenders pick their cut off point. Some will offer high risk borrowers loans but only at higher rates. Credit scoring is very common today. • Example: EQUIFAX produces a std. FICO score ranging from 300 to 850. • See, CreditScoring.com • Credit Scores are very important today. Paying bills on time each month is most important.

7. Real Estate Appraisal Appraisal = an estimate of value. Appraisal Regulation • FIRREA 1989 established a system of appraisal regulation • Key Agencies • Fed. Fin. Institutions Examination Council (FFIEC) consists of the Fed, FDIC, Comptroller of the Currency, Office of Thrift Supervision, and the Nat’l Credit Union Admin. It determines what real estate appraisals need to be done.

8. Appraisal Subcommittee, consists of one member of each of the 5 agencies above + one member from HUD. It monitors the Appraisal Foundation. • Appraisal Foundation is formed by the Appraisal Institute (the major professional organization in the appraisal field). The Foundation has 2 independent boards: • Appraiser Qualifications Board, set min. qualifications. • Appraisal Standards Board, sets min. standards of practice. • State Appraiser Regulatory Agencies NC Appraisal Board, operates a voluntary licensing and certification program: State licensed 1) residential appraiser, 2) Certified Appraiser, & 3) Certified General Appraiser

9. Required Appraisals: Loans greater than 250K must be performed by a state-licensed appraiser. • Appraisals by Real Estate Agents – Comparative Market Analysis (CMA) is not considered an appraisal. • Tax Appraisals. County assessors must be certified by the NC Dept. of Revenue. They often employ “mass appraisal techniques.”

10. What is Value? Value in 1) exchange or 2) value in use. In a competitive mkt., price = cost. Market Value = “the most probable price which a property should bring in a competitive and open market . . .” Factors that affect value: • Social trends • Economic conditions • Government regulations • Environmental conditions

11. Basic Economic & Appraisal Principles • Supply/demand • Anticipation • Substitution • Conformity • Contribution, or marginal benefit • Competition, profits attract competition • Change, neighborhood life cycle • Highest and best use: “the reasonably probable and legal use which is physically possible, appropriately supported, financially feasible and results in the highest value.

12. The Valuation Process • Problem definition • Data collection and analysis • Highest and best use analysis • Land (site) valuation • Application of Approaches to Value • Reconciliation and Final Estimate • Appraisal Report

13. Three Approaches to Value • Market Approach (Sales Comparison) • Cost Approach • Income Approach

14. Market Comparison Approach Sales ComparisonSubject Comp1 Comp2 Comp3 Price $146,000 $138,000 $136,000 Pool No Yes No No Garage Yes No Yes No Adjustments Pool -$5,000 Garage $2,000 $2,000 Adjusted Price $143,000 $138,000 $138,000 Weights 30% 40% 30% Estimated Value$139,500 $42,900 $55,200 $41,400

15. Cost Approach • Seeks to Estimate Replacement Cost not Reproduction Cost • Depreciation is the reduction in value because of age and use. Not the same as accounting depreciation • Physical Depreciation • Functional Depreciation (technologically obsolete • Economic Depreciation (brought about by a change outside the property)

16. Cost Approach (continued) • Land Value = estimated by mkt comparison • Construction Cost • House • Patio • Garage • Minus Depreciation • Equals Appraised Value

17. Income Approach • Calculation of Net Operating Income (NOI): • Scheduled Gross Income • Less vacancy allowance • Less Operating Expenses • Property Taxes • Insurance • Maintenance • Reserves • Other • Equals Net Operation Income (NOI)

18. Income Approach (continued) • Value = NOI/ Cap Rate • Cap Rate = Capitalization Rate (C) • C = k – g, • k = required return, • g = growth in NOI expected. • Appraiser knows Cap Rate by looking at the market.

19. Income Approach (continued) • Gross Rent Multiplier is a shortcut method. • Gross Rent * GRM = Value In traditional appraisal theory, the appraiser uses all 3 methods (market, cost, & income) and develops a weighted average estimate of value.

20. Homework • Problems 1 (do the analysis for the conventional mortgage only) on page 173 • Problem 2 on page 174