Understanding Real Estate Finance

In the blog post on benefits of owning real estate, I touch upon how single family rental real estate is a self-hedged investment. How, it tells you when to buy and when to sell. For those on the sidelines timing the market and waiting for the right time to get into real estate investing, I write this post. The questions are: Can you time the market? Should you buy at rock bottom?

If you are new to these posts, please read “Getting a Mentor” and “Getting Started” first. We discuss owning and operating single family rental residential real estate in the Dallas, Fort Worth, Denton area or the DFW metroplex. At times, like in this post, we discuss broader items that apply to Real Estate investing and the economy as a whole.

So, the topic of the day is can I time the market? I think understanding flow of real estate finance is key to answering this question. Unlike most things, home buying is not done with one’s own money. It’s a leveraged purchase. So what’s more important is the willingness of someone or some entity to loan money towards a home purchase. The total amount of money available for home loans will generally dictate the total volume in home sales. Take a look at this picture and then we’ll walk through it:

Real Estate Finance Flow

Real Estate Finance Flow

On the left you have one end of the chain of events, the buyer and on the right you have the other end, the investors. When we say investors here in this article, we are not talking about real estate investors (like we do in other places in this blog). Here we are referring to investors who buy and sell what’s called Mortgage Backed Securities. We’ll get to that. Let’s go back to the left for now….

As a buyer, home buyer or rent house buyer, you get a loan from a bank (assuming it’s not a cash purchase). We have discussed benefits of leverage before. The bank in turn needs to maintain a “reserve” of at least 10% of all outstanding loans (or liabilities). To achieve this they can borrow from other banks at “federal funds rate” (a.k.a interest rate) or as a last resort directly from the Federal Reserve at “discount rate”. The interest rate you pay on your loan – prime rate – is derived from what the banks pay each other. Today’s prime rate is 3.25%. These are for prime borrowers.

So, if your house costs $100K and the bank gave you $100K, you would have to assume that the bank had $100K to give from deposits and other interest earnings and of which they have to keep at least $10K as reserve. Except for the originating fees of 1 or 2% of the loan amount that the bank immediately collects, it will take the bank 30 years (in general) to collect the loan back. In this model, it is very difficult for the bank to continue to provide loans.

To avoid waiting for sufficient deposits and for interest earnings to accumulate, and to be able to make more loans, the banks quickly turn around and “sell your loan” to investment banks, Fannie Mae and Freddie Mac. Selling a loan means that they are selling some rights to collect payments from you to the investment banks. Bundled in these rights could be the right to foreclose if you don’t pay. The investment banks pay the lending (originating) bank a discounted value of the entire loan amount. This is calculated using current value of future amount method. That is, if the bank will collect $100K only after 30 years, how much should they be satisfied with right now? This “discount note value” is what the investment bank pays the originating bank.

The investment banks collect thousands of such discounted notes from the lending banks and creates “securities” with those rights. Any time, there’s an income stream, a security can be created from that stream. Given that the investment banks are collecting your monthly payment (or a part of it), and will collect it for an extended period of time, they have an income stream. They pool such income streams and issue securities based on these pools. This is very similar to a company issuing stock and the stock trading based on the company’s earnings. These securities are called Mortgage Backed Securities (MBSs). It’s a kind of a collateralized debt obligation or CDO. That is debt paid back over time on an asset that serves as a collateral. Your home or rent house is the asset.

The investment banks sells these MBSes in the “open market”. Typical buyers of MBSes are those that traditionally bought very safe investments like pension funds, governments, states and the Federal Reserve itself. However, since the crash of 2008, the only significant buyer of MBSes is the Federal Reserve. US treasury bought MBSes to boost the housing market. US treasury sells treasury notes that creates national debt. The single largest foreign holder of US debt is China.

We started by stating that volume of home sales and therefore home prices, go up based on the total volume of money available to fund loans. MBS investors are those that fund these loans (through an enormous labyrinth of complicated interactions between lending banks, investment banks, US treasury and the Federal Reserve). Federal Reserve completed their planned purchase of $1.25 trillion worth of MBSes in 2010. US Treasury steps in and purchases MBSes when they decide to prop up the housing market. As we all know this is borrowed money, a large part of it from China.

Now, that you understand the complexities behind real estate finance and how the market has a long way to go before independent investors can come back in to fund the loans, it must be now apparent to you that the players are not free market based. These are powerful governmental players with a printing press. There is no rational way to speculate their actions and so there is no rational way to time the real estate market.

To invest in real estate, in and around the Dallas, Fort Worth, Denton metro areas, read our blogs, get a mentor and get started. There’s a correct way to invest in real estate in every real estate market. It’s data driven and not speculative. Waiting to time the market is simply lost opportunity. Get a mentor, get started and build passive streams of income.

About Bernie

Bernie is a distinguished technologist (Motorola heritage). He along with his wife invest in residential real estate in north and central Texas. Bernie loves to teach, both technology and real estate investing and so authors posts on this blog. You can reach Bernie at mentor@buysellmls.com.
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2 Responses to Understanding Real Estate Finance

  1. Debra says:

    How would real estate finance work without a central bank artificially setting interest rates? And would it work better without a national debt?

  2. Bernard says:

    It would work great for some people! There will be very few home owners and a lot of tenants. The way Real Estate financing works in our country is the greatest opportunity distributor and if you know what to do, it will be a great wealth provider.

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